Tokyo Style: A Child of the Tax Code

Richard Katz (The Oriental Economist)

The original article appeared in the June issue of The Oriental Economist, posted here with permission of the author.

A failed stockholders' revolt at clothing-maker Tokyo Style recently put a spotlight on the tendency of Japanese corporations to hoard cash. Tokyo Style is holding \122 billion ($954 million) in cash and securities because its outlets for profitable investment are so poor. Investors consider the firm so wasteful of money that its market value is only ¥107 billion – less than the cash it holds. Yet banks, insurers, and other ‘stable shareholders' backed up management against recent demands that the firm distribute the excess cash to shareholders through higher dividends. A good sign is that a few institutional investors, such as trust banks that provide income to clients, have voted with the dissidents.

Still, the tax code reinforces Tokyo Style's wastrel habits.

The Japanese tax system gives incentives for interest income and capital gains at the expense of dividends. This is a mistake on both demand and efficiency grounds.

Currently, the top rate on interest income is 20%.

Long-term capital gains taxes are ordinarily 26%. However, in an effort to prop up stock prices, Tokyo eliminated the entire tax on capital gains on share sales up to ¥10 million ($80,000) on any shares bought after November 2001 and sold by 2005.

The upshot is that both interest and capital gains are taxed at a far lower rate than ordinary income, whose top rate is now 37% (50% with local taxes included).

By contrast, dividend income is generally taxed as ordinary income for individual taxpayers. From the corporate standpoint, interest expenses are deducted from income, reducing corporate taxes. But dividend expenses are not. When the double-taxation (both corporate and individual payment) on dividends is added up, the top effective tax rate in Japan ends up being 71%.

Clearly, the tax system provides strong incentives for firms to borrow rather than issue stock, and for households to put their money into banks rather than the stock market. When householders do invest in stocks, they are induced to accept capital gains rather than to demand dividends.

Dividends have two advantages that would be helpful to Japan. They allow investors to seamlessly and continually shift capital from low-profit firms to higher-profit ones, thereby increasing efficiency in the economy. Secondly, they provide cash income that households can spend.

The OECD comments on how this stifles the shift of capital to new firms who could use it better, saying the system "could ham-per the reallocation of funds from mature companies to their more innovative and fast growing counterparts."

These tax penalties for dividends also worsen Japan's chronically insufficient demand. They deprive households of much-needed income, which they could use for spending or to invest in better firms. High dividends prevent managerial empire-builders from hoarding cash à la Tokyo Style.

Taxes can make a big difference in dividend payout rates. In the US, until the 1980s, the dividend yield averaged 4.3%. But in the 1990s boom, it fell to only 1 to 2% after the capital gains tax was lowered to half the tax rate on dividends.

Yet, current discussion in Tokyo centers on further tax incentives for capital gains, not dividends.