Priorities for the Japanese Economy in 2016 (January 2016)

Working toward the Introduction of Refundable Tax Credits

Faculty Fellow, RIETI

In 2015, the Shinzo Abe administration committed to two unwise economic policies. One is the increase in the minimum wage, and the other is the application of a lower consumption tax rate on food products. At a glance, they may seem like two separate policies. Yet, they are similar in that they are both designed to secure the living standard of low-income households, may cause a side effect by distorting pricing structures, and have a better alternative policy, i.e., the introduction of the refundable tax credit system.

Concerns over the increase in the minimum wage

In the meeting of the Council on Economic and Fiscal Policy on November 24, 2015, Prime Minister Shinzo Abe revealed his plan to raise the minimum wage at around 3% per annum to bring it to 1,000 yen per hour on a national weighted average. The 2015 minimum wage stands at 798 yen on a national weighted average. At the rate of 3% per annum, the target can be met in eight years.

In 2007, the government amended the Minimum Wage Act to facilitate continuous increases in the minimum wage so that it surpasses the level of welfare transfer. The amendment was aimed at addressing the criticism over the fact that welfare recipients received more than what minimum wage workers earned. The national weighted average of regional minimum wages was 673 yen in 2006 and rose by 125 yen over the last nine years, which translates to a just under 2% increase per annum. Considering this past track record and in view of the growing momentum for wage inflation, Prime Minister Abe's target is reasonably realistic and likely to be implemented as it is.

However, compared to the minimum wage hike over the last nine years, the increase in the next eight years will have a greater impact on actual wages. Currently, different minimum wages are set from prefecture to prefecture. Reflecting upon each prefecture's average wages and other factors, the minimum wage is higher in high-wage regions such as Tokyo and low in low-wage regions such as Okinawa. Until 2007, the regional variations in minimum wages were not as great as variations in actual wages. For this reason, the minimum wage had little impact on actual wages in high-wage regions but had a strong impact in low-wage regions. However, following the 2007 amendment of the Minimum Wage Act, the minimum wage of high-wage regions including Tokyo and Kanagawa was raised substantially, emerging as a major factor impacting the level of actual wages even in these regions. As of October 1, 2015, Tokyo's minimum wage is 907 yen per hour. Its influence in actual wages is clear, judging from a swarm of job advertisements offering an hourly rate of 910 yen. The impact of the increase in the minimum wage was limited over the last nine years as the increase mainly occurred in regions where the minimum wage did not bind. Now, however, no prefecture is free from the impact of minimum wage. The increase in the minimum wage over the next eight years will thus affect actual wages more than ever before.

A potential drawback of the minimum wage hike is the loss of employment opportunities for low-skilled workers. According to several studies I conducted with fellow researchers, even before the 2007 amendment of the Minimal Wage Act, the increase in the minimum wage has had the effect of decreasing jobs for middle-aged women and youths (Kawaguchi and Mori, 2008; Kambayashi, Kawaguchi and Yamada, 2014). Another study pointed to the drop in the employment rate among teenagers following the increase in the minimum wage since 2007 (Kawaguchi and Mori, 2013). There is a notion that a higher minimum wage would make inefficient companies incapable of paying higher wages exit, and redistribute the workforce to companies with higher productivity. In reality, however, increasing the minimum wage leads to forcing low-skilled workers with low productivity to exit. In particular, we must not ignore the workers who have only completed junior high school (up to Grade 9), accounting for around 5% of the young working population aged 25 to 29. The number of jobs available to them is gradually decreasing, causing their employment rate to contract year after year (Arai, Ichimura and Kawaguchi, 2015). It is necessary to squarely face the prospect that further increases in the minimum wage could deprive these least advantaged people of employment opportunities.

Refundable tax credits is a policy that can boost the income of low-skilled workers without robbing them of job opportunities. It allows a substantial tax credit to low-income earners, and, when the amount of tax credit exceeds the person's total tax liability, the difference is refunded to the taxpayer. The system has already been introduced in the United States, United Kingdom, and Canada. This policy has advantages over social welfare payments or increases in the minimum wage. The system does not undermine people's motivation to work, unlike social welfare, in which increased earning reduces the amount of payments. It also does not erode corporate drive for creating jobs, as, unlike an increase in the minimum wage, the system does not force companies to hike their wages. The issue is how to finance such a scheme. According to micro-simulation by Shiraishi (2010), introducing a system similar to that of the United States would require 1.3 trillion yen in fiscal funding.

Concerns about adopting a lower consumption tax rate on food

Many economists have voiced their opposition to the application of a lower consumption tax rate on food products. I share their view. A lot of them pointed to the procedural issue, which is easy for the general public to understand, but I suspect their real concern lies in the distortion of pricing structures and resulting disparity in the distribution of resources. Economists have learned that a pricing structure determined by supply-demand balance enables efficient distribution of resources as a result of decentralized decision making. They share strong aversion toward governments distorting relative prices. From this perspective, the elasticity of substitution between food services (e.g., eating a beef bowl at a restaurant) and processed foods (e.g., buying a bento box and eating it at home) is greater than the elasticity of substitution between processed foods (e.g., buying a bento box and eating it at home) and perishable foods (e.g., vegetables, meat, fish). Thus, drawing a line between food services and processed foods, which was the final decision, would cause a more significant distortion than drawing a line between processed foods and perishable foods. In relation to this argument, some economists promoted the refundable tax credit system as a way of assisting low-income earners, but retreated from the discussion table at an early stage. Their proposal was a perfectly practical suggestion, considering the findings of the aforementioned simulation by Shiraishi (2010) and the facts that the latest decision to apply a lower tax rate to food products has created a fiscal hole of one trillion yen, and that the fiscal shortfall would have been 1.3 trillion yen if the lower tax rate were to be applied also to food services, as considered at one stage.

Working toward the introduction of refundable tax credits

The introduction of a reduced consumption tax rate may have been a politically inevitable conclusion due to strong insistence by the Komeito Party, part of Japan's ruling coalition. Some say that economists must wholly accept such a political constraint when providing a policy suggestion. This argument has its merit, but some constraints turn out to be non-constraints, as logical persuasion could always change people's mind. I cannot help but wonder whether the Komeito Party could have changed its mind if the concept of refundable tax credits had been more widely known, especially among Komeito supporters, as a more logical option for assisting low-income earners. The recent launch of the "My Number" social security and tax system that assigns a unique identification number to each resident has made the introduction of refundable tax credits more realistic. A team led by Chuo University Professor Shigeki Morinobu has been researching this system for many years. In 2016, I hope to see a broader group of researchers explore the concept to add depth to policy discussions.

December 25, 2015
  • Arai, Yoichi, Hidehiko Ichimura, and Daiji Kawaguchi, 2015. "The educational upgrading of Japanese youth, 1982-2007: Are all Japanese youth ready for structural reforms?" Journal of the Japanese and International Economies, vol. 37(C), pages 100-126.
  • Kawaguchi, Daiji and Yuko Mori, 2009. "Is Minimum Wage An Effective Anti-Poverty Policy In Japan?" Pacific Economic Review, vol. 14(4), pp. 532-554.
  • Kambayashi, Ryo, Daiji Kawaguchi and Ken Yamada, 2013. "Minimum wage in a deflationary economy: The Japanese experience, 1994-2003," Labour Economics, vol. 24(C), pp. 264-276.
  • Kawaguchi, Daiji and Yuko Mori, 2013 "Minimum Wages and Youth Employment in Japan: The impact of the 2007 revision of the Minimum Wage Law," Fumio Ohtake, Daiji Kawaguchi, and Kotaro Tsuru (eds,) Minimum Wage Reform, Nippon Hyoronsha Co., Ltd.
  • Shiraishi, Kosuke, 2010, "Income Security through Refundable Tax Credit," Board of Audit Journal, vol.42, pp. 11-28.

January 8, 2016