One Year until the Consumption Tax Hike - Aiming for a tax system centered on consumption tax

SATO Motohiro
Faculty Fellow, RIETI

The consumption tax rate is expected to increase from 8% to 10% on October 1, 2019. This tax hike has been postponed twice already (in October 2015 and April 2017). One of the reasons for this is that the economy experienced a significant downturn due to the temporary last-minute surge in demand prior to the hike and the subsequent rebound when the consumption tax rate was hiked by 3% in April 2014.

However, as the ratio of national and local government debt to gross domestic product (GDP) has exceeded 200% and social security-related expenses can be expected to increase with the growth of aging population, fiscal reconstruction is becoming a pressing issue. The government has pledged that it will achieve a primary balance surplus on both the national and local government by 2025. In order to put an environment in place that will make a consumption tax hike possible, the government aims to control economic fluctuations, such as the temporary last-minute surge in demand prior to the hike and the subsequent rebound, and to level off demand fluctuations, and in doing so, ultimately to stabilize economic fluctuations.

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Although consumption tax is a strong source of revenue and is stable because revenues are not very susceptible to economic trends or changes in the demographic structure, it has been criticized that it is regressive and is a burden to low income earners. However, from the perspective of economics, consumption tax is a multi-stage distribution transaction tax that is levied through income tax and corporate tax. This mechanism in which consumption tax incurred on business transactions is not accumulated, is called an input tax credit. A taxable business provider can deduct the consumption tax paid for inputs such as raw materials from the consumption tax on sales. In contrast, a consumer has to bear consumption tax because they are not a business provider subject to taxation and accordingly, they cannot receive input tax credits. For this reason, the consumption tax burden do not affect the production process. Capital expenditures by companies are not inhibited either, because they are subject to immediate deductions.

On the other hand, corporate taxes can have a negative effect on economic growth, including reductions in capital expenditures.

Consumption tax is also neutral in terms of the international competitiveness of domestic firms. Because the destination principle is applied, in which taxation occurs at the country where the products and goods are consumed, imports are subject to taxation, while the tax rate on exports is zero. Japanese consumption tax has no effect on domestic exporters that compete in markets overseas. On the other hand, because imports from overseas are subject to consumption tax, competing domestic taxable business providers do not suffer any disadvantages.

In contrast, corporate tax that adopts the source principle of taxation in the country where the business is based and social insurance premiums that are effectively a tax on personnel expenses have the effect of increasing production costs for domestic companies, which hurts their competitiveness compared to products from countries where taxes are low.

Destination principle taxation is becoming increasingly advantageous in a global economy in which people, goods, and money move across national borders. In fact, there is a tax reform trend in European countries of keeping corporate tax and social insurance premiums low and using consumption tax (value added tax) as an alternative. Although a destination-based cash flow tax that was proposed by the Republicans in the U.S. House of Representatives in 2016 was not enacted, it had the same aim of ensuring the international competitiveness of domestic firms.

Due to the input tax credit mechanism and the destination-based approach of consumption tax, from the economic point of view it is favorable compared to other forms of tax, such as corporate tax and social insurance premiums. Production efficiency is satisfied under the economic theory of optimal taxation.

Figure: Ratio of Tax Revenue and Social Insurance Premiums to GDP
Figure: Ratio of Tax Revenue and Social Insurance Premiums to GDP
Source: OECD Revenue Statistics

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Nonetheless, people tend to think that consumption tax has a negative impact on the economy based on their experience of the previous tax hike.

I would like to make a distinction here between the short-term economic climate and medium to long-term growth in economic activities. The short-term economic climate is highly susceptible to macroeconomic demand, including consumption, and can suffer from the impact of a consumption tax rate hike. On the other hand, it is the supply side that determines medium to long-term growth. Structural reforms such as working style reforms and regulatory reforms also aim to improve productivity on the supply side. Consumption tax is a form of tax that does not damage this productivity and tends to promote growth in comparison to other forms of tax.

According to estimates by the Cabinet Office, social security benefit expenditures will increase from 120 trillion yen in FY2018 to 190 trillion yen in FY2040. While it is necessary to work to achieve an appropriate level of benefits, it is also necessary to secure the required financial resources.

If the consumption tax is not increased, it would be necessary to increase social insurance premiums. However, the burden of social insurance premiums is mainly concentrated around working households, and in contrast to consumption tax, a mechanism of social insurance premium does not broadly share the burden among generations. Because insurance premiums for the national pension and national health insurance have a flat rate portion, it is regressive and a burden to low income earners. In addition, social insurance premiums paid by companies, such as employees' pension and health insurance society payments, constitute taxation on regular employment, and can serve as an incentive for the expansion of non-regular employment.

Although consumption tax may be a painful tax for citizens, social insurance premiums, including the adverse effect they can have on employment, are even more painful.

The tax system up until now that has been centered on corporate tax and social insurance premiums was based on the assumption of a population increase in the working generation that supports social security and high economic growth. Going forward, it is necessary to establish a new tax system that is centered on consumption tax in response to a new economic environment that is characterized by factors including the aging of society and the globalization of the economy.

This is not limited to national tax. Along with the hike in the consumption tax, the disparities in local tax revenues (disparities in tax revenues per person) has also been viewed as an issue. Local consumption tax (prefectural tax) is a portion of consumption tax, and 0.5% of the 2% tax hike will be a tax hike in local consumption tax. As a result, the tax increase will be concentrated in large cities such as Tokyo, and disparities in tax revenues from local tax among regions will increase.

The government has said that it will consider new measures to correct the uneven distribution of sources of tax revenue in local consumption tax. The taxes with the most significant disparities are the two types of corporate tax (corporate inhabitant tax and corporate enterprise tax), not local consumption tax. Looking at local tax overall, while the disparity between the maximum and minimum tax revenues per capita is about 2.4 times, it is 6.1 times for the two types of corporate tax (results for FY2016).

The reliance on the two types of corporate tax has brought about not only disparities, but also destabilization in tax revenues for local governments. For example, tax revenues for the Tokyo Metropolitan Government fell by about 1 trillion yen following the Lehman Brothers' collapse in 2008. These two types of corporate tax are not ideal from the perspective of a stable local tax system with few disparities. Local consumption tax should actually serve as the basic tax.

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This consumption tax hike should be used as an opportunity to re-establish the national and local tax systems along with fiscal reconstruction. Therefore, the tax rate will probably not stop at 10% ultimately. The Japan Association of Corporate Executives has recommended a consumption tax rate of 17%. The International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) have also called for a tax hike over 10%.

Of course, it is not ideal to repeat the process of a temporary last-minute surge in demand and a subsequent rebound every time there is a tax hike. Although the government intends to implement major economic measures, relying on such measures alone would go against the progress of fiscal reconstruction. The budget requested for the FY2019 has already exceeded 100 trillion yen, and cost for the economic measures would be in addition to this. It's putting the cart before the horse to further expand fiscal policy for a tax hike.

Instead, we should encourage the flexible passing-on of consumption taxes. Taking the administrative burden into consideration, one option would be to revise the tax-exclusive pricing system recognized under the Act Concerning Special Measures for Pass-on of Consumption Tax, and to make total amount (tax inclusive price) presentation obligatory. While the timing of price changes tend to be under the control of the timing of the tax hike if prices are presented as tax-exclusive, with prices presented as tax-inclusive (total amount), taxable business providers can flexibly choose when to pass-on the increase to consumers.

In addition, the newly introduced tax-qualified invoices can be used for transactions between business providers. Unlike the current book method, if the consumption tax amount is clearly stated on the invoice, the consumption tax amount that is an input tax credit will become self-apparent. By thoroughly ensuring transactions based on the tax-excluded price, it will also work to prevent the unfair demand for price cuts. Mechanisms that make it easy to pass-on tax increases are necessary for putting an environment in place that will make a consumption tax hike possible.

>> Original text in Japanese

* Translated by RIETI.

September 25, 2018 Nihon Keizai Shimbun

October 31, 2018

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