Problems Surrounding Japan's Taxation Systems

Debates over tax reform have heated up lately. In parallel with discussions in the government tax commission that began in January, the Council on Economic and Fiscal Policy has been working toward compiling a set of proposals in June.

Indeed, with the government's short-term measures-fiscal and monetary policies in particular-stuck in a quagmire, expectations are growing for tax reform to give a much-needed shot to reviving the economy and setting Japan on a mid- to long-term recovery path. The underlying motive behind this is a desire to follow the United States and Great Britain, where comprehensive tax reforms respectively initiated by President Ronald Reagan and Prime Minister Margaret Thatcher led to remarkable economic recovery. However, is it possible to revive Japan's economy by implementing tax reform? If there are things Japan can learn from the U.S., what are they? Even if Japan finally comes to understand the specific tax reform measures needed, will it be able to actually implement them? In this article, I would like to discuss and answer these questions from a political economic standpoint.

Let me first examine the tax reform implemented by the Reagan administration in the 1980s. The important viewpoints here are to clarify the roles economics played in this reform and to make a comprehensive assessment of the two stages of tax reform, namely, the Economic Recovery Tax Act of 1981 (ERTA) and Tax Reform Act of 1986 (TRA86). Among the centerpieces of the first stage of tax reform were substantial tax breaks on corporate investment, such as introducing an accelerated depreciation method and giving greater tax credits for investment-related expenditures. Behind these sweeping tax cuts was Harvard University Professor Martin Feldstein's elaborate empirical analysis of the late 1970s, in which he pointed out that inflation tends to cause under depreciation and place a greater tax burden on companies, thereby exerting a negative impact on capital accumulation. Thus, the U.S. had already accumulated data on the potential effects of tax incentives before launching its tax reforms. The subsequent disinflation that proceeded to a greater-than-expected degree in the 1980s, however, gave rise to a new perception that such investment tax breaks simply benefit smokestack industries and real estate investment. (ERTA was thus perceived to have ended up being an "unintended Keynesian macroeconomic policy" rather than supply-side policy.) In the second stage of tax reform in 1986, the U.S. government corrected its course, scaling down or abolishing special tax breaks-including those considered to be a hot bed for taxation loopholes-while reinforcing capital gain tax. The government simplified the income tax system, substantially lowering income tax rates and expanding the taxation basis at the same time. The first- and second-stage tax reforms together brought down the maximum income tax rate from 70 percent to 28 percent and reduced the number of tax brackets from 15 to 2. (Tax reform in 1993 raised the maximum income tax rate to 39.6 percent and the number of tax brackets to 5.)

Lesson from the U.S. experience
The lesson Japan should draw from the Reagan tax reforms, if any, would be the "spirit of the 1986 reform," specifically, taxation basis expansion through a reduction of special tax breaks, a substantial cut in the maximum tax rate and simplification of the taxation structure, all of which were carried out without hampering the neutrality of taxation.
As a means of revitalizing the economy, people tend to think about revitalizing the corporate sector, thus jumping onto the idea of reducing tax burdens on companies. Under the current circumstances in Japan, it would make certain sense to provide tax incentives for capital investment to encourage research and development activities and promote start-up businesses. However, it is quite unlikely that cost factors, including tax burden, are the prime reason behind the ongoing stagnation in capital investment; the strong sense of uncertainty Japanese companies hold for their future would be the more likely cause that needs to be addressed. Thus, the intended impact-enhancing the entrepreneurial spirit, in particular, of new and small businesses-will more likely be generated by promising greater returns on success; i.e., a drastic cut in the maximum income tax rate.

Income taxes and small business performance
A series of studies by Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey S. Rosen have brought interesting facts to light. Using a large volume of panel data on the self-employed in 1985 and 1988, they compared the business performance of small companies before and after the 1986 tax reform. Their studies found that the lowering of the marginal tax rate had positive impacts (on a scale economically meaningful) on those companies' investment, employment and growth. Meanwhile, R. Glenn Hubbard, chairman of the Council of Economic Advisers (CEA) and Columbia University Professor William M. Gentry focused on the progressiveness of income tax. Using panel data on American households, they confirmed that moderation in the progressiveness leads to the promotion of start-up businesses.
Japan's maximum income tax rate is currently 37 percent, among the lowest among developed countries. This effect, however, is substantially reduced when combined with local residential taxes. Considering the fact that the U.S., at one time, reduced the maximum income tax rate to 28 percent, Japan seems to still have some room for further reduction. As work and employment styles diversify in Japan, it may no longer be a dream at some companies that an employee with outstanding performance might earn a better salary than the company's president. As a way to enhance such a spirit of challenge, further reduction of the maximum income tax rate and simplification of the taxation system are options worth considering.

In considering any tax incentives for economic revitalization, it is imperative to boldly cut down on numerous special tax breaks and simplify the taxation system. To achieve this end, however, we must re-examine, from a political economic viewpoint, the reasons why so many special tax measures have been implemented through yearly tax reforms, resulting in today's complex taxation system.

Political process behind the taxation system
Taxation system reform, which affects both profits and incentives for economic entities, is one of the most important of economic policies. Compared to other economic policies and reforms, however, taxation system reform is under far greater political influence. The Finance Ministry and the government's tax commission do plan and draw up tax reform measures. The ruling Liberal Democratic Party-more specifically, its Tax System Research Commission-asserts far greater power in the final decisions on tax reform than it would in any other economic reform. Indeed, the LDP's tax council is so powerful that it often overturns the Finance Ministry's proposals. Then, why is tax reform subjected to such strong political influence? Even the slightest change in the taxation system has a direct and explicit impact on people's lives, increasing or decreasing their tax burden and altering the ways in which wealth is redistributed. Things that involve the redistribution of wealth through direct burden tend to become a political issue. The same tendencies can be seen with pension programs and other social security systems.

The taxation system in view of "transaction-cost politics"
Such strong political pressure and intervention often spur bureaucrats to chose and draw up policies that will cause the least political friction and cost. This has been termed "transaction-cost politics" by Princeton University Professor Avinash K. Dixit. It explains why taxation authorities insist on a consumption tax hike as a means of increasing revenues. Any other form of tax increase would have a negative impact on a specific group of people and resistance by politicians representing the interests of that specific group would inevitably become stronger. With a consumption tax hike, in which increased burden is broadly shared, bureaucrats are able to avoid the redistribution problem and face less resistance from politicians with special interests. At the same time, however, a consumption tax hike is a "measure of last resort" in the sense that it virtually affects the interests of all people and thus can destabilize the very foundation of an administration. Therefore, whenever the government tries to implement a tax reform affecting a specific group of people, "give-and-take transactions"-promises to implement other tax reform measures to compensate the specific interest group-take place among politicians as well as between politicians and bureaucrats. That is, various balancing transactions for the sake of smooth implementation, rather than designing optimum policy, take place, resulting in numerous ad-hoc special tax breaks that erode the taxation base.

The taxation system and its "historical path-dependence"
Therefore, it is often unclear why certain preferential taxation schemes have been introduced. Textbooks on Japan's taxation system provide only historical accounts, using such typical phrases as "since the so-called Shaup taxation system." This reflects the difficulty in finding any consistent theory or principle to explain Japan's taxation system, which has evolved into what it is today by incorporating "products of political compromise" from time to time. The same applies to Japan's pension systems. Institutional frameworks under strong political influence, such as taxation and pension systems, are strongly characterized by what comparative institutional analysis calls "historical path-dependence".

Beyond political cost and resistance
Understanding all the processes involving tax reform explains why economists' proposals for tax reform differ from bureaucrats' opinions. For instance, economists may argue that the government should introduce identification numbers for taxpayers and increase the number of tax officers at local taxation offices. For bureaucrats concerned with the political processes involved, however, this would be an option hard to swallow; that is, any policy that would bring politicians' incomes under a bright light would be too costly in terms of "political transaction cost" and hardly feasible. (They learned this bitter lesson in their attempt to introduce a green card system in the past.) In order to narrow the gaps, both economists and bureaucrats need to understand the role of the political process and its derived distortions.

Thus, the process of reducing or removing various special tax breaks-restructuring the taxation system-is bound to face extremely strong political friction and resistance. And if expansion of the tax base is pursued, it will inevitably bring into view introduction of a taxpayer identification number system, politically the most costly option. Unless the courage is found to squarely face and overcome such political resistance, based on a thorough understanding of the scale of political cost, there would be no successful taxation system reform in the 21st century.

In this column, I have tried to give a picture of a desirable corporate tax system based on lessons from the U.S. tax reforms under the Reagan administration. I have also pointed out the need to overcome political resistance to carry out a drastic reduction of numerous special tax breaks and expand the taxation base through the introduction of a numbering system for taxpayers. Of course, problems surrounding tax reform are diverse and there remain a number of subjects that need to be studied. Indeed, the Council on Economic and Fiscal Policy has listed up a number of items covering various fields as subjects for their discussions. However, a reform with too many goals is not necessarily a good reform. This holds true all the more for a package of tax reform measures, which tends to include a number of preferential measures as a result of political give-and-take transactions. By drastically narrowing the focus, we may be able to make the reform more effective. In doing so, we have to have a clear vision as to what is lacking in today's Japanese economy. I believe, that it is extremely important that economic entities have a spirit to challenge and compete in "experiments" of various business models. As a way to promote entrepreneurial spirit, I have discussed how we can reform the income tax system. To promote "experiments" in the public sector, for instance in the field of education, it is necessary to make local governments self-reliant. (For this, the current system of channeling the central government's tax revenues to local governments must be reviewed and greater taxation authority should be given to local governments.) I sincerely hope that economic revitalization will finally be realized as we proceed with bold tax reforms targeted at crucial areas by overcoming political friction and resistance.

March 28, 2002

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