The following OECD assessment and recommendations summarise chapter 4 of the Economic survey of Japan published on 7 April 2008.
Fiscal consolidation will require increased tax revenues, preferably as part of a comprehensive tax reform
Given the substantial primary budget surplus needed to stabilise the government debt ratio and the difficulty of significantly reducing spending, achieving the fiscal targets will require as much as 6% of GDP in additional revenue in coming years, according to a government estimate. Moreover, reducing the debt ratio would require even more revenue. The government should implement a comprehensive reform of the tax system to raise the necessary revenue. However, it is important to boost revenues in a way that limits any negative impact on Japan’s growth potential in the medium term. Moreover, changes in the tax system should be phased in so as to help sustain the current economic expansion. At the same time, an overhaul of the tax system should address the upward trend in income inequality and improve the local tax system. Tax reform should thus aim at balancing the objectives of efficiency, equity and simplicity.
Revenue should be increased primarily through a hike in the consumption tax rate…
The negative impact of taxes on growth can be minimised by shifting the composition of taxes from direct to indirect taxes. Given the need for additional revenue in Japan, the amount of direct tax revenue should be maintained while increasing indirect tax revenue. This requires a hike in the consumption tax rate from its current level of 5%, the lowest in the OECD area. A one percentage-point hike in the consumption tax rate would boost government revenue by about ½ per cent of GDP. In seeking additional revenues in this area, Japan should maintain a single consumption tax rate applied to a broad tax base and retain flexibility in allocating the additional revenues.
Japan has the lowest value-added tax rate among OECD countries
Standard rate in 2006
Source: OECD (2006), Consumption Tax Trends, OECD, Paris.
… while broadening the corporate income tax base and cutting the rate to promote growth…
This should be accompanied by broadening the corporate tax base by cutting tax expenditures and reducing generous deductions, thereby lowering the proportion of firms that do not pay tax. Indeed, only one-third of firms – and one-half of large firms – pay corporate taxes. Broadening the tax base would enhance potential growth by improving the allocation of resources and investment. The additional revenue generated by base-broadening would allow some reduction in the corporate tax rate, currently the highest among OECD countries at 40%, to a level closer to the OECD average of 29%, which would also promote growth. The negative effect on tax revenue from such a rate cut would be limited by positive supply effects, notably increased investment and a larger corporate sector.
Japan has the highest corporate income tax rate among OECD countries
1. Basic combined central and sub-central (statutory) corporate income tax rate. Averages are un-weighted.
2. Excludes Luxembourg.
3. Includes 17 OECD countries.
Source: OECD (2007), Tax Database, OECD, Paris (www.oecd.org/ctp/taxdatabase); European Commission (2006), Structures of the Taxation Systems in the European Union; and OECD (2007).
… reforming the personal income tax system, in part to reverse the deterioration in income inequality…
There is also considerable scope for boosting revenue by broadening the personal income tax base, given that less than half of wage income is taxed. This partly reflects the large deduction for wage earnings, which exempts more than a quarter of employees’ earnings from the tax base, in part to improve horizontal equity between employees and the self-employed. A reduction in the exemption for wage income must be accompanied by measures to increase the proportion of self-employed income that is taxed. Higher personal income tax revenue resulting from base broadening would help to offset any decline in corporate taxes, thus maintaining the overall level of direct taxes. A greater role for the personal income tax, which has a positive impact on income distribution, may also be beneficial from an equity perspective. The additional revenue from base broadening could be used to finance an Earned Income Tax Credit, as well as perhaps reducing personal income tax rates so as to increase work incentives. An Earned Income Tax Credit provides support to low-income households while strengthening work incentives, although there could be difficulties in administration and possible fraud. Such an approach is likely to be effective in Japan, given its relatively wide earnings distribution, low taxes on labour and low benefits for the non-employed. In addition, equity concerns should be met by strengthening the inheritance tax, which is applied to only 4% of persons at the time of death. Finally, elements of the personal income tax system that discourage work – such as the exemptions and deductions for secondary earners should be reformed, while improving the taxation of financial income to reduce distortions in the allocation of capital, thereby promoting growth.
The share of wage income subject to tax in Japan is relatively low
International comparison of wage income subject to personal income tax
at the central government level in 2006
Source: Ministry of Finance, National Tax Agency and OECD (2006), Taxing Wages 2005 2006, OECD, Paris.
… and improving the local income tax system
Tax reform should also focus on improving the local tax system, which is exceptionally complicated, with 23 taxes, while allowing only limited autonomy to local governments. Barriers to the effective use of existing powers to set local tax rates should be removed. The priority should be to phase out the local tax on corporations, while increasing revenue through the existing local taxes on personal income, consumption and property. Such taxes are more stable and have less adverse effects on the potential growth rate than taxes on corporations. Raising the overall consumption tax rate would boost the local consumption tax rate if it remains at a quarter of the national rate, thus providing additional revenue to local authorities. In addition, the effective rate of tax on property should be increased by bringing property evaluations closer into line with market prices. Greater revenue from these taxes would more than offset the abolition of local taxes on corporations, which are excessively volatile and discourage employment and investment. Moreover, eliminating the local corporate tax would bring the overall statutory rate more into line with the OECD average and thus have a positive impact on growth.
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For further information please contact the Japan/Korea Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by Randall S. Jones, Masahiko Tsutsumi and Taesik Yoon under the supervision of Stefano Scarpetta. Research assistance was provided by Lutécia Daniel.