Japan’s “growth strategy”

Corporate taxes (1): Room to cut based on “two balances”

The main points are: 1) the size of the tax cuts; 2) the speed of the cuts; and 3) the expansion of the tax base.

The first needs to be based on two balances: 1) between the national and regional components of the tax; and 2) between the consumption tax (VAT) and the corporate tax. Japan has both national corporate taxes and local corporate taxes, the latter comprising an enterprise (or income) tax and an inhabitant’s tax. Internationally, corporate taxation by local governments is not widespread, and the only major economies to apply local corporate taxes at an elevated rate of around 10% are Japan, the US and Germany (Figure 1).

The US and Germany have federal systems comprising individual states. By definition, these states are local governments. Although there are some constraints in relation to the federal or national government, these states function in a manner resembling national governments, eg, they hold legislative powers. From this viewpoint, it perhaps makes sense for the local governments of the US and Germany to tax companies at a somewhat elevated rate. In Japan, however, local governments (prefectures) can only enact ordinances within the scope of laws established by the national government. Among major economies, Japan is the only one without a federal system that has local governments able to apply an elevated tax rate on corporations. From this viewpoint, cuts to the effective corporate tax rate in Japan may need to take place primarily at the local government level.

Now consider the balance between the consumption tax rate and the effective corporate tax rate. Plotting the indirect tax rate (eg, the consumption tax in Japan, the VAT in other economies) on the vertical axis and the effective corporate tax rate on the horizontal axis for major advanced economies and Asian economies where Japan outsources much of its production, we can see a broadly similar relationship, whereby “indirect tax rates ≒ effective corporate tax rates – 15.”

Japan is an outlier, as evident from its position in the lower-right corner of the chart. In short, Japan has an extremely high corporate tax rate relative to its consumption tax rate. Assuming the consumption tax is raised to 10% in October 2015 from its current 8% as planned under existing legislation, Japan needs to lower its effective corporate tax rate to 25% from the current 35.64% in order to have a “normal” balance.

Corporate taxes (2): Ideal to reach targeted rates within four years

The next focus is how fast the targeted rates should be reached. Looking at the effective corporate tax rate since 1950, we see that reductions have generally been gradual. One exception was the cut from 49.98% in 1997 to 40.87% in 1999. However, this was primarily a cut to the national tax rate, whereas we argue above that cuts need to be made to the local tax rate.

The right of local governments to tax is legally recognized under Article 2 of the Local Tax Law and Article 223 of the Local Government Law, with the rate itself decided by local government ordinances, as stated in Article 3 of the Local Tax Law. The government is not authorized to freely move the local tax rate up and down.

However, the national government is able to exercise considerable influence because it sets a “standard tax rate” (“the rate that should ordinarily apply, provided there are not any special fiscal circumstances” according to the Local Tax Law) for the two local corporate taxes (enterprise and inhabitant’s taxes).

That said, with nationwide regional elections scheduled for April 2015, cutting these rates could prove politically difficult. In this sense, we believe there is still a risk of gradual cuts this time around.

For the market to sense a strong commitment by the government, how fast should the tax rate be lowered to targeted levels, eg, 25%? One ideal might be within four years. This would overlap with the maximum tenure of Prime Minister Abe, who has consistently called for corporate tax cuts.

Mr. Abe has shown a strong intention to include such cuts into this month’s “big bone” economic and fiscal reform plan. He has also emphasized that the rate cuts need to start from FY15. The longest PM Abe can remain in office as LDP president is until September 2018, based on the current LDP Constitution.

If so, Mr Abe could be involved (as PM) in drafting budgets through FY18. If he indicates a plan to reach the targeted corporate tax rate within four years, from FY15 to FY18, market participants would likely sense his strong political commitment to lowering the corporate tax rate.

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