No. 7 — February 18, 2000


Weekly Review

--- by Jon Choy

The prolonged recession, the record number of corporations reporting losses or filing for bankruptcy and the banking industry's stifling nonperforming-loan problems have cut deeply into the tax receipts of Japan's central and subnational governments. The revenue decline has put prefectural and municipal authorities between a rock and a hard place as they try to balance central government directives to pour huge amounts of money into public works projects with their worsening fiscal situation and growing demands from residents for various services. Faced with unprecedented budget deficits, Tokyo Gov. Shintaro Ishihara has outlined a groundbreaking plan to tax large banks operating in the metropolitan area based not on net income but on adjusted gross profits. The proposal has caused a stir in the central government bureaucracy and at the local level because it impacts the national debates over tax policy and local autonomy.

The Ministry of Home Affairs detailed the precarious fiscal health of Japan's 3,255 city, town and village governments in a February 10 report. A record 21 municipalities ran budget deficits in the year ended March 31, 1999, up from 13 the previous year. More troublesome to MHA bureaucrats, the ratio of current outlays — which include personnel costs and debt-service expenses — to discretionary revenues rose 1.8 percentage points to a record 85.3 percent. Fully 85 percent of all municipalities reported ratios at or above 75 percent, the level MHA considers unhealthy.

The picture was not entirely bleak, however. Aggregate municipal revenues rose 2.6 percent to ¥54.2 trillion ($492.7 billion at ¥110=$1.00) in FY 1998; spending totaled ¥52.4 trillion ($476.4 billion), up 1.9 percent. Excluding surpluses carried forward on multiyear projects, local governments ran a combined budget surplus of ¥929.2 billion ($8.4 billion), down only 0.9 percent from the year before. Aggregate tax revenues fell 3.1 percent to ¥18.7 trillion ($170 billion), although part of this drop presumably reflected personal income tax cuts. At the same time, shared revenues from the central government jumped 15.6 percent to ¥5.5 trillion ($50 billion). Total public works outlays were off 1.1 percent at ¥13.8 trillion ($125.5 billion), and those funded exclusively from local revenues dropped 6 percent to ¥8.5 trillion ($77.3 billion). Welfare-related spending, debt-servicing costs and other mandatory expenditures increased 3.4 percent to ¥22.2 trillion ($201.8 billion).

Because of higher demands for social services and the grandiose construction projects initiated by Tokyo at various times in the 1990s to get the economy moving, major urban centers face particularly dire circumstances. The Tokyo metropolitan government, for example, racked up ¥100 billion ($909.1 million) worth of red ink in FY 1998, the biggest deficit in 18 years. The city's outstanding debts are predicted to top ¥7 trillion ($63.6 billion) by the end of FY 1999. Moreover, budget planners project a deficit of ¥620 billion to ¥760 billion ($5.6 billion to $6.9 billion) for FY 2000, which begins April 1.

Faced with this gaping hole in the budget and the still uncertain prospects for the economy (see previous article), Mr. Ishihara proposed to the Tokyo metropolitan assembly February 7 a controversial five-year substitution of a new tax on banks for the local corporate income tax they now pay. Banks with assets of at least ¥5 trillion ($45.5 billion) would be subject to a special levy of 3 percent on their gross profits, adjusted for such "external standards" as the number of employees, capital and other measures of the scale of their operations. Currently, companies that report pretax losses are exempt from income taxes at both the local and the national level. Banks have slashed their tax bills in recent years because they have all the costs related to cleaning up their bad-loan problems and other losses to deduct from gross profits.

During the "bubble economy" period of the late 1980s, Japan's then-top 19 banks alone paid as much as ¥210 billion ($1.9 billion) annually in corporate taxes to the Tokyo metropolitan government. In contrast, city authorities expect revenues from this source to amount to only ¥3.4 billion ($30.9 million) in FY 1999. The governor told reporters that the new scheme would affect about 30 banks and would generate receipts of around ¥110 billion ($1 billion) the first year. Mr. Ishihara justified the switch in tax bases by saying that firms that incur losses still use city services and, in the interest of fairness, corporate tax payments should be linked to public services provided.

The Federation of Bankers' Association of Japan — all 24 of whose members would be hit by the new tax — warned that had the levy been in place in FY 1999, its banks' combined net profits would have been cut by ¥427.5 billion ($3.9 billion). Such a shrinkage would reduce the capital-adequacy ratios used by both the Ministry of Finance and the Bank for International Settlements to judge the financial health of banks. The proposed tax also would effectively eliminate some of the benefits of the central government's recapitalization efforts, which have helped to stabilize the nation's troubled banking system. Since the levy would not apply to them, foreign bankers have been silent. However, if the plan is widened to include all firms, this issue easily could become an international dispute.

Besides the expected sparing between Mr. Ishihara and the banking industry, the daring plan has ignited a furious debate on two points:

Mr. Ishihara's scheme springs from an ongoing discussion of comprehensive tax reform. In several interim reports, the central government's Tax Commission had floated the idea of encouraging municipalities to impose their own taxes. One suggestion involved the use of "external standards" as the yardstick for corporate tax liability. Commission members have argued, however, that changes in the corporate tax system must be part of an overall reform effort aimed at reducing the government's dependence on direct taxes while getting more money from indirect taxes, such as the consumption tax. Central government tax authorities are unhappy that Mr. Ishihara has forged ahead with his plan because the controversy could complicate their campaign for an overhaul of the tax code. Analysts disagree, arguing that the governor's bold maneuver might force bureaucrats and politicians to move faster on comprehensive changes.

Elected officials in other major urban centers and prefectures have taken great interest in Mr. Ishihara's proposal. While some have called it unfair to banks and have chastised the Tokyo governor for not first consulting with potentially affected banks or with central government policymakers, many also have said that they would impose a similar tax if Mr. Ishihara's initiative succeeds. Prefectural and metropolitan leaders also laud Mr. Ishihara's move as a turning point in their effort to develop greater autonomy. As the national government prepares to reorganize its ministries and agencies at the start of 2001, local officials are clamoring for more authority to address the issues of greatest importance to their constituents.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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