No. 19 — May 12, 2000

Feature Article

A LOOK AT JAPAN'S CONSUMPTION TAX

Hiroyuki Takahashi

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Summary

Every three years, Japan's Tax Commission — an advisory council of about 30 appointed by the prime minister, which includes academics, industry leaders, accountants, tax experts, governors and mayors — issues a comprehensive paper on the state of the nation's tax system. The commission's next report, due out in July, is expected to provide a road map for much-needed tax reforms.

The commission has been studying Japan's budget crisis, a problem greatly aggravated by revenue losses caused by recent tax-relief measures — mainly decreases in individual and corporate income tax rates — and by large increases in the government's deficit spending. It also has been examining new tax issues that have been created by the county's aging population's and low birth rate and by changes to the Japanese economy caused by globalization and emerging information technologies.

According to insiders, the report's authors will conclude that tax increases are necessary and will suggest that the national consumption tax is the best candidate for a tax hike. The commission, however, also needs to discuss whether the consumption tax revenue should be targeted for social welfare spending. The commission's position is sure to be politically charged. Reportedly, for this reason, the publication — originally scheduled for release in April — has been delayed.

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The Current Consumption Tax

Tokyo introduced a 3 percent national consumption tax in 1989 in the face of fierce public opposition. In the 11 years since, however, the public has gotten used to the tax and currently pays a 5 percent tax on all sales transactions, having accepted in 1997 a 2 percent hike that included a newly established 1 percent local consumption tax assessed and collected by prefectural governments. In FY 2000, prefectural governments are expected to raise ¥2.5 trillion ($22.7 billion at ¥110=$1.00), which will amount to 17 percent of the combined prefectural revenue for that year. Half of all prefectural consumption tax revenue is transferred to municipal governments. Thus, despite its continuing unpopularity, the consumption tax constitutes a vital revenue source at every level of government.

General tax revenue for FY 2000, is expected to total ¥48.7 trillion ($442.7 billion), of which 75 percent, or ¥36.5 trillion ($331.8 billion), comes from the three main taxes: personal income tax, corporate income tax and the consumption tax. Japan's almost decade-long recession, however, has dramatically changed the relative importance of these taxes. Revenue from the personal income tax peaked in 1991 at ¥26.7 trillion ($242.7 billion). The shrinkage in individuals' taxable income caused by the recession, compounded by cuts in the personal income tax rates, decreased the government revenue generated by this tax. In FY 2000, it is expected to raise no more than ¥18.7 trillion ($170 billion) — a 30 percent drop from the 1991 high.

A decline in corporate income and in corporate tax rates led to similar revenue decreases in the corporation tax. In FY 2000, corporate tax revenue is expected to drop to ¥9.9 trillion ($90 billion), a 48 percent fall from the record ¥19 trillion ($172.7 billion) collected in 1989.

During the recession, individual and corporate income tax revenues fell ¥18 trillion ($163.6 billion). The consumption tax, however, has remained stable and currently generates about as much revenue as the corporate income tax. The consumption tax is attractive from a revenue perspective precisely because, unlike income taxes, it is insensitive to shifts in the economy's performance. With only minor variability, people always will consume, making the consumption tax a stable source of revenue during recession (see Figure 1).

The consumption tax, however, has not been without problems, the most significant of which has been the rise in the number of businesses that fail to remit assessed consumption taxes. In FY 1998, businesses failed to remit ¥725 billion ($6.6 billion), a 34 percent increase over the year before. In fact, unremitted consumption taxes account for 40 percent of total national taxes in arrears. Consumption tax funds collected by a business are supposed to be temporarily held in deposit until turned over to the government, but some firms hurt by the recession have misappropriated the funds, using them for operating expenses.

Another revenue problem has developed during the recession. Often, small businesses that are struggling to survive in the face of stiff price competition have resorted to the practice of not charging their customers for the consumption tax.

In March 1998, the Ministry of International Trade and Industry conducted a survey to determine how businesses had coped with the previous year's 2 percent hike in the consumption tax. More than 90 percent of businesses surveyed responded that they passed on all or most of the consumption tax to their customers. Indeed, manufacturers and wholesalers almost unanimously replied that the entire tax was passed along to the customer.

Of the retailers surveyed, 90 percent answered that they passed the consumption tax on to the customer; 70 percent of service industry respondents answered the same. However, this practice was reported less frequently by businesses having less than ¥30 million ($272,700) in annual taxable sales; the share of businesses passing along the tax dropped to 70 percent for retailers and 50 percent for service industry firms.1 This result would seem to indicate that the effect of the consumption tax on business is not entirely insulated from the effects of the recession.

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The Horizontal Equity And Regressiveness
Of Consumption Tax

One advantage of the consumption tax over the income tax is its horizontal fairness. In other words, the tax is uniformly applicable to individuals and is based on the amount that each person purchases; it offers a relatively transparent and easily calculated tax that is applied uniformly to all consumers. The same cannot be said for the income tax. That type of tax is automatically withdrawn from salary workers' paychecks, but the tax collectors have the difficult task of identifying and taxing the income of farmers and the self-employed, who easily can hide their true income.

The downside to the consumption tax, however, is its regressive nature. People with smaller incomes tend to spend more of their earnings on consumption while people with higher incomes are able to put proportionally more of their earnings into savings, which, of course, are not subject to the consumption tax. Consequently, because persons with lower earnings spend greater portions of their income, more of their income is taxed (see Table).

Household Consumption Tax Burden by Annual Income,
Quintiles I through V, 1997

(in thousands of yen)

I

II

III

IV

V

Income (A)

¥3,530

¥5,100

¥6,400

¥7,750

¥12,650

Total Tax (B)

¥240

¥420

¥600

¥860

¥2,030

aaBurden = B/A x 100 (%)

6.8%

8.3%

9.4%

11.1%

16.0%

Consumption Tax (C)

¥90

¥120

¥140

¥170

¥230

aaBurden = C/A x 100 (%)

2.4%

2.3%

2.2%

2.2%

1.8%

Source: Ministry of Finance

 

This is true even though the top quintile's average consumption tax burden in 1997 — the year of the 1 percent hike in national consumption tax and the institution of the 1 percent local consumption tax — was about 2.5 times more than that of the bottom quintile. The regressiveness of this tax is offset, however, by Japan's progressive income tax rate structure.2 The bottom quintile paid not only less income tax in real terms, but also paid only 6.8 percent of its income, in contrast with the 16 percent paid by the highest quintile.

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Allocation Of Consumption Tax Revenue

The consumption tax revenue for FY 2000 is expected to total ¥12.4 trillion ($112.7 billion), with ¥9.9 trillion ($90 billion) coming from the 4 percent national consumption tax and ¥2.5 trillion ($22.7 billion) coming from the 1 percent local consumption tax. The national and prefectural governments will receive the following:

  • Prefectural Government Revenue: ¥2.5 trillion (22.7 billion) from the 1 percent local consumption tax + ¥2.9 trillion ($26.4 billion), representing a 29.5 percent share of the 4 percent national consumption tax = ¥ 5.4 trillion ($49.1 billion), or 43.6 percent of total consumption tax revenue.
  • National Government Revenue: ¥6.9 trillion ($62.7 billion), representing a 70.5 percent share of the 4 percent national consumption tax, or 56.4 percent of total consumption tax revenue.

Until 1999, consumption tax revenues went to general spending. Now, however, the funds for national government raised from consumption tax are earmarked for social welfare programs. Specifically, fiscal rules for the 1999 budget required that consumption tax funds be spent on basic pension (Japan's version of social security), medical care for the elderly and nursing care. The purpose of linking consumption tax revenue to social welfare spending was to increase public acceptance of this tax.

However, a comparison of FY 2000's projected consumption tax revenue for the national government of ¥6.9 trillion ($62.7 billion) with the ¥4.5 trillion ($40.9 billion) needed for basic pension, ¥3.3 trillion ($30 billion) needed for medical care for the elderly and 1.3 trillion ($11.8 billion) for nursing care shows that consumption tax revenue will fall far short of the ¥ 9.1 trillion ($82.7 billion) needed for these three programs.

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Why Raise The Consumption Tax?

A hike in the consumption tax rate would solve two of Tokyo's problems. First, Japan's aging population and low birth rate mean that Japan's traditional income tax revenue base is shrinking at the same time that medical and pension expenses for the elderly are expanding. If fewer and fewer working-age citizens pay income taxes and more and more people are becoming pensioners who require a higher level of medical attention, those who do pay income taxes must shoulder an ever-increasing burden.

One way of avoiding overburdening working-age taxpayers is to increase the amount of revenue produced by the consumption tax, a result easily accomplished by raising the rate. Because everybody consumes, a rate hike would force those not earning wages to shoulder part of the tax burden, meaning that older Japanese would share in paying for the social welfare services that they enjoy. While Japan has increased its dependency on consumption-based taxes, there has been little change in dependency on income-based taxes (see Figure 2).

In February 1999, Japan's Economic Strategy Council submitted a report to then-Prime Minister Keizo Obuchi that outlined needed tax reform. The report concluded that the current taxation system was insufficient for building "a competitive society with soundness and creativity."3 The question, of course, is how to shift to a new system.

Osaka University Professor Naozumi Atoda's answer is to raise the consumption tax to 15 percent, a rate that he figures as follows. First, since, in his opinion, Japan's financial health depends on cutting back its government deficit, the ratio of government debt (national, prefectural and municipal) to gross domestic product should be reduced to 60 percent from its current 105 percent. This would make Japan's government debt-to-GDP ratio comparable to that of other industrial nations and in accord with standards established by the European Union for new members. Reducing government debt alone would require a 5 percent hike in the consumption tax. On top of that, Mr. Atoda proposes a 3 percent raise to bring in additional revenue for the basic pension and 2 percent to compensate for lower corporate tax revenues. Adding these to the current 5 percent consumption tax, Mr. Atoda arrives at a rate of 15 percent. This, he believes, is the minimum necessary to solve Japan's growing fiscal crisis.4

Indeed, unless recent income tax breaks — a trend that began with the 1988 cut in the personal income tax — are reversed, fiscal reconstruction must rely on a consumption tax hike. For 1998 and 1999, the Diet approved a ¥10 trillion ($90.9 billion) combined tax cut effected through deep reductions in both the individual and corporate tax rates. These tax breaks have caused a sharp drop in government tax revenues.

With the economy still showing mixed signs, it would be unthinkable for Tokyo to make an about-face and raise income taxes. Raising income taxes has a negative impact on working-age taxpayers and creates a disincentive for entrepreneurship. Such a result is the opposite of what the government is trying to achieve with its drastic tax reform since 1988, which is a tax system that strikes a good balance among income, consumption and property taxes by reducing income tax under the principles of equity, neutrality and simplicity.

Raising the consumption tax is the only feasible alternative to make up for the ¥10 trillion ($90.9 billion) in lost revenue; with a tax rate increase, it gives the government access to a large and dependable source of money. Tax Commission Chairman Hiroshi Kato told major Japanese daily Yomiuri Shimbun that the consumption tax should be raised only enough to offset the revenue loss caused by the income tax cuts.

As far as timing, Mr. Kato indicated that if the economy recovered, the hike could be implemented as soon as 2003; if recovery was slow, it could be as late as 2010.5 It is doubtful that the upcoming Tax Commission report will provide exact numbers or dates for an increase in the consumption tax rate, but at a minimum, it will stress the need for a hike.

Public support for a consumption tax hike is sure to be sparse. In fact, many people are calling for a reduction in the consumption tax rate to speed the economy's recovery. For example, in October 1999, at the 10th annual meeting of the Association for Abolishment of the Consumption Tax, participants called for a consumption tax cut as a way of easing the hardship created by layoffs and corporate restructuring. The AACT criticized the levy as a tax on those most harmed by Japan's recession — people without income.6 The Japanese Communist Party also seized on this issue in October 1999, introducing a bill to lower the national consumption tax from 4 percent to 2 percent.

A reduction in the consumption tax would be welcome by most members of the public. A close look at the ramifications of any such cut, however, reveals that its rewards would be fleeting at best. Furthermore, it would produce a number of problems in the long term. First of all, it would be difficult to lower the tax then turn around and raise it. A consumption tax cut would be inconsistent with the expected proposal by the Tax Commission to shift from income tax to consumption tax.

With Japan's elderly population growing rapidly, a shift to the consumption tax revenue is justified not only because it eases the tax burden on the dwindling number of working-age Japanese, but also because it encourages people to save. As the older generation dips into its savings to meet expenses, Japan's renowned household savings rate is likely to decline.

The current income tax structure encourages consumption at the expense of savings by taxing savings twice: first, as income and second, against interest earned at a rate of 20 percent (15 percent national and 5 percent local). By replacing revenue earned from these taxes through a bigger consumption tax, the disincentive would shift from savings to consumption, ameliorating the drop in savings rates caused by the fact that a large part of the population is aging. Some analysts, however, disagree with this argument, maintaining that a drop in the savings rate might be good for the economy because it would stimulate aggregate demand and foster growth.

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Consumption Tax Rate Hike And Multiple Consumption Tax Rates

As long as consumption tax revenue is considered general revenue, it is not clear who benefits from the tax; moreover, its regressive nature also remains an issue. If the consumption tax rate is raised, its regressive nature would be exacerbated, which could be politically explosive. To solve this problem, Japan could adopt a multiple-rate structure similar to that which has been implemented in Europe. For example, in the United Kingdom a value-added tax of 17.5 percent is assessed against all purchases, except for residential heating oil and electricity, which are taxed at 5 percent, and food goods, water, newspapers, books and medicine, which are exempt. Japan could follow this method, hiking the general consumption tax rate, but setting a new, lower rate for essential household goods.

This solution, however, also is problematic for several reasons. First, the selection of goods and services to be taxed at reduced rates could be arbitrary and would make goods taxed at a lower rate more attractive than goods taxed at the higher rate. Second, the reduced rate may favor higher-income consumers more than the intended beneficiaries in the lower-income brackets, because the former have more income to spend on lower-rate goods, which gives them the opportunity to take advantage of the lower rate.

Indeed, the Tax Commission addressed these issues in 1994, when it examined Japan's then relatively new consumption tax. The commission noted that the goals of taxing all purchases fairly, preserving the tax structure's economic neutrality and keeping the tax simple all pointed to establishing a single-rate consumption tax for certain goods. The commission reported that the economic and social costs of implementing a reduced tax rate outweighed the benefits,7 a conclusion that is reflected in public opinion.

Many commission members still think that the burden of complying with a multiple tax rate scheme is not merited since, unlike Europe, the single tax rate is not even in the double digits. They are worried that instituting multiple rates would distort the economy. The current consumption tax applies to almost every conceivable transaction with the same low rate. This economic neutrality would be undermined by a structure that divided goods into categories that always are somewhat arbitrary. The commission believes that multiple rates might be justified once Japan raised the consumption tax to a double-digit rate.

The Tax Commission's Chairman, Mr. Kato, explained his idea of raising the consumption tax rate without using multiple rates in an interview published by leading daily Asahi Shimbun. He proposed that after hiking the tax rate, the government would give back a certain amount of fixed consumption tax to each individual at the end of every fiscal year. Since the reimbursement would be a uniform and fixed amount, people in the lower-income brackets would get a bigger proportional benefit. According to Mr. Kato, this plan would avoid having to implement multiple rates in conjunction with a consumption tax hike. This would partly offset the effect of tax hike and convert the consumption tax into a progressive expenditure tax, offering Japan a third revenue option.8

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Problems With The Consumption Tax

The government needs public support to move forward in its efforts to raise the consumption tax. In response to stiff opposition from small businesses, the Diet inserted a number of special tax breaks in the consumption tax. These breaks have created problems and have undermined public confidence in the fairness of the tax and must be fixed in order to garner public support for a tax hike. Three problems in particular have attracted attention since the consumption tax was introduced in 1989.

Documentation - Japan's consumption tax works like a value-added tax, although exemptions for certain businesses create inconsistencies. Every seller of a good must collect from the buyer and remit to the government a tax equal to 5 percent of the sales price. The value-added created by a tax-exempt firm is not taxable. The rule that a seller need not collect tax on value obtained from an upstream supplier who already collected the tax (or was so exempt) works like a deduction. In European countries, a business that deducts the value of goods obtained from an upstream dealer must document the deduction with an invoice from the upstream seller that declares the value of the good and the amount of tax collected.

The same method for declaring a deduction is allowed in Japan. Until 1997, however, Japan also allowed a business to record the amount of tax paid to the upstream supplier in its ledger and to claim a deduction based only on its own ledger entry. No supporting documentation was required. This latter method was abused by businesses to defraud the government.

Tax-Exempt Enterprises - Another loophole that has been abused is the tax exemption for small-volume businesses. Like European VAT countries, Japan does not require businesses with sales volume under a certain cap to collect the consumption tax. In Europe, however, a business that buys material from an exempt entity receives no invoice for the sale. Thus, when the business sells a good that incorporates exempted material, it has no proof of a deduction and must collect tax for the portion of the sales price that reflects the value of the previously exempted material. Consequently, businesses in Europe avoid buying from exempt entities, a practice that Japan sought to avoid when it implemented its consumption tax.

As mentioned earlier, the European invoice system was not introduced in Japan. Businesses, therefore, have no reason to avoid transactions with exempt entities, and as a result, the collected taxes go into the pockets of the exempt entities when they collect the consumption tax. It has become a huge windfall for small businesses that can charge the tax, but end up keeping the funds. Because Japan's cap for tax exempt status is set at a rather high ¥30 million ($272,700) in sales volume, more than 60 percent of all businesses qualify for the exemption. Thus, in the eyes of many, the sales tax has become an unjustified transfer of tax from consumers to small businesses.

"Deemed Rate" Windfall - A similar problem arose from the simplified method for calculating the deduction for value added from an upstream supplier. In modern economies, finished goods are manufactured using a variety of raw and semiprocessed materials. Japan's consumption tax, like a VAT, taxes a good each time it is sold, but deducts taxes already paid on the parts used to produce the good. Japan's consumption tax, like Europe's VAT, uses the following formula for calculating the tax arising from each transaction:

Consumption tax = 5 percent (sales price - cost of already-taxed materials)

Keeping track of the materials for which taxes already have been paid can be a complicated accounting task. Many businesses, especially smaller ones, opposed the consumption tax on grounds that its record-keeping requirements were too burdensome. In response, the Diet included a special simplified method for calculating the deduction for already-taxed materials.

The simplified method assumes that a certain percentage of the value of any good will come from previously taxed materials. The simplified method substitutes this percentage, termed the "deemed rate," for the actual cost of already-taxed materials, to obtain an approximate amount for the taxable value added by the current seller. The 1989 formula was as follows:

Consumption tax = 5 percent (sales price - (sales price x deemed rate)), where the deemed rate is 90 percent for wholesalers and 80 percent for others

In effect, depending on which deemed rate (80 percent or 90 percent) is applied, the simplified method assumes that the current seller added 20 percent or 10 percent of the item's value to the item and taxes 5 percent of that added value. The simplified method is problematic because that businesses can exploit it and gain a windfall when the simplified tax is less than the amount assessed under the traditional method. Although the purpose of the simplified method is to avoid the paperwork burden of keeping track of the cost of already-taxed materials, businesses compare the tax owed under the two methodologies. They charge the amount owed under the standard formula and pay the government the amount owed under the simplified methodology and pocket the difference.

Interest Earning on Tax Withholdings - Firms hold consumption taxes collected on sales in their general bank accounts. Originally, the business paid over the tax collected once or twice a year, meaning that the government's money sat in the firms' accounts earning interest for the businesses instead of the government.

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Fixing The Consumption Tax

The various ways in which businesses, particularly smaller ones, have exploited special tax breaks has stirred up public resentment. This public opposition has led to a number of tax code revisions (see Appendix), which have alleviated many of the problems by making the consumption tax more equitable and a more reliable revenue source.

However, two major problems remain unaddressed. First, the new tax code bars new companies with capitalization of ¥10 million ($90,900) or more from utilizing the tax exemption for their first two years of operation. This regulation only postpones the problem for a short time. The cap for the small sales volume exemption permits 60 percent of businesses to avoid collecting the tax. Any attempt to lower the cap will trigger strong opposition.

Second, a European-type of invoice system is needed. That reform, however, will be opposed unless a solution is found for tax-exempt businesses who would lose sales to businesses that do not want to deal with a seller who cannot issue an invoice. Furthermore, firms will resist making documentation mandatory because of the paperwork burden. However, in light of the numerous accounting software packages now available, some argue that adopting a European invoice system is not necessary.

In any event, the current method that requires a company to keep both its ledger and the supporting documentation is not much different from the European system and new software makes record-keeping much easier than when the consumption tax was first introduced.

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Social Welfare Tax

Earmarking consumption tax revenue for social welfare spending and limiting such spending to the revenues generated by the consumption tax is the least-controversial aspect of the possible changes, although it is not expected that the Tax Commission will propose such a restrictive approach to raising and allocating revenues. According to an Asahi Shimbun survey, in October of last year, 59 percent of respondents supported earmarking consumption tax revenue for social welfare programs, 27 percent were opposed and 14 percent had no response.9 What is remarkable is that such a small percentage of respondents was opposed to this change.

Earmarking the funds would be an attempt to ameliorate the perceived regressive nature of the tax. For example, if the tax were used solely to fund the basic pension, each taxpayer would pay a fixed amount into the basic pension fund. Pension sizes at retirement differ slightly depending on how many years the person paid into the fund, up to a maximum of 40 years. Compared with this fixed-premium, fixed-payment approach, the consumption tax is relatively progressive. People at higher income levels tend to consume more and to pay a larger amount of consumption tax in absolute terms than those with lower income levels. Pension payments, however, are fixed and everyone receives the same amount.

Therefore, tying the consumption tax to pension payments means that taxpayers in the higher-income brackets levels fund a larger proportion of a fixed benefit that is shared by all. Otherwise, to ensure the long-term health of Japan's social welfare system, it would be necessary to increase contributions from older Japanese. A proposal to raise the pension premium or to directly tax older Japanese, however, would be met with fierce opposition. Converting the consumption tax into a social welfare tax remains the most feasible political solution to this problem.

The social welfare tax proposal may remind some readers of the National Welfare Tax proposed by then-Prime Minister Morihiro Hosokawa in February 1994 (see JEI Report No. 6B, February 11, 1994). Mr. Hosokawa proposed eradicating the consumption tax and replacing it with a new 7 percent consumption tax. The National Welfare Tax, however, was a welfare tax in name only. In fact, revenue gathered under Mr. Hosokawa's plan would not have been earmarked for social programs. His proposal, which was nothing more than a tax hike, met with harsh criticism and was withdrawn five days after its introduction

Fast-forward to October of 1999, when the Liberal Democratic Party, Liberal Party and New Komeito Party formed a three-party coalition government (see JEI Report No. 39B, October 15, 1999). That month, at the urging of the Liberal Party, the coalition agreed to earmark consumption tax revenue for social welfare spending. The details of that agreement, however, never were worked out. Now that the Liberal Party has left the coalition (see JEI Report No. 14B, April 7, 2000), the fate of the proposed social welfare tax remains unclear.

One issue that is central to the proposal is the projected growth in social welfare spending. In September 1997, the Ministry of Health and Welfare presented the Economic Strategy Council with data that predicted the total cost for Japan's basic pension, medical care and nursing care programs would reach ¥29.1 trillion ($264.5 billion) in 2000 and quadruple by 2025 to over ¥107 trillion ($972.7 billion) (see Figure 3).

This March, the Diet approved a bill to change the national pension system (see JEI Report No. 13B, March 31, 2000). The reform includes a plan to increase the government's contribution to the basic pension fund from one-third to one-half of the fund's revenue by FY 2004. It remains uncertain how ¥2.7 trillion ($24.5 billion) of this new obligation will be met. This increase in public funding for the basic pension will amount to a ¥6.7 trillion ($60.9 billion) increase by 2025. It is projected that for 2025 a 1 percent increase in the consumption tax would produce approximately ¥3 trillion ($27.3 billion) in revenue, which means that the government would need to raise the consumption tax by 2 percent to meet the revenue needs generated by the March reforms alone. It is estimated that a consumption tax rate of 36 percent would be necessary to fund the entire ¥107 trillion ($972.6 billion) in social welfare spending projected for 2025.

Switching to a social welfare tax would involve a number of other problems. First of all, earmarking the consumption tax revenue for spending on just three programs deprives the government of its discretion in how it allocates resources. With the consumption tax now the second-largest source of revenue after the individual income tax, earmarking that money places limits on the government's spending in other areas. Indeed, this may explain why no other country has earmarked by law its VAT revenue for social welfare spending.

Making the consumption tax a social welfare tax is largely a public relations matter. Business enterprises may provide important encouragement in convincing the public of the benefits of this idea. Industry would like to see the current pension premium, half of which is paid by the employer, replaced with a consumption tax. However, linking the tax and spending itself may create problems. Increases in social welfare costs would lead to pressure to increase the consumption tax; or the reverse might happen — pressure to maintain or lower the consumption tax might be channeled into pressure to cap (or even decrease) spending on welfare programs.

Consequently, the proposal faces two great challenges. First, its proponents must obtain positive public consensus. The second, and perhaps greater challenge, will be maintaining a consensus on what constitutes an appropriate tax rate and a reasonable amount of social welfare spending.

The social welfare tax proposal also creates a big problem for the prefectures, who receive about 44 percent of total consumption tax revenue and use the funds as their general revenue.10 When the local consumption tax was instituted in 1997, the prefectures accepted the reduction of local inhabitant tax and the abolition of a transfer that had given them 20 percent of national consumption tax revenue in exchange for the termination of many local indirect taxes in 1989. If the consumption tax is tied to social welfare spending, the question remains whether the portion currently paid to the prefectures will continue to be paid to them as general revenue or will be allocated to national social welfare programs. From a historical perspective, the latter option would create what many think would be an unfair hardship on the local governments.

Preliminary information on the Tax Commission report indicates that it will acknowledge the various problems of the social welfare tax proposal; however, the government cannot easily find alternative revenue sources to meet this area of growing public spending. Since Tokyo cannot count on income-based taxes to pay for these programs, the consumption tax should be available for that purpose, although earmarking is not the only alternative.

One variation would involve a special consumption tax for social welfare revenue in addition to the current consumption tax. This would be similar to the special tobacco tax instituted in 1998 to raise funds for the pension fund of the former Japanese National Railway and to pay down debt accumulated by national forestry and field business managed by the Forestry Agency.

For example, the consumption tax could be raised to a rate of 10 percent, which would include 5 percent for national and prefectural general revenue and 5 percent for basic pension, medical care and nursing care. Then, if social welfare spending increased, the consumption tax could be raised and the additional revenue allocated strictly to the social welfare programs. This solution would preserve current revenue while providing a new tax to pay for increasing social welfare spending, but would do so in a way that avoided the cost and compliance hassles of instituting a new tax.

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Banking Tax, Nonincome-Based Tax And Consumption Taxes

In March 2000, the Tokyo Metropolitan Assembly approved a 3 percent tax on the gross operating profit of major financial institutions (see JEI Report No. 7B, February 18, 2000). The tax will be imposed on gross profits before deducting operating expenses, including personnel costs. The move has sparked the interest of other local governments in instituting similar taxes. The LDP already had been examining a proposal to implement a similar tax nationwide beginning next year.11

This banking tax, classified as a nonincome-based tax, would work something like a VAT. The introduction of this type of tax by many local governments could complicate the efforts of central government politicians and bureaucrats seeking to expand the consumption tax. Opponents of the local gross-profit tax argue that its implementation would be costly and cumbersome and that it could discourage certain types of economic activity. Furthermore, it would distort the economy if not applied uniformly. Whatever the political consequences, a consumption tax hike is a far simpler means of meeting future revenue needs of local governments; however, creating a new tax is much easier for prefectures than raising the rate of the local consumption tax.

Many fiscal analysts are calling for an overhaul of the rest of the tax system to make it more fair and efficient before the consumption tax is increased. A hike in the consumption tax rate probably is inevitable, but before that can happen, a number of other policies should be considered to make the current system more efficient and fair:

  • The current threshold for income tax exemption, ¥3.7 million ($33,600) for a single-income earner with a spouse and two dependent children, allows up to 15 percent of households to avoid paying taxes. Decreasing the minimum taxable amount would increase revenue as well as spread the tax burden more evenly across the population.
  • With larger numbers of women joining the work force, the deduction for spouses needs to be reexamined. Since the maximum deduction of ¥760,000 ($6,900) is gradually reduced if a spouse earns more than ¥700,000 ($6,400) in a year, many potential workers have hesitated to take full-time jobs for fear of losing the spouse deduction. Decreasing the minimum taxable amount and eliminating the spouse deduction would raise revenue without raising marginal tax rates, which, in turn, could enable the government to reduce the size of any consumption tax rate hike.
  • Reforms to the consumption tax itself could both raise more revenues and make any increase more palatable. The main area for consideration encompasses the several special measures applied to small businesses.
  • The 1997 consumption tax hike chilled Japan's slowly recovering economy, pushing it back into recession. Any future increase should be implemented only when the economy is in a more robust condition.

Even if these conditions are met, implementing a tax hike will be difficult. The last time the consumption tax was raised from 3 percent to 5 percent, it was accomplished only in exchange for a cut in the individual income tax rates. The current fiscal situation will not permit such generosity a second time. Regardless of potential political opposition, however, the government cannot avoid some sort of tax hike, especially since Japan's tax burden is one of the lowest among advanced countries.

Kanako Yamada provided research assistance.

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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Notes
aaa

1aa Ministry of International Trade and Industry, "Heisei 9 Nendo Shinshouhizei Kanren Kakaku Jouhou Nettowaaku Choosa no Kekka ni Tsuite, (1998 Survey of Pricing Information & the New Consumption Tax)" (July 1998). Available at http://www.miti.go.jp/press-j/industry/r80722b1.html. Return to Text

2aa See Hiroyuki Takahashi, "Prospects For Personal Income Tax Reform In Japan," JEI Report No. 24A, June 26, 1998. Return to Text

3aa Economic Strategy Council of Japan, Strategies for Reviving the Japanese Economy. Online version (February 26, 1999) available at http://www.kantei.go.jp/foreign/senryaku/chap2.html. Return to Text

4aa Naozomi Atoda, "Shohizei 15% ga Zaisei Saiken no Saiteijoken to Kakugo Seyo,(Acknowledge that Raising the Consumption Tax to 15% is the Minimum Condition for Rebuilding Japan's Fiscal Health)," The 21, March 1999, p. 24. Return to Text

5aa Hiroshi Kato, "Shohizeiritsu 5 percent Age Hitsuyou, (5 percent Consumption Tax Hike Is Needed)," Yomiuri Shimbun, March 8, 2000, p. 2. Return to Text

6aa Saeko Umemura, "Fukushi Mokutekizei wa Daizozei no Michi, (A Welfare Tax Will Lead to Higher Taxes)," Zenei, December 1999, p. 50. Return to Text

7aa The brief summary of Tax Commission's report in 1994 regarding this subject is available in Japanese at http://www.mof.go.jp/jouhou/syuzei/siryou/syou/syou10.htm. Return to Text

8aa "Zeisei Chuuki Toushin, Honkaku Rongi e, (Tax Commission Starts Earnest Discussion To Make Its Medium-Term Report)," Asahi Shimbun, February 12, 2000, p. 9. Return to Text

9aa Umemura, op. cit., p. 51-52. Return to Text

10aa See Hiroyuki Takahashi, "Fiscal Crises In Japan's Prefectures And The Debate On Corporate Tax Reform," JEI Report No. 40A, October 22, 1999. Return to Text

11aa For more information on nonincome-based tax, see Takahashi (October 1999), op. cit. Return to Text

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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