2. New Trend 1: From Fairness to Efficiency

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1 Hitotsubashi Symposium Fundamental Tax Reforms in Japan In Search of Equity-Efficiency Balance Shigeki Morinobu Professor, Chuo Law School President of Japan Tax Institute 1. Introduction Upon entering the 21 st century, tax reforms throughout the world are continuing to create trends. One of these trends is the flow from fairness to efficiency in the principle of taxation. The second trend is that as a result of placing emphasis on economic growth based on an efficient taxation, there is an increasing necessity to give consideration to income distribution(equity), and it is becoming necessary to establish measures for income redistribution in a form that is different from larger scale of the government, which is the conventional method. Concretely, this refers to creating a design that integrates taxes with social benefits, and linking tax reductions with benefits efficiently. In order to think of fundamental tax reforms in Japan, it is necessary to aim for fiscal management based on securing financial resources for social security in a stable manner coping with the aging of society and giving consideration to these kinds of world trends in tax reforms. 2. New Trend 1: From Fairness to Efficiency The first international trend in the taxation system is the flow from fairness to efficiency, though it may be more accurate to say that in order to aim for fairness, it is necessary to think of an efficient taxation system." If the individual/corporate income tax rate is made higher, it will become difficult to seek high income tax burdens in these times where capital and manpower escape easily to foreign countries, and it is desired to make the substance of the taxation system more efficient and growth-oriented. When looking at the tax revenue/gdp ratios for each country, the ratios for the OECD member countries decline after reaching a peak in FY2000, but it indicates the condition where further additional tax burdens cannot be imposed. The maximum tax rate for individual income and corporate income as designated by law has decreased by several points in a period of only 5 years. On the other hand, efficient and growth-oriented tax reforms have been initiated. The pioneer for this was the Dual Income Tax system in Northern Europe. This is a system 1

2 where taxes on capital income and earned income are imposed separately through different systems. As capital is mobile, this was first introduced in Nordic countries that are relatively small in size, but before long, it was also introduced in the Netherlands, and it was decided to implement separate withholding taxation of 25% for interest, dividends, and capital gains in Germany (starting in 2009) as well. In the United States, there were 2 proposals by the President s Advisory Panel on Federal Tax Reform (November 2005), where the second proposal consisted of the same idea as Dual Income Tax, with a 15% tax imposed on dividends, capitals, gains, and interest. In Russia and Eastern European countries, a Flat Tax was introduced, for a further radical and efficient taxation system where, for example, income tax as well as consumption tax is 15%. The question is, why was the shift from a comprehensive income tax to an separate income tax system made? First of all, the problem with the comprehensive income tax system had become highlighted (= narrowness of tax base, the complexity of the tax system, stems from pursuing fairness, problem of mobile income, the spread of tax mitigation, etc.). Secondly, there is the problem of double taxation and the problem of neutrality of equity financing and debt financing. With debt financing, interest is deducted as expenses, but with equity financing, taxes are imposed on dividends. In the United States, double taxation of dividends is not adjusted at all, and this is an important problem. In addition, when focus is placed on debt financing, corporations start to over-borrow, and there are concerns regarding the weakness of these corporations. There are discussions such that double taxation should be eliminated, and that procurements from the capital markets should be made neutral in terms of the taxation Thirdly, there are now various choices in the area of consumption taxation, such as Dual Income Tax, Flat Tax, X tax, BAT, etc. In the United States, it has been said that VAT will not be introduced since there is already state retail tax, but it is believed that there will be little resistance if the taxation system will be one of consumption taxation such as Flat Tax, BAT or Dual Income Tax. The OECD Tax Committee and the IMF state that in a world that has become globalized, there are the 4 grand designs of comprehensive income tax, expenditure tax, Dual Income Tax, and Flat Tax as taxation systems for capital income, and the recognition of progressing towards expenditure tax, Dual Income Tax, and Flat Tax in the real world in place of comprehensive income tax, for which taxation of capital gains is difficult, is apparent. The positioning of Dual Income Tax as a tax system is that it is the step towards 2

3 consumption taxation. Consumption taxation is a tax that is not imposed until consumption takes place, and is synonymous to not imposing taxes on returns of savings (capital). If taxation on return of capital is lowered under Dual Income Tax, it can be equivalent with consumption taxation. In this kind of way, the tax reforms in Germany that are being carried out in 3 stages serve as an instructive reference for us. As the first stage, the value-added tax was raised (from 16% to 19%), of which 1% was appropriated towards lowering the unemployment insurance premium, and the remaining 2% was appropriated towards financial restructuring to fulfill fiscal standards for the EU. As the second stage, the corporate tax rate was lowered by 30%. As a result, the effective corporate tax rate for only the United States and Japan, out of the advanced countries, remains approximately 40%. Expansion of the tax base is also being carried out at the same time, and the reform is one with mostly revenue neutral principle, but the fact that fiscal restructuring was secured by raising the value-added tax is large. As the third stage, there are plans for a reform that follows the concept of Dual Income Tax, where separate withholding taxation of 25% on interest, dividends, capital, and gains will be applied in In thinking of drastic tax reforms in Japan, the raising of the consumption tax, the widening of the tax base for corporate tax, the lowering of the effective corporate tax rate, and the alleviation of social security burdens, etc., serve as an important reference. 3. New Trend 2: Integration of Tax and Social Security Contribution When looking at tax reforms in advanced countries, there is another trend of a strengthening of the income distributional function, and a response to this has been made in the form of designing and managing the tax system and social security contribution in an integrated manner. In tax reforms after the 80s, there was a trend towards expanding the tax base and lowering the tax rate, but based on these tax reforms, the lowering of the tax rate caused a bias in favor of the upper income brackets, and the problem of income disparities became apparent. In addition, when looking at the Gini coefficient over a span of 10 years, it can be seen that global disequalization has progressed, as indicated by the escalation of international competition, progression of alternatives for employment, etc, and an expansion in income disparities in advanced countries, as a result of the rise of China and India. The major issue here is to determine how to compensate for the regressive problems that arise as a result of this globalization of the economy. 3

4 In response, the idea of making the effects of tax reductions be more applicable to the lower income brackets, by making a change from income deduction to tax credit, was presented. Both the first and second proposal by the President s Advisory Panel on Federal Tax Reform in the United States follow this idea. In tax credit, there is a large income distributional function as compared to income deduction, and this function is starting to be applied to rectify the expansion in income disparities, which was the negative aspect that accompanied economic growth, by lowering the tax rate by expanding the tax base since the Reagan-Thatcher tax reform. In addition, for the people who cannot enjoy tax deduction, the implementation and expansion of social benefits have been put into action by Earned Income Tax Credit (ETIC) system. This system was introduced during the Nixon administration as a measure to fight poverty, but was implemented extensively afterwards, during the Blair administration in Great Britain and the Clinton administration in the United States. The mechanism for tax credit is that tax credit is granted based on how much one works. The deduction amount (reduction of tax) decreases the more yearly income increases. Refunds are given in cases where deductions cannot completely be made. The marginal tax rate for the upper income brackets does not change, but the progressiveness for society overall increases. It is possible to deepen the curve for progression and reinforce income redistribution based on tax credit combined with social benefits, without increasing the maximum tax rate. Similarly, there is also a refundable Child Tax Credit, which is yielding large results as a measure against poverty for households with children which contributes preventing declining birthrate. These systems also contribute to integration and streamlining of administrative authorities, as the tax authorities are the ones that provide the benefits. When looking at the situation in Great Britain, although the maximum tax rate for income tax was reduced to less than half the original rate due to Thatcher s tax reforms and was instrumental in vitalizing the economy, the gap in income levels expanded. Those in the lower income brackets were unable to receive good education and training, and as this was linked to low income, the problem of social rejection arose. In response to this, rather than going back to a large government, the EITC system was introduced in order to effectively implement measures for people of lower income, based on the concept of the Third Way. As the background to the introduction of such a system, there is a new concept known as workfare, where social security is implemented by building up the power to work. Welfare provides only a safety net for rescuing things that fall from above, but workfare builds up strength in things that have fallen, through the expansion of education and training, and pushes them back once more 4

5 towards the market economy. This is also referred to as a trampoline or springboard measure. This kind of system has been introduced in various European countries such as France, the Netherlands, etc., as well as in Korea. 4. Drastic Tax Reforms in Japan: Tax Reforms in harmony with World Tax Reform Trends It is necessary to carry out these kinds of tax reform that follows global trends in Japan as well. First of all, there is the problem surrounding corporate taxation. The burden of corporate income taxation in Japan is second highest after the United States, when looking at the nominal effective tax rate. Great Britain plans on lowering corporate income taxation this year, and it is predicted that France will follow suit as well. This will make only Japan and the United States have a corporate income taxation that is over 10% higher than in other countries. In the case of the United States in particular, there are many tax lawyers and advances made in tax planning, and the actual effective tax rate (the actual amount of tax assumed/earnings before taxes) is approximately 17%, which is half of the statutory tax rate. Ingenious planning such as to establish holding companies in countries with low tax rates, concentrate functions, risks, patents and trademarks, gather income, make total tax burdens lower, and turn over headquarters operations to tax haven countries, has been implemented on a regular basis. Even in Japan, these kinds of endeavors have been initiated under new corporate laws, but as they are not on a large scale as in the United States, the real burden of Japanese corporations is of a level higher than that in the United States. However, when making comparisons by taking social security burdens into comparison, the burden on corporations is not high in Japan. When taking the corporate tax and social security burden into consideration as a total, the burden in Japan is still lower than that in European countries, but as the 10% difference in corporate tax rate is a large handicap for not only Japanese corporation but also Japan s advantage of business location and Japanese economy. Therefore the problem of the high corporate effective tax rate must be resolved at some time or other. It is necessary for Japanese corporations to secure competitive power in the international market, for the flow of corporate income to foreign countries to be controlled, and at the same time, for a corporate taxation system where foreign corporations can make investments in Japan easily to be established. One of the reasons for lowering the tax rate is that when foreign 5

6 corporations foray into Japan, they create holding companies in Asian countries with low tax rates since they do not like the burden of high taxes; plans to ease tax burdens in Japan are being carried out, by aggregating risks and functions in lower tax countries, but this is in turn linked to outflow of added value and employment in Japan. As the reason for lowering the effective tax rate in Germany, there was a strong intent to stop plans by German companies to move operations to countries with low tax rates such as the Netherlands and Ireland. However, in tax reforms for Japan, it is safe to say that talk of tax reductions for corporate will not come before arguments on consumption tax that have an important impact on the lives of citizens, such as on social security. In addition, when reforming corporate tax, it is necessary to also review the various problems with local corporate tax, such as the problem of the 2 types of corporate taxes. In other words, it can be considered that a reform where the nation picks up the burden of corporate taxation and enriches the local consumption tax by that amount will be carried out as part of drastic tax reforms. As described above, the ideal taxation system in Japan was thought of as consisting of the building of an efficient tax system, such as by lowering the corporate effective tax rate, the promotion of a change from income deduction to tax credit (possibly refundable) as a measure for income redistribution, but in considering the grand design, the most important issue is how to secure financial resources for social security in order to support the aging society. To construct a safe and secure society it is necessary to amend the imbalance between burdens and benefits. As for the magnitude of the government when doing so, intuitively, a medium scale of a government larger than that of the United States, where there is low public medical insurance, but smaller than that of Europe, where the completeness of social security is causing moral hazards, seems to be the best. Concretely, there is an image such that the burden of taxes/social insurance premiums would be increased by a few percent, to approximately 30% of GDP (which is equivalent to 40% of the Gross National Income). Based on this, Japan would become a country that assumes tax burdens lower than those in Europe and higher than those in the United States, while maintaining social security standard equivalent to that in Europe. Suffice it to say, Japan is a middle-welfare and middle-tax burden state. 6

7 Burden ratios for taxes and social security premiums (FY2004) % of GDP ratio Tax burden Social insurance Total Budget deficit ratio premium burden ratio Japan United States EU ( countries) Source: OECD statistics Secondly, the question is by when these comprehensive tax reform should be achieved. What is important is that only the goal of achieving primary surplus by 2011 is not sufficient. This is due to the fact that achieving a primary balance surplus does not mean reducing past accumulated government debts. In order to reduce past debts, it is necessary to aim for the securing of fiscal resources for social security, at the same time as establishing interim fiscal management goals to make the general government budget deficit within 3% in relation to GDP and the debt outstanding within 60% in relation to GDP, which is what the EU agreed upon when establishing a common currency. Reviewing these kinds of ideas, a scale for the government that enables public services for security and safety is determined, and in cases where additional financial resources are necessary, it is desirable to respond to the situation by giving greater importance to consumption tax, which can be considered an effective tax. 7