Taxation in Japan

The role of taxation in the transformation of the Japanese
Economy Introduction Before the Meiji restoration under the feudal Tokugawa Shogunate, taxation was mainly a tool for warfare and military power. The system was highly regressive and pressed lightly on the rich and profit-earners.
It was calculated to preserve a very unequal distribution on incomes and to stimulate the accumulation of private capital.
This tendency somehow continued and was magnified before
W.W.II when direct taxation was introduced for a more equal and balanced system. However, the Meiji restoration did bring with it tremendous changes to the tax system and the use of the revenues. The Japanese government has since had an active participation in the economy, yet not controlling it directly but rather through market mechanisms.
It took responsibility for promoting economic growth by using incentives and taxes collected in an effective way. The often cited goal of taxation in western countries that was equality was often sacrificed for the goal of economic growth in order to prevent being colonized, then to pursuit the desire to become an imperialist nation and then for pride and export. The role of government and its fiscal policies played an important role in the transformation of the Japanese economy through the periods of Meiji restoration, before
W.W.II and post W.W.II period where taxes respectively shifted from land taxes to internal indirect taxes to income / direct taxes. (Fig 1) Period of Meiji Restoration During the first years of the Meiji reforms, the government had serious financial difficulties with tax revenues inadequate for its massive commitments. In 1873, land reforms gave tittles to landowners and customary tenants, freed the transfer and sale of land from feudal restrictions and imposed tax obligations equal to 3 per cent (which was lowered to 2.5% in 1878) of the value of land. In addition a 30% local surtax was imposed on the land taxes. These heavy land taxes were used to provide monetary compensations to the old ruling class for the termination of their feudal incomes in kind and to finance the new administration which introduced new education and to support its military. The agricultural sector, and in fact the peasants, therefore bore the great bulk of the cost to Japan 's modernization. The land taxes contributed to over 70% of the central government 's revenue during the first decade of the Restoration. Since the capital needs of agriculture were small even after the landlords devotion to the improvement of agricultural techniques and introduction of winter drainage, the increasing savings and surplus of landlords were transferred out of the primary sector into other sectors. The fiscal system as a whole was heavy in absolute terms yet highly regressive. The burden was constantly on the agriculture sector, even when non-agricultural sectors were growing at a phenomenal rate.
As seen in Figure 1, under indirect taxes, before the turn of the century, the excise taxes played a prominent yet second to land taxes at about 20% of the government 's total revenue. These included taxes on soya, sugar, textiles and government monopoly profits in tobacco, camphor and salt.
The combined effect of the land taxes and consumption taxes was heavy taxes on both peasant and consumer and a lighter burden for the landlord and industrial-merchant classes. The income tax did not appear until 1887 and the business tax which was the corporate tax did not come into effect until 1896 and at a low flat rate of 3%. The result was the subsidizing of the manufacturing and service sector at the expense of the primary sector. To strengthen the incentives for reinvestment and accumulation of productive wealth was strengthened by the absence of inheritance and real estate taxes before 1905 and a relatively low rate thereafter. The role of the family and the firm that existed also as a closely bound unit also made the saving, transferring form generation to generation and development favorable. Therefore, the
Zaibatsus, the conglomerate oligopolies could charge monopoly prices and concentrate on exports. At this time, between the 1870-1900, there was the traditional export expansion of silk and other produces, coupled with mild primary import substitution. Tariffs and revenue on foreign trade were also low at the time due to the fact that the
Japanese government was under the influence of foreign countries and autonomy of tariffs was not until 1899.
However, this tradition had little change even after the gradual regaining of autonomy. This was a very different from the path followed by other developing countries which usually place heavy taxes on trade because they are the simplest and easiest form of taxation. Japan, by not following the easy path and concentrating on export substitution and land taxes for internal revenue creating a thriving export of primary goods before the 1920s. Period before W.W.II The era of the land taxes ended in 1908 and was followed by indirect taxes, mainly on alcoholic beverages and tobacco. It was not until 1935 that income taxes on individuals and corporations became the most important source of total revenues. The modern tax form only took form in the 1940 to prepare for the wartime economy, the whole tax system was thoroughly overhauled to base on direct taxes. The individual tax was a scheduler tax, under which different sources of income were levied by different tax rates. It was supplemented by a progressive comprehensive tax which applied to an individual 's aggregated income above a specific amount. On the other hand, the corporate income tax was imposed on corporate income at a flat rate of 18%. The commodity tax was introduced in 1937 mainly to collect revenue for wartime expenses, and the tax on alcoholic beverage was also simplified in 1940. The relative share of indirect taxes fell as a result of the tax reforms. The 1940 reform also separated the personal income tax from corporate income tax. This period saw the rise of the power of the military in the government and influence after the winning wars of the Sino-Japaneses and Russia-Japanese earlier in the century and the ailing and corruption of the civilian government. The government was engaged in continuous military activities and was penalized with increased tariffs. However, due to expansion of its own empire and influence which included Taiwan and Korea, export suffered little and actually had a 70% increase in volume between 1929 and 1937. This period also saw heavy taxes and direct investment of government in industries resulting in rapid growth of war related industries. This period ended with the GNP declining from 1939 and 1944.
The tax system became the tool for direct financing in this period. The military drove the economy and accounted for
27.98% of GNP by the second world war which could be said as the grand continuation of the feudal Tokugawa
Shogunate military expansion policies. Post W.W.II With the occupation forces lead by the United States taking over the government, reforms were held on all aspects of the government. Immediately after the war, the scheduler tax on individual income was replaced by a unified tax on an aggregate basis with graduated tax rates. In order to collect necessary revenues, a 1% turnover tax was levied on the basis of the sales amount at every stage of transaction. As for the long term tax system design, it was also based on the
US system but was also an experimental ground for the
Shoup Mission which was a pioneer in many aspects of the direct tax. The Shoup reform in 1949 was not the first reform after the war to the chaotic after-war tax system, but it has had the most lasting effect on the development of the
Japanese economy. The Shops Report tried to build a progressive direct tax based tax system with local autonomy and simplicity that would be permanent and stable. Indirect taxes were not recommended due to the inequality among the tax payers, dull the sense of civic responsibility and make local governments uneasy. However, the Japanese government regained autonomy during the Korean war and made modifications such as the resuming taxation at the national level and sacrificing equity which Shops put at the utmost priority for convenience of efficiency and administration. The burden on firms, especially big business was lowered. This was to give priority to the restoration of the postwar economy and the promotion of capital accumulation. Capital gains tax was abolished, under the missions guidelines and this had a effect of the promotion of capital accumulation as a national goal. Although partially successful, the Shoup plan broke away from the military roots of the Japanese tax system and engaged in a responsive tax system which was in touch with the economy.
The four major taxes, income, corporate, accession and consumption taxes all varied to different degrees from the
Shops Mission. However, the four taxes have been remarkably stable in structure since 1950. The global income tax system proposed by Shops was modified to a combination of a comprehensive tax and a scheduler tax.
Instead of aggregating most incomes with progressive tax rates, some incomes such as capital gains or interest income were now subject to income taxation or were taxed at reduced flat rates, separate from other incomes. These tax concessions were intended to stimulate savings and income and to improve the welfare level among specific taxpayers.
As for corporate income taxes, a split-rate system rather than a uniform one in which a single rate is imposed on a whole corporate income. This was similar to the one used in
West Germany in which retained profits and dividends were taxed at different rates. Numerous tax measures have made the corporate income tax extraordinarily complicated. As for the accession tax on transfer of wealth proposed by Shops
Mission was replaced by a combination of inheritance and gift taxes. Consumption taxes, in contrast to the general modification of direct taxes remained unchanged since the
Shops Mission and there has been no general consumption tax in Japan until April 1989. Therefore, Japan depends its revenue from taxes on income and corporate income taxes, which is the highest among OECD countries. Social security contributions which are equivalent to payroll taxes also play an equally important role in the raising of taxes. Japan is also the only advanced country that does not impose a general consumption tax. In 1985, of the total tax revenues collected in Japan, 45.8% came from individuals and corporate income taxes, 30.2% from social security contributions, 14% from taxes on goods and services, 8.6% from property tax and 1.1% from inheritance and gift taxes. Before the 1973 oil shock, the government engaged in a tax system with incentives to promote exports, private savings and investment, housing and technological development to promote economic growth. These measures were included in the Special Tax Measures Law and was formulated to prepare a list of most of the incentive provisions applying mainly to individual and corporate income taxes. As seen in
Figure 2 and Table 1, the corporate revenue lost to these special tax measures but declined in importance after the mid
-1970s. The special tax measures was around 12.6 and
13.2% of total income tax revenues in the late 1950s fell to
8-9% in 1961-1962 then rose to 12% in 1965 and then gradually declined to 5.0% in the early 1980s. The special measures could be classified into tax exemptions and credits and tax deferrals like accelerated depreciation and tax-free reserves. These exemptions targeted specific industries such as steel and machinery and also developing technological innovation. The six main objectives of the tax incentives are outlined the Ministry of Finance (MOF) as promotion of saving; promotion of environmental quality and regional development, promotion of natural resources, promotion of technological development and modernization of industrial equipment, strengthening of the financial position of firms and other incentives. As seen in Table 2, the greatest decline in importance is promotion of export and foreign investment which included special deductions of export income from taxation and accelerated depreciation for export orientated firms. However, this is still an understatement of the magnitude of tax incentives due to hidden incentives that are not included by the MOF in special tax incentives. Firstly, there is the provision for capital gains, interest and dividends as part of the basic income tax law. Second, the fractionation of individual income tax into separate classified taxes loses a great deal of revenue and greatly reduces the progressivity of the nominal rate structure, particularly at the top brackets. Third, business expenses as special depreciation accounting and deduction for part of social and entertainment expenses are also not included. Fourth, housing subsidy and low interest loans to executives are not regarded as special tax measure. Fifth, the official estimate of revenue is constantly low, so therefore, the special tax measures are estimated low. Another feature of the Japanese growth economy was the annual tax-cutting policy due to the fact that GNP rose by an average of 15% a year between
1950 and 1960. The reason for the annual cuts were due to the fact that Japan had a highly elastic income tax reaching
2.0 in the 1960s meaning that for every 10% growth in GDP that would be a 20% growth in revenue. The Japanese government did not use the money in the expansion of government or counter-cyclical to obtain stable growth.
Social welfare was also limited for the insistence on investment into growth and export. The tax cutting policy is to keep the revenues to national income constant at around
20%. This was maintained between 1955 to 1965. This was targeted at the individual income tax while both corporate income tax and indirect taxes showed varying changes over time. Corporate taxes increased much more frequently while indirect taxes were raised to adjusted for the rise in commodity prices. The result of the tax cutting and keeping a lid on the growth of the public sector coupled by the lowest expense on defense in the developed country was the lowest tax rates in the developed country. Therefore, this permitted the rapid increase in private demand. As mentioned above, the tax system stresses simplicity instead of equity with the result of benefiting business and professionals rather than the employee. First, the Shops Mission suggested the "blue return" system which is a self-assessment income tax for small to medium size businesses. The benefits of the blue return include basic deduction for blue return, special deductions for wages of family members working in the same company, and special tax-tree reserves for employees ' retirements, allowance for bad debt etc. These special treatments reduce the tax burden of the family small business firms. Secondly, there is the issue of withholding tax system for wage and salary incomes. More than 80% of individual income tax is withheld at the source. Although withholding is applied to interest, dividend, and other income, the largest portion of withheld taxes relate to employment income. As seen in Figure 3, the income of salary earners is almost fully identified by tax authorities while self-employed and farmers have much an advantage in taxable income. This is often referred as the "ku-ro-yon", 9-6-4 ratio of salaried workers, self-employed and farmers. The third issue is the anonymous and fictitious accounts. Banks accounts could be opened with seals rather than signatures and banks make no attempt to identify the seals. By creating a number of these tax-free treatments, the wealthy was able to abuse the system.
Therefore, although the tax system structure was not prominently regressive, the legislative side make the wage-earners pay a higher price of taxation for the reason of simplicity to businesses as proposed by the government. Tax
Structure and Economic Development In the period since the Meiji Restoration, there has been government transfer and tax incentive from the peasant and wage earners to business to stimulate growth. Japan has had phenomenal growth in the past hundred years, however, the question is that if there is a direct relationship between tax structure and economic development. In Table 3, y/N stands for per capita real GNP with N as the total population, Ag/Y is the agricultural products ' share in GNP with Ag as the output of the primary sector, M/Y or (M+X)/Y as the openness of the economy where M and X stand for import and export respectively. As seen in Table 3, there is a significant correlation between y/N, Ag/Y and T/Y between
1885-1944. Before the war, the agriculture sector still played an important role in taxation structure. This is often referred to as the dual sector and where the taxes in the form of land taxes were charged heavily in taxation. There is also no correlation between the postwar period of 1951-86 but y/N and T/Y are still significantly related. As from
1951-1986, openness provides a better index than the other two variables mentioned 25 years before the prewar period, and it becomes even more significant in explaining T/Y for the postwar period. Therefore, there is a correlation between the openness of the economy, which is imports and exports and the taxation structure. However, one could emphasize the passive nature of the evolving tax system , in which one could even say that the major determinant of tax structure change is the structural change in the economy itself during the process of economic development. When we consider Table 4, where Tl is land taxes, Ti is indirect taxes, and Ty income taxes on individual and corporate income. It shows the relationship (R2)that land taxes made up the principal shares revenue in 1885-1898 while indirect taxes made up 1899-1935 and incomes taxes from 1936-86. This proves the time division as mentioned above. However, more importantly, as y/N increases, Tl/Tn and Ti/Tn decreases. The relative importance of land and indirect taxes faded when growth increased. As for the openness (M/Y or
(M+X)/Y) can be explained from the opposite signs in Ti/Tn before and after the war (3.101 to -1.808). The negative correlation after the war showed that openness was no longer effective in increasing the indirect tax base at this level of economic development and that the declining importance of indirect taxes happen to have a close bearing with the openness in a growing economy. That leaves us with Ty/Tn dominantly affected by y/N, with the relative share of income taxes rising in the course of development. The supply-side point of view emphasizes the link between savings and investment with I=S+(T-G) with net export as zero. As taxes revenue were greater than government expenditures before
1975, investment from saving could be maximized. With net exports as positive, it would also help on investment in the country. As seen in Table 5, there was constant government surplus before 1975. Therefore, it was only 1975, that the government could continue the role using taxes to promote investment and growth. As deficit grew, it would eat into the savings and therefore investment. This was also the tax-cutting policy which was before 1975 to prevent the overburden of the tax payer with their high elasticity of personal tax revenue. The growth can be shown using the formula k=sx-(n+d)k which means for an increase in capital stock savings has to be larger than depreciation. The
Japanese government promoted savings through tax cuts and tax incentives and also allowed increased depreciation under tax laws more rapid growth. Studies of the impact of the special tax measures on Japanese economic growth are, for the most part, inconclusive. There is virtually no relation between the special tax measure to promote household savings and the rate of private savings. Many of the special tax measure were used in industries that were not regarded as strategic from the standpoint of growth, such as the textile industry which received favorable treatment but grew relatively slowly. As mentioned above, though, the initial depreciation allowances were used widely for expansion and modernization in such strategic industries as steel and machinery. Therefore, except for the stimulus in these industries, the special tax measure did not have a substantial effect on investment and growth. Although the tax system and its effect on the economy is inconclusive, tax system may affect economic activity in several ways. First, fro business and managerial incentives, the regular salary earners with tax withholding has a fully taxable income. As for the business innovator and risk taker, the rewards are scarcely taxed by the tax system which permits the tax-free accumulation of capital gains and requires only modest tax payments on other property incomes. As for management incentive, the typical manager obtains his satisfaction through prestige of job, expense of account which is often easily deductible under tax laws. Implicit tax exemption fro unrealized capital gains derived from undistributed corporate earnings permit the manager to accumulate large amount of corporate wealth.
Second, the effect on economic stability, Japan with its high elasticity on income taxation could be used for the stabilizing effect of the economy to cushion the economic bumps.
However, the Japanese government has reduced the tax rate and used monetary policy for short-run stabilization. As for the effects on saving and investment, gross savings increased from about 25% of GNP in the mid-1950s to about 40% in the 1970s. Increase of the stock of capital is important for growth because it raises productivity directly and permits the adoption of newer and more efficient technologies. The national budget with its surpluses added to the national saving and helped to provide the margin of resources needed for the production of large and growing volume of investment good. Government savings also averaged above 40% of private savings even with the annual tax reductions. This was due to the systematic underestimation of tax revenues. The policies to promote private investment such as accelerated depreciation makes bankers more willing to make loans.
Therefore, the tax incentives made have had an indirect effect on investment and growth. Finally, the simple fact that the low tax rate in Japan may be the prevailing explanation for the high rate of private saving and investment in Japan.
Other Determinants of Tax Structure Development and
Growth The military factor before W.W.II and after was reduced drastically to less than 1 % of GNP. Before the
W.W.II the figure was around 28% of GNP. This is low in international comparisons of military expenses-GNP ratio where it is 6.3% in the USA. Japan has a low level of welfare commitments. The average transfer payments to national income in 1961-1970 in various countries was
20.8% in France, 7% in USA with 5% in Japan. By 1984, the US ratio grew to 15.1% while France went up to
35.2%, in comparison with Japan 's 14%. Another factor is the savings in Japanese thriftiness. Even at high direct taxation on the wage earner, the average saving rate was still between 25% and 40% GNP. This started since the Meiji
Restoration with moral suasion from the government with slogans like "Let us avoid all luxuries so that we keep up with the world; truly the development of our national productive strength has its roots in reverent obedience." This was coupled with the favorable inheritance tax laws and capital gains law that made accumulation of wealth feasible and worthwhile to the family centered Japanese worker.
Future of Tax System in Japan As seen in Table 5, huge deficits arose since 1975 from the first oil shock and accelerated due to the second one and amounted to 4.4 % of the GNP in 1979. This has caused more alarm compared with other countries with similar levels of debt. The government was no longer able to cut taxes on personal taxes and government incentive programs because of their large losses in tax revenue were cut (Table 1). On top of the economic repercussions, the original tax system was repressive and unjust for the stress on simplicity. In 1989, the Value Added Tax (VAT) was added as the consumption indirect tax after almost ten years of debate at 3%. Reform was necessary for between 1975 and 1984, the tax burden rose sharply in Japan with central government taxes up by
4.1% and local taxes by 2.7% taxes. The dissatisfactions could be categorized in the difference in tax burden among taxpayers in which the tax ratio was "ku-ro-yon", 9-6-4 ratio among workers, self-employed and farmers. Mismatch between the wage system and income tax structure in which the wages rose with seniority and taxes also increased steeply where the middle class need it the most with the children 's education or for a residence. Therefore the progressiveness of the income tax for middle-class salaried workers is too high. The unfairness in taxation on capital income, as mentioned above is major source of savings and investment but also is a source of inequitable tax system and behind the massive account surpluses. The heavy corporate tax burden which has risked dramatically since the 1970s have caused much complaint. The outdated indirect taxes which pose no tax on service is a failure to reflect the changing consumption patterns. The standard procedure for the tax reform is to reduce marginal tax rates by broadening the tax base with the introduction of indirect consumption taxes. It is also a cheaper and more effective way to stimulate savings for consumption tax does not tax savings instead of using special tax incentives. The reform is also necessary in view of the aging population and its need for larger social security . Tax preferences for expenses and depreciation allowance should be reduced to reduce the loss in tax revenue. A comprehensive tax system will not only will achieve what Shops Mission 's real goal of tax equity but also ensure the future mature growth of Japan for with a large deficit, the previous tax provisions and incentives can no longer be continued. Japan 's tax system is still midway between a comprehensive income tax and an expenditure tax. Change is necessary, but the role of government and taxation still pose many hard decisions to politicians.
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