Tax

June 2003

With demographic change affecting Japan's finances, the government's tax panel proposed scaling back tax breaks for the elderly and doubling the consumption tax to pay for rising pension and medical care costs. In its mid-term tax reform proposals, the Tax Commission said that the government will need to increase the consumption tax, now 5%, to 10% or higher within 10 to 15 years. The commission proposed tax reforms should be discussed over a timeframe of three to 10 years, depending on public opinions and addresses short-term goals. Titled a "Tax System Desirable for the Declining Birthrate and Aging Population," the report is based on the concept of alleviating inequities concerning the tax burden shared by young and older generations. The report recommends a substantial increase of the consumption tax rate from the current 5% and the broadening of the tax base on individuals, with the aim of financing ballooning government spending on social welfare. It points out the need for a thorough review of the existing preferential tax system for the aged, including tax breaks for elderly pension beneficiaries. The report notes that sufficient attention must be paid not to unduly penalize those low-income old people who make their living only on pension benefits. Instead, the report urges a heavier taxation burden on wealthy beneficiaries who have other sources of income apart from the pension such as rental and wage income. Regarding the consumption tax, the report is the first time for commission has officially referred to the necessity of boosting the rate to 10% or more, depending on approval from the public. The report says when the planned consumption tax hike is carried out, the government should consider introducing lower tax rates for foodstuffs and other daily necessities. In raising the consumption tax by a substantial percentage, the government should use the extra revenues gained entirely for social welfare spending, while clearly explaining to the public the relationship between such expenditures and the tax burden, according to the report. In addition to steps to reduce preferential tax treatment for the aged, the report urges a review of the current tax exemption for social security payments. Those who receive pension benefits under pension plans for their deceased spouses and those who obtain unemployment insurance benefits, who currently are exempt from income tax, should be subject to taxation, according to the report. The percentage of employee's income exempt from tax, which currently amounts to an average of 28.8%, should be reduced to lower their taxable income. The head of Tax Commission, Hiromitsu Ishi, said that the commission is talking about the advisability of tax hikes in a year or two. However, income tax and the consumption tax will inevitably of pivotal importance in securing tax revenues to fund administrative services necessary in future years. (June 18, the Daily Yomiuri, the Japan Times, the Nihon Keizai Shimbun)

The government's Tax Commission has drafted a medium-term tax reform plan prescribing broad-based hikes, mainly for levies on personal income and consumption. The poor state of Japan's public finances makes tax increases inevitable in the long run. However, there are still many things the government should do before boosting taxes such as cutting wasteful spending, initiating reforms to rectify taxation inequities and increasing efforts to resuscitate the economy. However, hikes are unavoidable. Tax receipts in the current fiscal year will account for only half of the government's general-account budget. As Japanese society ages and the birth rate falls, the financial burden of social security is increasing. Nevertheless, raising taxes is a politically delicate maneuver. Any increment will be seen as reasonable or the government may face severe public backlash. Discussion should focus the extent to which the ratio of taxes and social-security payments to national income can be raised from the current 36%. To eliminate voter concerns over the fairness of the current system, the government also needs to rid the tax system of disparities in the tax-to-income ratio for different fields of employment. The Tax Commission has proposed a taxpayer identification number system to help pinpoint unfair differences. If the government will limit the scale of tax hikes to avoid political suicide, it must stimulate the economy out of its current deflationary hole and put it on a growth path. One potentially helpful step is to ease the conditions for tax incentives for investment by startups. Only 20 such companies have benefited from the system in the past six years. Policy efforts should also be directed to helping banks enhance their capital bases. Measures to improve the environment for tax increases will have to be taken in the next three to four years. Finance Minister Shiokawa has predicted the consumption tax will be raised in fiscal 2007, after Prime Minister Junichiro Koizumi, who has ruled out a hike during his tenure, leaves office. Regardless of the political situation, fiscal conditions will probably force the government to start boosting taxes soon. According to the tax panel, the consumption tax will have to be raised above 10% from the current 5%. But such predictions only raise public doubt about the government's commitment to spending cuts and administrative reform. Cost-cutting efforts could help reduce the margin of the tax hike. Income tax increase should come from cuts in deductions for employment income and the public pension scheme, to be partly offset by increases in basic allowances and deductions for dependents. There is strong justification for slashing deductions for employment income, which in most cases exceed actual job-related expenses paid by employees. The minimum tax threshold for pensioners is higher than that for non pensioners by more than \1 million. So pensioners who are still employed enjoy massive tax deductions. Such unfair tax privileges enjoyed by elderly high-income earners should be removed. The tax panel also suggested future cuts in corporate taxes. To be sure, the effective corporate tax rate in Japan (40.8%) is roughly on a par with the level in the U.S. (40.7%) or Germany (39.6%). But this level puts Japan at a disadvantage in competition with other Asian countries for business investments. The government should steadily reduce corporate taxes to bring them more in line with those of Japan's Asian rivals. Unified taxation on income from financial assets is a good idea for both consistency and simplification of the tax code. But the panel's proposal to increase local governments' leeway in taxation requires a cautious approach in order to maintain discipline in taxation. (June 18, the Nihon Keizai Shimbun)

Finance Minister Shiokawa announced that Japan and the United States have agreed to revise the bilateral tax treaty for the first time in 30 years in a bid to encourage trans-Pacific investment and exchange of human resources. Reflecting the close economic relations between the two strategic partners, the agreement will encourage mutual investment as well as prevent tax evasion. Under the new rules, certain types of cross-border income transfers will be tax-exempt, including royalties, certain dividends from subsidiaries to parent firms and some interest charges. Details will be decided later. The existing treaty, established in 1954 and last revised in 1972, aims to avoid double taxation and prevent tax evasion. There has been strong demand by corporations involved in cross-border trade to update the treaty. The two economic powers first began negotiating a revision to the treaty in October 2001. The rates under the current treaty are higher than global standards. At present, interest and royalties each attract a 10% withholding tax. There is also a 10% tax on dividends from subsidiaries that are owned 10% or more by their parent company. Under the OECD model treaty, the tax on dividends is 5%, while that applied to royalties is zero percent. (June 12, the Japan Times, the Nihon Keizai Shimbun)

Japan's Finance Ministry and the U.S. Treasury Department announced that they have agreed to an amended bilateral taxation treaty calling for tax exemptions or reductions for dividends and interest paid by subsidiaries to parent companies located in the two countries. Both Tokyo and Washington will move to ratify the amended version over the coming months to be put into effect by the end of next year. Currently, a 10% tax is levied on dividends paid by subsidiaries in one of the countries to their parent firms. Under the amended treaty, companies with clear parent-subsidiary relationships for their trans-Pacific operations will be exempt from paying the levy. As for the current 10% tax imposed on interest paid between corporate parents and subsidiaries in both countries, it will be abolished for financial institutions. A tax on trademark, patent and copyright royalties will also be terminated under the new pact. Designed to prevent companies from reducing their tax liability through manipulation of inter-group transaction prices, other aspects of the taxation system will also be revised under the new treaty. Tax will be levied only on transactions that are up to seven years old. Japanese Minister of Finance Shiokawa said that the new arrangement makes bilateral economic relations even closer through greater trans-Pacific investment and personnel exchanges. To eliminate double taxation and promote cooperation on tax matters, the current tax agreement was signed more than 30 years ago. Japan and the U.S. started talks on revising the pact two years ago hoping that the treaty is now out of sync with the realities of global corporate activities.　(June 11, the Nihon Keizai Shimbun)

The Ministry of Finance (MOF) will allow a partial transfer of income tax revenues from the central to local governments for moving forward the trinity reform addressing local financing. MOF will shift a portion of revenues from the income tax to localities as requested by such parties representing the local governments as the Ministry of Public Management and Home Affairs. In exchange, subsidies and local allocation tax grants will be reduced. Regarding the transfer of income tax revenues to local governments, reducing the national income tax and collecting that portion through a local residence tax would be a possibility. MOF took the minister's statement one step further, using it to break the impasse over the trinity reform, which calls for a reduction in subsidies to local governments, the transfer of tax revenues to localities, and the reform of the local allocation tax grant system. Aiming to implement the reforms in fiscal 2004, the government hopes to unveil guidelines by the end of June. However, reassessment of the subsidies has faced stiff opposition from various ministries and agencies. Plans to reduce local allocation tax grants have not moved forward, resulting in the entire process coming to a halt. The MOF's reluctance to transfer tax revenue sources also caused the stalled reform talks. MOF had considered shifting to localities revenue sources that compose a relatively small portion of the central government's income stream, such as the tobacco tax, but had expressed reservations toward transferring revenues from such sources as income and consumption taxes, as advocated by the Public Management and Home Affairs Ministry. Personal income tax revenues collected by the central government for fiscal 2003 are estimated at \13.8 trillion, about one-third of total tax revenues. Municipalities are projected to collect \8.2 trillion through local residence taxes. While income tax brackets now rise up to 37% according to income levels, MOF plans to reduce overall rates when local subsidies are cut. The lower income tax would allow municipalities to boost taxes. The amounts of the local tax increases will be determined after decisions are made regarding the sizes of the reductions in subsidies and local allocation tax grants. Individual local government will allow the authority to decide whether to increase the local residence tax. By increasing municipal discretion over the residence tax, which is set at different rates depending on where taxpayers live, the MOF sees local autonomy increasing. Residents can decide on where to live based on the services provided by localities and the local tax burden. (June 6, the Nihon Keizai Shimbun)

A government panel for promoting decentralization failed to devise a concrete plan to overhaul the finances of local government. The Council for Decentralization Reform compiled proposals that center on the transfer of taxing authority in two stages from the central government to local governments. But the panel members remained divided over some of the proposals. The Council on Economic and Fiscal Policy will take over the discussions on decentralization. The panel has discussed a set of three reforms advocated by Prime Minister Koizumi: cuts in state subsidies to local governments, a review of the local allocation tax grant system, and the transfer of taxing authority to prefectural governments. The panel will submit its proposals to P.M. Koizumi. According to the proposals, the central government will initially cede its authority to collect certain types of taxes to local governments, with the sole purpose of helping them cover a shortfall in revenues resulting from cuts in state subsidies. And the government will consider a full-scale transfer of taxing authority later as part of a broader tax reform. The panel also proposed as one option the idea of pooling part of tax grants to local governments, so that the funds will be channeled in larger proportion to local governments with relatively small tax revenues. But the idea drew strong resistance from local governments worried about a sharp cut in tax grants. In the end, the panel incorporated the objections voiced by four members to the idea into its proposals.　(June 4, the Nihon Keizai Shimbun)