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Japan’s Tax Reforms and its Blockbuster GDP Growth

By: Alan Cole

Japan has been implementing some substantial economic reforms lately. This year might be a good experiment in taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy, where a country trades an increase in one sort of tax for a decrease in another.

The tax hike happened earlier this year. As of April 1st, Japan's sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. has risen from 5% to 8%. In the quarter prior to the tax increase, the growth was rate was extremely high. After revisions, the Cabinet Office determined that Japan's economy grew at a ludicrously-fast 6.7% rate – a number that almost certainly includes consumption-shifting in order to get big purchases in before the April 1st deadline. Consistent with that hypothesis, Japan had poor retail sales in April. Over the long term, of course, the consumption-shifting opportunity will no longer be available. Purchases from now on will have to deal with the 8% tax.

Taken completely in a vacuum, this tax increase would be bad for Japan. The tax increase essentially takes away 3% of Japanese citizens’ purchasing power on a static basis, and even more once one considers the deadweight loss from disincentive effects.

However, put in context, the tax increase looks a lot better. Japan’s public debt is well over 200% of GDP; it has to raise some revenues to keep that debt under control. The government also looks set to increase the consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. again, to 10%, in October 2015.

Consumption taxes are the most neutral tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. of all; all economic activity is done for the eventual purpose of consumption. A broad-based consumption tax taxes all economic activity exactly once.

The good thing about this tax hike is that it may allow Japan to reduce far more damaging taxes, like its 35% corporate rate. That rate is the second highest in the developed world, behind only the United States at 39.1%. Japan is eyeing a reduction to 30% or even 25%.

Paired together, theory would predict that these two tax changes create a structural shift in the Japanese economy; the more favorable corporate tax climate would encourage investment, and some income would be spent on that new investment instead of immediate consumption. Over the long term, this will boost Japanese wealth and productivity, and eventually allow for a higher standard of living than before.

The data fit this theory so far; private nonresidential investment grew at a “blockbuster” rate of 7.6% in the first quarter of 2014. We will continue to watch Japan’s progress because it has a tax situation very similar to our own; it is a very large, wealthy economy with low consumption taxes, high corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es, and moderate individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es. If Shinzo Abe’s reforms are successful, they can serve as road maps for the United States. So far, so good.