Japan’s Pending VAT Increase in Context

June 23, 2015

Come 2017, Japan plans to increase its Value-added Tax (VAT) from 8 percent to 10 percent. This is part of the leading party’s plan to reduce Japan’s government debt and spur economic growth in the country. Given the country’s anemic economic growth in the past couple of decades, one would think that increasing taxes would be a poor choice for Japan. Many news reports have blamed the previous VAT increase from 5 percent to 8 percent for the recent Japanese recession. But taken in context, this VAT increase makes sense in the long term.

Japan faces a major fiscal issue. Japan’s government debt is about ¥1 quadrillion or $8.7 trillion, giving it the highest debt-to-GDP ratio in the world at about 200 percent of GDP. This level of debt is troubling by itself, but Japan also faces a rapidly aging population. This will place additional fiscal pressure on its social security system and will drive their government spending (and debt) higher as time goes on.

In addition, Japan has seen nearly no economic growth in the past 2 decades. Japan’s GDP per capital today is about as high as it was in 1995.

Thus, the challenge the Japanese ruling party faces is how to develop policies that reduce Japan’s sizeable debt without harming an already weak economy.

What the ruling party has come up with in regard to tax policy makes sense. Japan will raise its VAT: in 2013 the VAT was increase from 5 percent to 8 percent. In 2017, it will increase again to 10 percent. Japan’s VAT will still be far lower than the average among advanced economies (about 20 percent).

The increase in the VAT is being paired with a cuts in the corporate income tax rate. In 2012, the Japanese corporate income tax rate (national plus local rates) was 39.5 percent. In 2013 the rate was reduced to 36.99 percent and today is 32.11 percent. The government has plans to reduce it below 30 percent over the next several years. This will bring its corporate income tax rate closer in line with other advanced economies (25 percent).

Taken together, this tax trade will increase revenue for the Japanese government, but there is little reason to think that this will harm growth in the long term.

Japan is shifting its tax burden away from capital and towards consumption. Lower taxes on capital reduces what is called the cost of capital. This leads to higher desired capital stock and an increase in investment and economic growth. So even though Japan is raising more revenue overall, the way Japan is raising taxes is more efficient and more conducive to long-term economic growth.

Japan faces a number of economic challenges, much of it demographic-related. Tax reform alone cannot address those problems. However, Japan is helping its long-term prospects by making its tax code friendlier to investment.


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