Discussion Paper No. 624

AN ASSESSMENT OF CONSUMPTION
AND INCOME TAXES IN JAPANCharles Yuji Horioka
andShizuka Sekita

November 2004

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

An Assessment of Consumption and Income Taxes in Japan*
Charles Yuji Horioka**Institute of Social and Economic Research, Osaka University
Shizuka Sekita
Graduate School of Economics, Osaka University
November 22, 2004
Abstract
In this paper, we conduct a theoretical analysis of the consumption and income taxes
from the viewpoints of efficiency and equity, we evaluate the past and present structureof Japan’s consumption and income taxes, we consider the role of the consumption tax instimulating the economy, in reforming the public pension system, and in achieving fiscal
reconstruction, and finally, we make policy recommendations based on our findings.
We find that the structure of Japan’s current consumption and income taxes isproblematic from the viewpoints of both efficiency and equity and make policy
recommendations that will simultaneously improve both the efficiency and equity ofJapan’s tax system.
Key words: Consumption tax, Corlett and Hague, economic stimulus, efficiency, equity,
excess burden, fiscal reconstruction, income tax, inverse elasticity rule, Japan,
Japanese economy, optimal taxation, pension reform, Ramsey, and tax reform

Journal of Economic Literature classification numbers: H21 (Efficiency/Optimal
Taxation),

H23(Externalities/Redistributive

Effects/Environmental

Taxes

and

Subsidies), H24 (Personal Income and Other Nonbusiness Taxes and Subsidies).

**Address for correspondence: Institute of Social and Economic Research, Osaka
University, 6-1, Mihogaoka, Ibaraki, Osaka 567-0047, JAPAN.
6-6879-8586 or 8574.

Facsimile: (81) 6-6878-2766.

Telephone: (81)

Email: horioka@iser.osaka-u.ac.jp

1. Introduction
Recently, the consumption tax has attracted widespread interest in Japanbecause of its potential role in stimulating the economy, in improving the finances of the
public pension system, and in achieving fiscal reconstruction.

For example, many

economists have suggested reducing, then gradually raising, the consumption tax as away of stimulating the economy and generating inflationary expectations, both theruling Liberal Democratic Party and the number one opposition party (the Democratic
Party of Japan) have proposed using the consumption tax to improve the finances of the
public pension system, and the government is proposing a sharp increase in the
consumption tax as a way of achieving fiscal reconstruction.
In this paper, we conduct a theoretical analysis of the consumption and income
taxes from the viewpoints of efficiency and equity, we evaluate the past and present
structure of Japan’s consumption and income taxes, we consider the role of theconsumption tax in stimulating the economy, in reforming the public pension system,
and in achieving fiscal reconstruction, and finally, we make policy recommendations
based on our findings.

We find that the structure of Japan’s current consumption

and income taxes is problematic from the viewpoints of both efficiency and equity andmake policy recommendations that will simultaneously improve both the efficiency andequity of Japan’s tax system.
The structure of the paper is as follows:

In section 2, we conduct a theoreticalanalysis of the consumption and income taxes from the viewpoint of efficiency andequity; in section 3, we evaluate the past and present structure of Japan’s consumption
and income taxes; in sections 4, 5, and 6, we consider the role of the consumption tax instimulating the economy, in reforming the public pension system, and in achieving fiscal

1

reconstruction, respectively; and finally, in section 7, we make policy recommendations
based on our findings.

2. A Theoretical Analysis of the Consumption and Income Taxes
In this section, we conduct a theoretical analysis of the consumption andincome taxes.

When evaluating a tax, there are two criteria that are commonly

used—efficiency and equity.

Efficiency refers to whether a tax distorts the decision-

making process of economic agents (i.e., whether it causes an excess burden), and equity
refers to whether a tax has favorable or unfavorable distributional consequences. In
this section, we evaluate the consumption and income taxes from the viewpoints of both
efficiency and equity.

2.1. Efficiency
First, we analyze the consumption and income taxes from the viewpoint ofefficiency.

2.1.1. The Consumption Tax
The consumption tax introduces at least two distortions: it distorts the
allocation of consumption among different consumption goods (excluding leisure), and it
distorts the allocation of consumption between leisure and other consumption goods.
Looking first at the distortion in the allocation of consumption among different
consumption goods (excluding leisure), the consumption tax distorts this allocation
decision by raising the prices of some or all consumption goods.

A comprehensive

consumption tax raises the prices of all consumption goods (excluding leisure) by the2same percentage, but this does not necessarily mean that such a tax does not cause any
distortions.

The reason is that different consumption goods have different

compensated price elasticities of demand.

Even if the prices of all goods are increasedby the same percentage, goods whose compensated price elasticity of demand isrelatively high (in absolute value) will show a more pronounced decline in demand than
goods whose compensated price elasticity of demand is relatively low (in absolutevalue).
Ramsey (1927) first pointed out this problem and proposed the “inverse
elasticity rule” or “Ramsey rule” as a way of eliminating the distortion in the allocationof consumption among different consumption goods caused by the imposition of aconsumption tax.

This rule states that the tax rate of each good should be inversely

proportional to the absolute value of the compensated price elasticity of demand of that
good. As pointed out by Hatta (2004a, 2004b), this rule is not very useful in actual
practice because it suffers from an important defect: it makes the unrealistic
assumption that all cross-price elasticities of demand are zero and that even goods witha high compensated price elasticity of demand (in absolute value) have no substitutes.
Moreover, since necessities often have low compensated price elasticities of demand,
applying Ramsey’s (1927) inverse elasticity rule will require us to impose higher tax
rates on necessities, making the tax regressive.

Thus, implementing the inverse

elasticity rule may or may not improve efficiency, and moreover, it will have an adverse
impact on equity.
Looking next at the distortion in the allocation of consumption between leisureand other consumption goods, it is almost impossible to accurately measure the leisureconsumption of each individual (i.e., the number of hours each individual devotes to3leisure), and thus it is not feasible to impose a tax on leisure.

And if all consumption

goods other than leisure are taxed while leisure is not, this will lead to a distortion in
the allocation of consumption between leisure and other consumption goods, withleisure being overconsumed and all other consumption goods being underconsumed.
Corlett and Hague（1953）pointed out that this distortion can be alleviated bytaxing complements of leisure (such as summer homes, yachts, golfing goods, movie
tickets, etc.) more heavily and substitutes of leisure (such as washing machines,
vacuum cleaners, electric ranges, etc.) more lightly than other consumption goods.

2.1.2. Income Tax
The income tax introduces at least two distortions.

The first distortion causedby the income tax is that, by taxing labor income, it discourages labor, or to put it
another way, it subsidizes leisure, as in the case of the consumption tax. Thus, it leads
to an undersupply of labor and to an overconsumption of leisure.

The solution is tomake labor income tax-exempt.
The second distortion caused by the income tax is that, by taxing capital income(interest, dividends, rent, etc.), it discourages saving.

The solution is to make capitalincome tax-exempt.
However, if both labor income and capital income are made tax-exempt, thegovernment will not be able to raise any tax revenue.

Thus, the government needs toimpose taxes on either labor income and/or capital income.

It can be shown that it is

optimal to tax labor income if labor supply has the lower compensated price elasticity
and to tax capital income if saving has the lower compensated price elasticity.

It isbelieved that labor supply has a lower compensated price elasticity than saving, and if4

that is the case, it is optimal to make capital income tax-exempt and to tax only labor
income (i.e., to impose a wage tax).

2.1.3. Conclusion
As we have seen, both the consumption and income taxes cause distortions in
consumer behavior. The only tax that does not cause any distortions is the poll or
lumpsum tax, which collects the same amount of tax from each individual, or if
individuals are heterogenous, a poll or lumpsum tax that collects the same amount oftax from all individuals of each type, but poll taxes are unrealistic, not to mention
regressive.

Thus, the only choice is to impose a tax that causes one kind of distortionor another.
As Hatta (2004a, 2004b) notes, it is often the case that, by mitigating one
distortion, one exacerbates a different distortion.

For example, raising the tax rate oncomplements of leisure and lowering the tax rate on substitutes for leisure will mitigate
the distortion in the allocation of consumption between leisure and other consumption
goods, but at the same time, it will exacerbate the distortion in the allocation of
consumption among different consumption goods (excluding leisure).

Thus, there is atrade-off between these two kinds of distortions.
An optimal tax structure is one that takes account of this trade-off andmaximizes social welfare.

According to Hatta (2004a, 2004b), an optimal tax structureis one in which a higher tax rate is imposed on strong complements of leisure, a lower
tax rate is imposed on strong substitutes for leisure, and a uniform tax rate is imposedon all other goods (goods with a low cross-price elasticity of demand with leisure).

Inother words, he finds that it is optimal to use consumption taxes to alleviate the5distortion in the allocation of consumption between leisure and other consumption
goods.

2.2. Equity
In this section, we analyze the consumption and income taxes from theviewpoint of equity.

2.2.1. Consumption Tax
Since the propensity to consume generally decreases with income, a sales tax
that is imposed at the time of sale will be regressive and hence inequitable.
solution is to impose an expenditure tax instead of a sales tax.

The

An expenditure tax is a

tax in which individuals file a tax return and pay a tax on the difference between theirincome and their saving (where saving is calculated as the net increase in their assets).
The two taxes are similar in the sense that they are both imposed on consumption but
they are different in the sense that a sales tax cannot be made progressive while anexpenditure tax can be made as progressive as one wants.

The problem is that an

expenditure tax is difficult to implement and has never been tried in actual practice inany country.
Given that an expenditure tax is not practical, the second-best solution is to
impose a sales tax but to impose a lower or zero tax rate on food and other necessities
and to impose a higher tax rate on luxury goods.

There are many examples both inJapan and in other countries of certain goods being exempted entirely fromconsumption taxes or of differential tax rates being imposed on different commodity
groups.

For example, in the United States, there is no national consumption tax, but

6most states have a state sales tax, and in about half of the states that have a sales tax,
food is tax-exempt, and in most states that have a sales tax, prescription drugs are
tax-exempt.

As another example, in many European countries, the consumption(value added) tax has two or three tiers, with a lower tax rate being levied on food.

Asa final example, Japan imposed a commodity tax on certain consumption goods(primarily luxury goods) until the general consumption tax was introduced on April 1,
1989.

Thus, many countries including Japan have made efforts to alleviate theregressivity of the consumption tax.

2.2.2. Income Tax
The income tax can be made as progressive as one wants, and thus it is easy toachieve equity using the income tax.

2.2.3. Conclusion
Unless the consumption tax takes the form of an expenditure tax, which is notpractical, it is difficult to achieve full equity using the consumption tax, and thus it iseasier to achieve full equity using the income tax.

2.3. Consumption Tax or Income Tax?
In order for the government to function, it needs tax revenue, and thus thegovernment needs to impose one kind of tax or another.

The trick is to find a tax

system that simultaneously achieves efficiency and equity.

The problem is that,

although it is sometimes possible to achieve efficiency and equity simultaneously, thetwo objectives are often contradictory.

7

For example, in the case of the consumption tax, since the compensated priceelasticity of demand is often low (in absolute value) in the case of necessities, if we apply
Ramsey’s (1927) inverse elasticity rule, we would have to set a higher tax rate fornecessities than for other goods, and thus we would have to sacrifice equity for efficiency.
By contrast, since Corlett and Hague’s (1953) rule entails imposing a higher tax rate oncomplements of leisure and since many complements of leisure are luxury goods, we canachieve both efficiency and equity simultaneously by implementing Corlett and Hague’s
rule.
In the case of the income tax, it is optimal from the viewpoint of efficiency to
tax labor income more heavily than capital income (assuming that labor supply is moreprice-inelastic than saving), but in general, the share of capital income in total income
rises with income, and thus from the viewpoint of equity, it is optimal to tax capitalincome more heavily than labor income.

Thus, the two objectives conflict in this case.

Hatta (2004a, 2004b) argues that we should not attempt to achieve equity
through the consumption tax because there are other taxes (such as the progressive
income tax, the land tax, the inheritance tax, etc.) that are better suited to attaining
equity. Hatta (2004, 2004b) asserts that we should leave the attainment of equity tothese taxes and that we should use the consumption tax to alleviate the distortion in the
allocation of consumption between leisure and other consumption goods by applying
Corlett and Hague’s (1953) rule, but as argued earlier, we can achieve both efficiency
and equity simultaneously by applying Corlett and Hague’s rule.

3.

An Evaluation of Japan’s Tax System
In this section, we evaluate the past and present structure of Japan’s

8consumption and income taxes from the viewpoints of both efficiency and equity.

3.1. Consumption Tax
First, we evaluate the past and present structure of Japan’s consumption tax.

3.1.1. Efficiency
Until March 31, 1989, Japan did not have a general consumption tax but
commodity taxes ranging from five to 30 percent were imposed on certain goods (mostly
luxury goods).

If we look at the structure of the commodity taxes, food and other goods

with a low compensated price elasticity of demand (in absolute value) were tax-exempt,
meaning that Ramsey’s (1927) inverse elasticity rule was not being followed and thatthe opposite was being done. Looking next at whether the structure of the commodity
taxes was consistent with Corlett and Hague’s (1953) rule, many of the goods uponwhich commodity taxes were imposed are clearly close complements of leisure (such as
golfing goods, billiard goods, motor boats, water game supplies, hand gliders, musicalinstruments, televisions, stereos, etc.), and some of them are close substitutes forleisure (such electric vacuum cleaners, electric washing machines, etc.) so it is not clear
whether or not the structure of the commodity taxes was consistent with Corlett andHague’s (1953) rule.

However, it is probably the case that commodity taxes were

imposed more frequently on complements of leisure than on substitutes for leisure,meaning that they alleviated the distortion in the allocation of consumption between
leisure and other consumption goods to some extent, thereby improving efficiency.
The Japanese government abolished the commodity taxes on selected goods
and introduced a 3% general consumption tax on April 1, 1989, and raised the general9consumption tax from 3% to 5% on April 1, 1997.

This general consumption tax is

uniform, and thus it does not reflect either Ramsey’s (1927) inverse elasticity rule orCorlett and Hague’s (1953) rule. Thus, it distorts both the allocation of consumption
among different consumption goods (excluding leisure) as well as the allocation of
consumption between leisure and other consumption goods and is not an efficient tax byany means.

However, unlike the earlier commodity taxes, food and other necessities

with a relatively low compensated price elasticity of demand (in absolute value) are nolonger tax-exempt, and thus the current general consumption tax is closer to Ramsey’s(1927) inverse elasticity rule than the earlier commodity taxes.

However, whereas theearlier commodity taxes adhered to Corlett and Hague’s (1953) rule to some extent, thecurrent general consumption tax does not adhere to this rule at all.
Thus, by moving from the earlier commodity taxes to the current general
consumption tax, the distortion in the allocation of consumption among different
consumption goods (excluding leisure) was alleviated but the distortion in the allocationof consumption between leisure and other consumption goods, a more serious problem,
was exacerbated.

Thus, there is a high probability that the overall efficiency of theconsumption tax declined due to the transition from commodity taxes to a general
consumption tax.

3.1.2. Equity
In the case of the commodity taxes that were in effect until March 31, 1989,
food and other necessities were tax-exempt and a high tax rate was imposed on many
luxury goods.

Thus, the earlier commodity taxes achieved equity to a considerable

extent.

10

However, the general consumption tax that was introduced on April 1, 1989, isa sales tax rather than an expenditure tax, and moreover, the tax rate on food and othernecessities is not relatively low or zero and the tax rate on luxury goods is not relatively
high.

Thus, it can be said to be a regressive and thus inequitable tax.

3.1.3. Conclusion
As we have argued, the transition from commodity taxes to a general consumption
tax probably reduced the efficiency of the consumption tax and clearly reduced theequity thereof.

Thus, from the viewpoint of optimal taxation, one cannot say that it

was a desirable tax reform.

3.2. Income Tax
Next, we evaluate the past and present structure of Japan’s income tax.

3.2.1. Efficiency
In the past, the Japanese tax code included many tax breaks for saving (capitalincome) such as the maruyuu system (the tax-free system for small deposits), and as aresult, the tax rate on capital income was probably lower than the tax rate on labor
income.

Thus, (assuming that labor supply is more price-inelastic than saving) the

structure of Japan’s income tax scored high with respect to efficiency.
However, the maruyuu system was restricted primarily to those aged 65 orolder on March 31, 1988, and it is scheduled to be abolished totally (in principle) on
December 31, 2006, and other tax breaks on saving (capital income) have also beenabolished.

This has reduced the efficiency of the income tax and will cause it to decline11

even further in the future.
Turning to a separate issue, the progressivity of Japan’s income tax has
declined over time, as discussed in section 3.2.2. below, and this will improve efficiency
to the extent that it alleviates the disincentive effects on the labor supply ofhigh-income individuals.

However, since labor supply is believed to be relatively

inelastic, the efficiency gains from reduced progressivity are presumably relatively
small.

3.2.2. Equity
Japan’s income tax is non-linear and progressive, but the degree of
non-linearity and progressivity has declined over time.

Table 1 shows how the numberof brackets and the range of tax rates have fluctuated over time, and as this table shows,the degree of non-linearity and progressivity and hence the equity of Japan’s income tax
has declined since the 1980s.

Table 1: Trends in the Number of Brackets and in the Range of Tax Rates of the
National Income Tax in Japan
1971~83: 19 brackets（10～75％）
1984~86: 15 brackets (10.5～70％)
1987: 12 brackets（10.5～60％）
1988: 6 brackets（10～60％）
1989~98: 5 brackets（10～50%）
1999～present: 4 brackets（10～37％）

12

Next, we would like to confirm these trends from another perspective.

Tables2 and 3 show the share of taxpayers for whom each marginal tax rate applied in 1988
and 2001, and as can be seen from these tables, the 1999 income tax reform caused
the share of taxpayers for whom the 10% marginal tax rate applies to increase
sharply from 60.8% to 69.2% and caused the share of taxpayers for whom the 20%
marginal tax rate applies to decrease sharply from 28.4% to 22.0%, as a result of
which the lowest marginal tax rate applied to a full 70% of taxpayers.

This

corroborates the trend toward a less non-linear, less progressive, and less equitable
income tax.

Table 2: The Share of Taxpayers for Whom Each Marginal Tax Rate Applies (1998)
Marginal Tax Rate

Share of Taxpayers

10％

60.8％

20％

28.4％

30％

6.5％

40％

2.3％

50％

2.0％

Source: Kokuzei-chou Toukei Nenpou-sho (The Statistical Yearbook of the National Tax
Agency), 1998 edition

Table 3: The Share of Taxpayers for Whom Each Marginal Tax Rate Applies (2001)
Marginal Tax Rate

Share of Taxpayers

10％

69.2％

20％

22.0％

13

30％

5.3％

37％

3.6％

Source: Kokuzei-chou Toukei Nenpou-sho (The Statistical Yearbook of the National Tax
Agency), 2001 edition

3.2.3. Conclusion
Assuming that labor supply is more price-inelastic than saving, the gradualabolition of various tax breaks for saving (capital income) has lowered the efficiency ofJapan’s income tax, and the reduction in progressivity has reduced the equity thereof.
Thus, Japan’s recent income tax reforms have reduced the efficiency as well as theequity of the income tax, and thus one cannot say that they were desirable from an
optimal taxation standpoint.

4.

The Role of the Consumption Tax in Stimulating the Economy
The Japanese economy is finally recovering from more than a decade ofrecession and price deflation, and during the recession, many economists advocatedusing the consumption tax as a tool for stimulating the economy and ending pricedeflation.

In this section, we explain how one could stimulate the economy using theconsumption tax and the merits of doing so.
On January 18, 2002, one of the co-authors of this paper wrote an opinion piecein Nihon Keizai Shinbun in which he proposes lowering or abolishing the general
consumption tax for a fixed period of time and then raising it gradually (see Horioka(2002) for details).
Such a policy would have at least four advantages:

14

First, it would be effective.

By lowering or abolishing the general

consumption tax for a fixed period of time and then raising it gradually would stimulate
consumption and hence the economy as a whole because consumers would accelerate
purchases of consumption goods, especially non-perishable goods, in order to takeadvantage of temporarily lower consumption taxes.
Second, it would not cost the government very much in foregone tax revenue.
If the permanent income hypothesis applies, a temporary income tax cut would not havemuch impact on consumption because it would not have much impact on permanent
income.

In order to be effective in stimulating consumption, the income tax cut would

have to be permanent so that it increases permanent income, but a permanent income
tax cut would lead to a massive loss of tax revenue.

By contrast, a consumption tax cut

would be more effective if it were temporary because only a temporary consumption tax
cut would induce consumer to accelerate their purchases of consumption goods.

Thus,

a temporary consumption tax cut would be preferable to a permanent consumption tax
cut for two reasons—first, because it would be more effective, and second, because it
would not cost the government nearly as much in foregone tax revenue.
Third, it would be effective as a means of ending price deflation. Lowering or
abolishing the general consumption tax for a fixed period of time and then raising it
gradually would generate inflation, and if the inflation that is generated causes
inflationary expectations to take root, inflation will continue even after the gradualincreases in the consumption tax rate end.

Thus, if all goes well, the same fiscal policy

would simultaneously stimulate consumption and end price deflation.
Fourth, it would be equitable.

Since the propensity to consume generally

declines with income, low-income consumers will receive a disproportionate share of the15benefits of the temporary consumption tax reduction or abolition. Thus, the temporaryconsumption tax reduction or abolition would have the added benefit of increasing
equity.
Thus, a policy of temporarily reducing or abolishing the consumption tax would
confer at least four advantages and does not have any major disadvantages.
The Japanese government relied on temporary income tax cuts to stimulate
consumption and hence the economy as a whole during the decade-long recession, but as
noted earlier, theory predicts that income tax cuts will not be effective unless they arepermanent but permanent income tax cuts would have been too costly to thegovernment in terms of foregone tax revenues.

Thus, the Japanese government would

have been better off temporarily reducing or abolishing the consumption tax instead oflowering income taxes as a way of stimulating the economy.
The Japanese economy is finally recovering, but the recovery is showing signsof slowing down, and if the Japanese economy should slide back into recession, theJapanese government should consider using a temporary reduction or abolition of theconsumption tax as a way of stimulating the economy.

5. Pension Reform and the Consumption Tax
Japan’s public pension system is, in effect, a pay-as-you-go system, meaningthat the pension benefits of retirees are financed by the pension contributions of current
workers.

Thus, the finances of the public pension system will depend heavily on theage structure of the population, and the finances of Japan’s public pension system aredeteriorating rapidly due to the rapid aging of her population.

The Japanese

government has tried to improve the finances of the public pension system by reducing

16

benefits, raising contributions, and raising the age at which pensions are paid, but eventhese reforms have proven to be inadequate.

As a result, many have proposed raising

the consumption tax and using the additional revenue to bolster the finances of the
public pension system.

In this section, we discuss the merits and demerits of using

consumption tax revenue to bolster the finances of the public pension system.
Both the ruling Liberal Democratic Party and the number one opposition party(the Democratic Party of Japan) have proposed raising the consumption tax and using
the additional revenue to bolster the finances of the public pension system, but their
proposals differ greatly.

5.1.

We now discuss the two parties’ proposals in turn.

The Liberal Democratic Party proposal
As part of the 2000 reform of the public pension system. it was decided that thesubsidy from general revenues to the basic pension (a fixed-sum public pension forwhich everyone is eligible) would be increased from one-third to one-half, but it was not
specified how this increase in the subsidy from general revenue would be financed.
The most likely financing method is to increase the consumption tax, and the Tax
Deliberative Council has recommended increasing the consumption tax after “clarifying
the connection between the higher consumption tax and social security-related
expenditures.”

However, Prime Minister Junichiro Koizumi has pledged not to raise

the consumption tax during his tenure, so any hike in the consumption tax will have to
wait until after his term ends.

5.2.

The Democratic Party of Japan proposal
The Democratic Party of Japan proposes creating a two-tiered public pension

17

system for which everyone is eligible.

The first tier (the National Basic Pension(Kokumin Kiso Nenkin)) would be financed by a Pension Earmarked Consumption Tax(Nenkin Mokuteki Shouhi-zei), a 3% consumption tax that would be levied on top of thecurrent 5% tax.

The second tier (the Earnings-related Pension (Shotoku Hirei

Nenkin)) would be financed by the pension contributions of current workers and would
be proportional to the beneficiary’s past earnings.

Two unique features of the

Democratic Party of Japan’s proposal are (1) that the 3% increment to the consumption
tax would be used exclusively to finance the National Basic Pension and (2) that theamount of the National Basic Pension would not be fixed for everyone but would behigher for those with a lower Earnings-related Pension.

In other words, even thoughthe 3% consumption tax that would be used to finance the National Basic Pension isregressive, the amount of this pension is higher for the low-income and thus theregressivity of the way in which this pension is financed would be largely offset by theredistributive benefit structure.

5.3.

Conclusion
Thus, both the Liberal Democratic Party and the Democratic Party of Japanpropose relying on the consumption tax to finance the basic pension (the National Basic
Pension in the case of the Democratic Party of Japan proposal), but we are against theidea of using a regressive tax such as the consumption tax to finance the basic pension.
However, the Democratic Party of Japan proposes paying a larger National Basic
Pension to low-income individuals, and doing so would cause the regressivity of the way
in which this pension is financed to be largely offset by the redistributive benefit
structure. Thus, we feel that the proposal of the Democratic Party of Japan is far

18

preferable to the proposal of the Liberal Democratic Party.
We would actually prefer switching from a pay-as-you-go public pension to a
fully funded system that pays actuarially fair benefits and financing the unfundedliabilities of the public pension system via the issuance of long-term government bondsthat would be retired gradually so that the burden of these unfunded liabilities would
be spread out over a number of generations (see Horioka (2001) for details)).

However,

if implementing this proposal is not politically feasible, we favor the Democratic Partyof Japan’s proposal as a second-best solution.

6. Fiscal Reconstruction and the Consumption Tax
The Japanese government’s outstanding debt as a ratio of GDP is by far thehighest among the major industrialized nations, due in large part to the repeatedeconomic stimulus packages implemented during the decade-long recession, and thus
fiscal reconstruction is an urgent priority of the Japanese government. The Japanese
government plans to rely primarily on hikes in the consumption tax to achieve fiscal
reconstruction, and its calculations suggest that the consumption tax would have to beraised from the current 5% to 21% during the next ten years.
However, we are strongly against the use of hikes in the consumption tax toachieve fiscal reconstruction, at least if the current highly regressive structure of theconsumption tax is not changed. Unless the consumption tax can be converted to an
expenditure tax, which can be made as progressive as one wants, or the tax rate on foodand other necessities is set at a low or zero rate, we favor relying instead on increasing
income tax revenue by stricter enforcement and/or greater progressivity. In Japan,
there is widespread evasion of income taxes by the self-employed, farmers, etc., (even19though salaried workers are unable to evade income taxes because such taxes areautomatically deducted from their paychecks), and thus, revenue from the income tax
could be increased considerably even without changing tax rates if enforcement weremade stricter (for example, by introducing a taxpayer identification number system,
increasing the number of tax officials, and/or increasing the proportion of tax returns
that are audited).

Moreover, stricter enforcement of the income tax would

simultaneously enhance the inter-occupational equity thereof, thereby killing two birds
with one stone.

If stricter enforcement of the income tax does not increase tax revenue

by a sufficient amount, we favor increasing tax revenue by increasing the progressivityof the income tax.

Since the burden of income taxes in Japan is far lower than in othercountries, there is considerable scope for generating more revenue from the income tax
by increasing its progressivity.

We favor achieving fiscal reconstruction by raising

revenue from the income tax rather than by raising revenue from the consumption tax
primarily because of equity considerations.

The income tax is far more progressive(and hence more equitable) than the consumption tax to begin with, and moreover, if weincrease the amount of revenue generated by the income tax by increasing its
progressivity, the income tax will be made even more equitable at the same time thattax revenue is increased, thereby killing two birds with one stone.

7. Policy Recommendations
In the foregoing sections, we conducted a theoretical analysis of the consumption
and income taxes from the viewpoints of efficiency and equity, evaluated the past andpresent structure of Japan’s consumption and income taxes, and considered the role ofthe consumption tax in stimulating the economy, in reforming the public pension system,

20

and in achieving fiscal reconstruction.

In this section, we make some policy

recommendations based on the findings of the foregoing sections.
Regarding the structure of the consumption tax,
(1) We recommend implementing Corlett and Hague’s (1953) rule by raising the
tax rate of the consumption tax on complements of leisure and lowering the tax rate on
substitutes for leisure.
(2) We recommend enhancing the equity of the consumption tax by lowering
the tax rate on food and other necessities to a low or zero rate.
Recommendation (1) would enhance both the efficiency and equity of theconsumption tax, assuming that complements of leisure tend to be luxury goods, while
recommendation (2) would enhance the equity of the consumption tax but would havean adverse impact on its efficiency.
Regarding the structure of the income tax,(3) We recommend alleviating the disincentive effects of the income tax onsaving by re-introducing tax breaks on saving (capital income).
(4) We recommend enhancing the equity of the income tax by increasing its
progressivity.
Recommendation (3) would enhance the efficiency of the income tax but would,
at the same time, have an adverse impact on equity (assuming that the share of capitalincome in total income increases with income), but recommendation (4) would enhancethe equity of the income tax, thereby offsetting the adverse effect of recommendation (3)on the equity of the income tax.

Recommendation (4) would, at the same time, have an

adverse impact on efficiency to the extent that it discourages the labor supply ofhigh-income individuals, but this effect would presumably be small since labor supply is

21believed to be relatively inelastic.
Regarding the three current policy issues discussed above,(5) We recommend temporarily lowering or abolishing the consumption tax,
then gradually increasing it, if the economy should fall back into recession and pricedeflation because such a policy would simultaneously stimulate demand and create
price inflation.
(6) We recommend moving from a pay-as-you-go public pension system to a
fully funded system, but assuming that this is not politically feasible, we support the
Democratic Party of Japan’s pension reform proposal.
(7) We recommend achieving fiscal reconstruction not by raising theconsumption tax but by stricter enforcement and greater progressivity of the income
tax.
Regarding recommendation (7), the Japanese government seems intent onachieving fiscal reconstruction primarily by raising the consumption tax and has
calculated that the consumption tax would have to be raised to 21% by 2014 in order toachieve fiscal reconstruction.

We are strongly opposed to this proposal because of theregressivity of the consumption tax, but if there is no way to avoid implementing thegovernment’s proposal, we feel that it is all the more necessary to enhance the efficiency
and equity of the consumption tax by implementing recommendations (1) and (2).
Regarding recommendation (2), it is indeed fortunate that the Japanese government’s
Tax Deliberation Council has indicated its willingness to consider introducing a lower
tax rate on food when the consumption tax is increased despite possible
implementational difficulties if there is sufficient public support for such a proposal.
We are confident that, if our policy recommendations are implemented, they22

will make Japan’s tax system more efficient as well as equitable and that they will
revitalize Japan’s economy.

Acknowledgements
We are grateful to Miyohei Shinohara and the other members of the Public Policy Study
Group of the Institute for Statistical Research (Toukei Kenkyuu-kai) for their valuablecomments, and Horioka is grateful to the Ministry of Education, Culture, Sports,
Science and Technology of the Japanese Government for Grant-in-Aid for Scientific
Research number 12124207, which supported this research.

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