Corporate income tax reform in Japan
Motohiro Sato
Hitotsubashi University

Background: Globalization and International tax competition
Japanese Economy and Policy Measures
MOF 2014• With economic globalization, high CITturn to be impediment tointernational competitiveness ofdomestically locating business.
 High CIT is translated into highproduction cost
• Countries now compete one anotherreducing own CIT to ①defend
domestic business and to ②attract
foreign investments/profits⇒Globalization intensifies international
tax competition

Cut of corporate income tax (CIT)• Japan government has decided to lower CIT rate
combining both the central and local rates below 30% .
 It remains high compared with other Asian countries.
 President Trump proposes federal CIT rate down to15%!
⇒Does Japan need to conduct further CIT cut?
• Why is Japan CIT high?
 On the top of central CIT, there are local CITs charged,undermining international competitiveness ofdomestic business.
 Local CITs (enterprise tax and corporate inhabitant tax)
leads to inter-regional fiscal gap and unstable local tax
revenue.
⇒We need to conduct reform of local CIT(business tax).

JapanUSUK Singapore

Impact of CIT rate cut?
• Corporate sector in Japan has accumulated cashholdings⇒Lower CIT may simply increase their cash… without
being invested or raising wage/ employment
 CIT cut is just windfall gain to companies• Accumulated cash-holdings cause orconsequence…
 It may be a consequence of lower net of tax returnon investment in Japan..
• Lower CIT rate can enhance net of tax return If firms are forward looking, high net of tax returncan encourage them to invest
 But there can be other things that undermine theirincentives of investment

OECD Economic Surveys
JAPANAPRIL 2015

Tax base broadening• Corporate tax reform follows the principle of lower tax rate with broadening tax base The principle is not only for revenue neutrality.
• Marginal versus average effective tax rate
 Effective tax rate accounts for not only statutory but also depreciation allowance, inflation, interest
deduction and tax credits influencing real response of business including investment and location whereas
statutory tax rate affects profit shifting/ tax planning Marginal effective tax rate applies to marginal or zero net of tax return investment and is lowered withinvestment tax credits.
 Investment tax credits in general enhances low return (less productive) investments/projects that would nothave been otherwise undertaken Average tax rate on investment is weighted average of statutory and effective marginal tax rates whereweight relies on invest return Average effective tax rate converges to statutory tax rate as return increases and to marginal effective tax
rate as it decreases.
⇒Tax reform Involving statutory tax cut and tax base broadening diminishing tax credit favors higher returninvestments/ projects promoting their location as well as containing incentive of profit shifting.

Too broad tax base?
• Loss carry forward is limited to 50% for large
business after April 2018 (currently it is 55%)
whereas its period is extended to 1o years.

After tax profit

Making Loss

• For on-going business, loss carry forward serves
as risk sharing device with the government.
 Income taxation has insurance function when
gain and loss are treated symmetrically.
• Limit loss carry forward implies profit is taxable
Compensation
but loss is not compensated = asymmetrictreatment=loss carry forward⇒ It could undermine the insurance function
which could discourage business to take risky
investment.

tax

0Before tax profitLocal Business VAT in Japan• To compensate revenue loss to local government, pro-forma standard taxation is enhanced.
 It includes added value base = Business VAT• The tax is more or less equivalent to VAT (consumption tax) ⇒Hidden VAT increase?
• It applies only to large business and origin based and thus distortive compared to VAT that is levied on allbusiness and follows destination principle.
・VAT is better than the pro-formula
standard tax
Profit + wage + interest payment= sales – purchase of inputs

Source: MOF

IP/Patent Outflow?
 CIT reform preserves or even enhances
R&D tax incentives.
 Both R&D site and IP can be internationallymobile There can arise not only international tax
competition over R&D activities but also
over IP/patent Given that many firms/subsidiaries acrosscountries are being involved in R&D
activities, it is increasingly difficult toidentify right place of IP/patent to locate
 Multi-national firms may be able toundertake cherry-picking behavior,undertaking R&D in a country withgenerous R&D tax incentives and moving IP
to another country with lower patent boxtax rate.
 National government cannot recover tax
revenue from successful R&Ds

IP/Patent can move to lower tax country

Financial constraint and SCC
 CIT gives favorable treatment to SMEs
including lower tax rate and generous tax
incentives.
 It is SSC (social security contribution) thatSME bears a lot.
 Cutting CIT may not be helpful much forinnovative SMEs
 In the Netherland, R&D spending can bedeductible from SSC (WBSO).
• Unused R&D tax credit in CIT may be
used to lower SSC• Or overall SSC on firms should bereduced Sifting from CIT/SSC to VAT may support
SMEs

Burden of Social security contribution on firms in Japan

SSC/Proceeds of Sales (%)
SMEs

Large firms

METI(2016).

Increasing dominance of VAT• In the last decades, (i) VAT has been widely spreading in both developed and developing countries, (ii) its
share in GDP increasing relative to CIT and SSC• There has been shift in tax mix toward consumption tax away from income taxation including SSC(Socialsecurity contribution)⇒VAT fits better to newly emerging economic environment namely economic globalization% of GDP (OECD Unweighted Average)

Source: OECD Revenue Statistics

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What is good about VAT?
• VAT burden accrues to the final consumption domestically and internationally.
 It does not accumulated at the production stages that assures the production efficiency.
 It does not undermine “international competitiveness”.
 In contrast, CIT as well as SSC (Social Security Contribution) distorts both (i) production efficiency and(ii) international competitiveness.
 VAT levied on every stage of transaction works to secure tax revenue as well
 Fiscal devaluation = moving away from source based taxation such as CIT and social security
contribution toward destination based taxation
Key feature

Economic consequenceTax refund/credit
mechanism

Production efficiency⇒Growth friendly

Destination principle

International competitiveness⇒ Fiscal devaluation

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Cash flow tax in Japan?
• Fundamental CIT reform may be to transform corporate income taxation to cash
flow taxation or its equivalence.
 Cash flow tax = tax on economic rent Destination based cash flow tax = VAT minus SSC
 ACE allows deduction of opportunity cost of equity finance = Equivalent of R+F
origin based cash flow tax• Japan—2014 Article IV Consultation Concluding Statement of the IMF Mission
 As an alternative to a CIT rate cut, consideration could be given to opt for anAllowance for Corporate Equity (ACE) system, which would be a more cost effective
way of encouraging investment.
 An ACE treats debt and equity financing in the same manner and has recently been
adopted in some advanced and emerging economies.
12Capital income taxation
・At the individual level, economic rent or above normal return can be taxed differently from normal

return.

⇒Combination of capital income tax and cash flow tax may work to reconcile income redistribution
with growth

Economic rent
Business/
Corporation
Individualtaxable
ACE＝R+F baseor R based cash flow tax

Normal return
Non taxable

Taxable at a flat rate with full loss offsetting
Surcharge / progressive taxation