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The Japanese Tax System— Directions for Reform
By Satoshi Watanabe

Author Satoshi Watanabe

Challenges for the Japanese Tax System
The Japanese economy is facing several serious challenges and theJapanese tax system is expected to cope with the difficulties arisingfrom these challenges. First, the Japanese population has begun to
decline and the population structure is aging rapidly, which causes
uncertainties over the long-term sustainability of the social security
system. Second, with the process of the globalization of economic
activities, the tax system has to be more carefully designed so that itremains effective without producing too many adverse effects,
including the loss of industrial competitiveness. Third, the tax systemneeds to be adapted to the “digitization” of the economy with ever
evolving information and communication technology and new
business models. Although some aspects of these challenges bringabout opportunities for the economy, it is indispensable to seek toestablish a tax system that is more suited to the rapidly changing
environment.

Population Structure
The Japanese population peaked at about 128 million around 2010,and has been declining gradually since then. The pace of the decreasein population will accelerate in the coming decades and the populationin 2050 is expected to be around 100 million (Table). The aging of the
population is even more remarkable. In 2060, the share of people whoare 60 years old or over is estimated to reach 45% of the total
population. Also, it is projected that the share of very old people whoare 80 years old or older will increase from 9% in 2020 to 19% in
2060. In the coming decades Japan is expected to become a “superTABLE

Population & its structure in the
coming decades
Total
Population(millions)

Age 60and over(%)

Age 70and over(%)

Age 80and over
(%)

2020

1.25

35%

22%

9%

2030

1.19

38%

25%

13%

2040

1.11

43%

27%

14%

2050

1.01

44%

31%

16%

2060

0.93

45%

32%

19%

Source: National Institute of Population and Social Security Research, “Population Projections
for Japan (2017)”

40 Japan SPOTLIGHT • September / October 2018aging society”, in which the share of very old people among older
people becomes quite substantial. The ratio of people older than 80 topeople older than 60 will increase from 25% in 2020 to 42% in 2060.
The Japanese social security system, including the public pension
systems and the public medical and care insurance systems, isbasically managed on a pay-as-you-go basis. Therefore, the increasing
share of the older population puts the sustainability of the social
security system at risk. While public pension expenditure increases at
a similar pace as the population of people who are older than thepension age, which is in principle 65, expenditure for medical and careservices generally increases at an even higher pace as the process of“super-aging” continues. To make the social security system slimmer
and more efficient is a crucial goal in Japanese social policy. However,restraints in social expenditure alone cannot achieve the sustainabilityof the system with some reasonable level of social security benefits.
Therefore, measures to raise revenues from taxes or social security
contributions are also required. This point is very relevant when we
discuss directions for tax reform, and the aging of the population
raises a formidable challenge for the Japanese tax system.

Globalization
The globalization of economic activities poses a difficult challenge
for the tax system. The process of globalization in recent decades,
together with the development of information and communication
technologies (ICT), has nullified the effectiveness of border controls oninternational economic activities in many areas. The tax system,
however, has to be managed by the tax authorities of each country,
and the relative position of the tax administrations vis-à-vis
multinational corporations (MNCs) has substantially weakened.
The globalization process has made it easier for MNCs to choose thecountry where they operate. Because tax is one of the factors in thatchoice, some countries have tried to attract MNCs by offering lower
tax burdens, which has intensified international tax competition.
Countries engaged in extremely aggressive tax competition are
sometimes called tax havens. Also, MNCs have gained moregeographical flexibility in arranging their global operations. Thus,business taxation on MNCs has become more difficult, and theeffectiveness of corporate income tax (CIT) on internationaltransactions has been reduced.
Tax authorities all over the world are facing the challenge ofglobalization and the base erosion and profit shifting (BEPS) project
has been promoted by the G20 and OECD, with a view to restraining
abusive tax avoidance by MNCs. If the BEPS project is successfully
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implemented and international cooperation between tax authorities isstrengthened, the CIT system might be able to survive. (International
cooperation, in particular effective exchange of relevant information
among the tax authorities, is recognized as important also in thecontext of personal income tax (PIT) and value added tax (VAT).)
However, it should be noted that too severe regulation of MNCs tomake them improve their tax compliance might have an adverse effecton their efficient international economic activities.

Digitization
With the rapid progress of ITC, digital technology is already an
indispensable element of the current economy. On the one hand, newbusiness models equipped with new technologies often annoy tax
administrations. On the other hand, tax administrations in many
countries are making efforts to use ICT to enhance their abilities in
implementing the tax system. The digital economy, or the digitizedeconomy, has both negative and positive implications for tax
administrations. It would be desirable if ITC is used for making tax
administration more effective and for reducing the tax complianceburden for taxpayers.
With the digitization of the economy, various kinds of multi-sided
platform business, which connect different types of users of platforms,
have emerged, for example in the case of Airbnb, between people whowant to get short-term accommodation as guests and people whowant to rent a vacant room for a short-term basis as hosts. Multi-sided
platform businesses can reduce transaction costs, which makes bothsides better off through the indirect network effect. For example,
travelers or potential guests are better off as the number of available
rooms increases and potential hosts are better off as the number oftravelers increases. The indirect network effect also makes the pricing
strategy of multi-sided platforms complicated and they often subsidize
one side of the users instead of charging service fees.
In the digitized economy, successful platform businesses get huge
profits and cause international tax problems because a country might
not be able to get any CIT revenue from them even though a lot ofusers of the platform live within the country. The problem might bemore difficult if the users in the country just provide data to theplatform without paying any fees. Multi-sided platforms also render
the concept of the place of business obscure, which irritates the tax
policy makers in some countries, as I will discuss.

What About Income Discrepancies?
So far, we have discussed the aging of the population structure,
globalization, and digitization. While many people would agree thatthese challenges are important elements to be considered in thecontext of tax policy, some people might ask about the role of tax inimproving distribution of income and wealth. In Japan, as in manyother countries, the problem of income discrepancies has become
serious. Too much inequality is not only against the principle of equity
but also might be harmful for economic growth. All of the factors
mentioned above — aging, globalization, and digitization — tend to
make income distribution more uneven. I agree that income
discrepancy is a serious issue and to cope with it is one of the mostimportant policy goals.
I believe, however, that the scope of the role of tax policy inaddressing the distributional issue is quite limited. In traditional
textbooks on public finance, it was discussed that tax policies,
particularly policies on PIT, should play an important role in improving
income distribution and the concept of progressive income tax has
been cherished. However, globalization makes it difficult for tax policy
makers to make the tax system very progressive. If you place too
heavy an income tax burden on wealthy people, they would have astronger incentive to engage in tax avoidance. In particular, they would
shift their wealth to overseas, and they might even emigrate to othercountries with lower taxes. If you charge too heavy a CIT on
businesses, they might shift their operations to overseas. In Japan,
these reactions would erode the tax base. Moreover, it is difficult tohelp very poor people through tax policies because they do not bearmuch tax burden in the first place. Because the level of minimum
income subject to PIT is relatively high in Japan, many lower-income
people do not pay any PIT. Thus, policies to improve income
distribution through progressive taxation face serious limitations.
The major tool for supporting the poor is to provide social security
benefits including public assistance, which should be managed outside
the tax system. Some people advocate introducing a “refundable tax
credit” system in the PIT, but the nature of this type of “tax credit” issimply a form of providing social security benefits. While it isimportant to support the unemployed in getting jobs and to support
families with young children in raising them, these policies should
directly aim at fostering the accumulation of human capital.

Directions for Tax Reform
Now we will turn to the issue of tax reform. Before getting into
concrete points, it should be emphasized that tax policies are part ofoverall economic policies and that we cannot expect tax policies toresolve all kinds of economic problems. As discussed above, theincome discrepancy problem cannot be addressed by tax policy alone.
That problem should be dealt with by social security and social welfare
policies, together with labor and education policies. I believe there are
two important factors that are relevant for the direction of tax reform inJapan. First, sufficient tax revenues and social security contributions
should be secured in order to maintain the sustainability of the social
security system in a super-aging society. Second, the tax systemshould be reformed to be more efficient and effective in the changing
economic environment caused by globalization and digitization.

Sustainability of the Social Security System
As discussed above, the process of rapid super-aging has started toincrease pressures on social security expenditures. Because the total
population is declining and the pace of the decrease in the number ofpeople of working age will accelerate further, the base of taxes andsocial security contributions is not likely to increase strongly, andJapan faces a serious risk in the sustainability of the social security
system. In order to cope with this severe situation, it is indispensable
to undertake a through reform of the social security system, including
raising the pension age and reducing the subsidy rate for medical andJapan SPOTLIGHT • September / October 201841

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CHART 1

Trend of general account tax revenues (1987-2017)(¥1 trillion)
35(¥1 trillion)70

60.1 59.8

60
54.9

50

26.0

50.8

26.7 54.4 54.1
51.0

49.4

18.4

19.0

20.4
18.4

18.0

30 15.8

19.5

19.2
19.0

14.5

13.7
13.7

Corporation tax (Right axis)

5.0

5.6

5.2

5.8

14.8

11.4
10.1

10.8
10.4

13.9

11.7
10.3
9.8

9.8

6.1

44.3
41.5

14.7

9.8
9.5

13.3
11.4

10.1
9.7

10.0

10.6

16.1
14.9
14.1
10.5

57.7

43.9

38.7
16.8
15.5

15.0

14.7

13.0
12.9

10.0
10.3 10.0
9.8

Consumption tax (Right axis)

42.8

13.5

9.4

17.8 17.7 17.9
17.4

16.0

16.8 17.1

14.0

10.2 10.4
10.0
9.0

30

25

47.0

45.6

15.6

54.0

56.3 55.9

51.0

Income tax (Right axis)

17.8

15.4

13.5

9.3

5.6

18.8
17.0

12.1 12.4

20

4.6

49.1 49.1

47.9

47.2

43.8 43.3

16.6

10

50.7

23.2

21.4

17.4

53.9

23.7

46.8

40

51.9 52.1

General account tax revenues (Left axis)

9.8

20

15

12.4
10.8
10.5

11.1
11.0 10.8

6.4

10

5

3.3

0

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

(Fiscal year)

Source: Ministry of Financecare services, as soon as possible. As time goes by, the proportion ofelderly people continues to increase, making social security reform
politically more difficult. To increase the labor participation rate ofelderly people is another important factor. However, some measures toincrease revenues for social security expenditure are necessary. Even if
we succeed in restraining per capita expenditure for social security
benefits, total expenditure is expected to increase because the numberof aged people, and of the very elderly in particular, will continue torise over the next 20 years and beyond.
If more revenue is needed for increasing social security
expenditures, we have to think how to raise it. Social security
contributions will continue to be a major revenue source, but we needto examine the possibility of raising taxes. The major tax items are PIT,
CIT, and VAT (Chart 1). It is difficult to raise the CIT rate because theglobal trend is to reduce CIT rates. Until the Tax Reform implemented
by US President Donald Trump, the US CIT tax rate was higher thanJapan’s, but now it is no longer the case. The CIT rate of France is still
higher than in Japan, but it is expected to be lowered, and Japan isgoing to become the country with the highest CIT rate.
To raise the PIT burden for upper-income people is difficult becauseof globalization, and even if it is implemented the expected revenue
would be small because of the small number of upper-income people.
To raise PIT rates on lower incomes might be possible because morethan 80% of taxpayers in Japan are subject to the marginal tax rate ofno more than 10% (no more than 20% together with local personal
income taxes). However, only VAT, known in Japan as theConsumption Tax, is likely to produce substantial revenue to make the
42 Japan SPOTLIGHT • September / October 20180social security system sustainable.

The Role of Consumption Tax
The Consumption Tax was introduced in Japan in 1989. The tax rate
was only 3% when it was introduced, but was increased to 5% in 1997
and to 8% in 2014. As indicated in Chart 1, the Consumption Tax has
produced stable revenue, whereas revenues from PIT and CIT havefluctuated because they are strongly influenced by such factors as
business cycles and asset prices. Because of the stability of revenue,
the Consumption Tax might be considered to be lacking in the functionof a “built-in stabilizer”, which is expected to smoothen the businesscycle. Still, the stability of revenue is a desirable feature as a source forsocial security expenditure. The standard rate of the Consumption Tax
is scheduled to be raised to 10% in October 2019, which is a firstimportant step toward sustaining the social security system in the near
future.
Another feature of the Consumption Tax is that its burden is born by
all generations, including the elderly, whereas the incidence of PIT ismainly on working generations. Also, the burden of the Consumption
Tax is clearly recognized by consumers, where the incidence of CIT is
not transparent. These are some of the reasons why the Consumption
Tax is so unpopular among people in general, and particularly among
the older generations. Although the Consumption Tax needs to beraised further in the coming years, this issue will face tremendous
political difficulties.
The Consumption Tax has not adopted a reduced-rate system andSpecial

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CHART 2

International comparison of VAT rates (standard tax rates & tax rates on food)(%)(As of January 2017)

30

25

25
20

20

21 21

24

24
20

20

25

25
23

22

19

23 23
21

21

22
20

21

20 20

25

24
19

17

21
18

19

Legend

27

19
17

15

18
16

Standard tax rate … ■Reduced tax rate … ■

17

15
12

10

10
15

5 10

18
14

6

0

13
5.5

7

10
0

3

6

5

6

10 9.5 10

12

5

9
0

5

5

0

0

0

15

8

8

10 10 10

10

6

13

11

10
7

7
5

8
0

0

2.5

0

0

0

0

0

0

0

0

0

TaiwanVietnamThailandSingapore
Philippines
Malaysia
Laos
Indonesia
Cambodia
China
South Korea
Japan
TurkeySwitzerland
NorwayNew Zealand
MexicoIsrael
IcelandChile
CanadaAustralia
Romania
Malta
Lithuania
CyprusCroatia
Bulgaria
UK
SwedenSpain
Slovenia
Slovakia
Portugal
PolandNetherlands
Luxembourg
LatviaItaly
Ireland
Hungary
GreeceGermany
FranceFinland
Estonia
Denmark
Czech Republic
Belgium
Austria

Source: Ministry of Finance

OECD

EU

has kept a single-rate system, which makes the current system simple
and efficient. As indicated in Chart 2, some countries including
Denmark, Estonia, Latvia, Chile, and New Zealand have single-rate
systems, although the standard tax rates of these countries are muchhigher than 8%, the current Japanese Consumption Tax rate.
Unfortunately, a reduced rate of 8%, which is applied to food andnewspapers, is to be introduced for political reasons when theConsumption Tax rate is increased to 10% in 2019. A multiple-rate
system for VAT is infamous among tax scholars as a poor tool forincome redistribution. If you want to support the poor, direct income
transfer is much better than a reduced VAT rate on food or othernecessities. To introduce a reduced rate is a serious step backward for
the Japanese Consumption Tax system.

Tax Reform in the Globalized & Digitized Economy
As the economy is more and more globalized and digitized, it
becomes even more difficult for the tax authorities to implement
taxation on profits of MNCs and the sustainability of the CIT system is
at risk. In order to cope with these difficulties, the tax authorities of theworld recognize that they have to strengthen international cooperation
to exchange tax information. Also, they have started to recognize that it
is no longer possible for any country to keep a CIT system that is very
different from other countries. Japan is probably going to be obliged to
streamline the CIT system so that the risk of being evaded (or avoided)by MNCs is reduced. Thus, it is expected that the ratio of CIT in the
total tax revenue will gradually decline, and the Consumption Tax will
become more and more important as a revenue source.
Some European countries are making arguments for a drastic

OECD

ASEAN+3

reform of the current international tax system. In March 2018, theEuropean Commission proposed to introduce a “digital tax” to be
imposed on some huge IT companies (mostly, US companies) which
provide electronic services within the European Union. The United
Kingdom and India have other new tax measures with similar
purposes. While it is becoming more difficult for the current CIT
system to survive in the digital environment, it might cause otherproblems if some countries introduce unilateral measures. Japan,
together with the OECD, is expected to play a role in promoting careful
discussions on the possible reform of the international tax system sothat it will not distort international economic activities.
Finally, Japan has to substantially strengthen efforts to modernize
the tax administration system so that it adapts to the digital
environment. While Japan has finally introduced a taxpayer
identification number system, which is called the “my number”
system, it is not fully used as yet. Although the Japanese authorities
have to care about the protection of people’s private information, they
can never construct an effective tax system without a taxpayer
identification system equipped with digital technologies. The “mynumber” system is also expected to play an important role in making
the social security system work efficiently. To promote e-government
functions in Japan is indispensable not only for adapting the tax
system to the digital economic environment but also for enabling thesocial security system to survive under the pressure of super-aging
that Japan will face in the coming decades.
Satoshi Watanabe is a professor at the School of International and Public
Policy, Hitotsubashi University. He is a former Ministry of Finance official, andspecializes in taxation and public finance.

Japan SPOTLIGHT • September / October 201843