The Effects of a Lower Capital Income Tax Rateon the Japanese Economy(Very Preliminary and Incomplete)
Selo İmrohoroğlu (USC) and Nao Sudo (BoJ)

December 26, 2014 Canon Institute for Global Studies

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Capital Income Tax and the Japanese Economy
Less is More?

In April 2014:
the Japanese government announced plans to reduce thecorporate income tax rate from 35% to 25%
a medium term goal of achieving a primary surplus in 2020

In this paper, we study the impact of a lower capital income tax
rate on the Japanese economy
We also calculate the size of fiscal adjustment needed to delivera primary surplus in 2020

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Capital Income Tax and the Japanese Economy
Where Are We Now?

Net debt to GDP ratio at about 150% in 2013
Dependency ratio projected to rise from 40% in 2013 to 92% in2092
We study the long run impact of the proposed policies but focus
on the short run from 2014 to 2020

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Macroeconomic Outlook in Japan: ESRI Estimates
Deficits: Reference vs Revitalization

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Fundamental Problem 1: Aging Population
0.9

0.8

0.7

0.6

0.5

0.4

0.3

65+ to 20−64
70+ to 20−69
0.2

2010

2020

2030

2040

2050

2060

2070

2080

2090

2100

Figure : Dependency Ratios
Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Fundamental Problem 2: High Debt
10.8

0.6

0.4

0.201985

1990

1995

2000

2005

2010

Figure : Net Debt to GNP Ratio
Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Implications of Aging Population
Fukawa and Sato (2009)
G/Y
0.25

0.2

0.15

0.1

1990

2000

2010

2020

2030

2040

2050

2060

2070

2080

2040

2050

2060

2070

2080

TR/Y
0.250.2

0.15

0.1

1990

2000

2010

2020

2030

DecemberRatios
26, 2014 Canon Institute for Globa
Figure : Government
Expenditures to GNPCapital Income Tax Reform and the Japanese Economy/ 44

Selo İmrohoroğlu and Nao Sudo

Introduction

What We Do
Formulate and calibrate a neoclassical growth model of Japan.
What is the effect on the Japanese economy from a reduction inthe capital income tax rate?
What is the implications of this tax reform on the fiscal
imbalance?
How much revenue must be raised to achieve a primary surplus
in 2020?
How much spending must be cut to achieve a primary surplus in2020?

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44Introduction

What We Do
Hayashi and Prescott (2002), Chen, İmrohoroğlu andİmrohoroğlu (2006), Hansen and İmrohoroğlu (2013)
Standard growth model.
Characterize how model performs from 1981-2013.
Take as exogenous TFP, tax rates, government consumption,transfers and population.
Use observed values 1981-2013.

Use model to forecast from 2014 and beyond; perfect foresightand also ’MIT’ simulations.
Government projections for population to 2050.
Forecasts of Fukawa and Sato (2009) of G /Y and TR /Y to2050. [Consistent with independent projections of İmrohoroğlu,Kitao, and Yamada (2013)]
Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Features of Model

Endogenous labor choice ⇒ consumption and labor income
taxes are distorting.
Primary balance is endogenous and produces a path for debt.
Produce deterministic and stochastic simulations.

Selo İmrohoroğlu and Nao SudoDecember 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Introduction

Related Literatureİmrohoroğlu and Sudo, “Productivity and Fiscal Policy in Japan:
Short Term Forecasts from the Standard Growth Model”
Experiment with policies to eliminate budget deficit in near
future by increasing consumption tax. 15% not enough.

İmrohoroğlu and Sudo, “Will a Growth Miracle Reduce Debt inJapan”
Assess possibility that high TFP growth could eliminate
government debt. China-like growth for a decade not enough.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Model Economy

Model: Household’s Problem

1+1/ψ∞

hmax ∑ β Nt log Ct − α t
1 + 1/ψ
t =0t



subject to(1 + τc,t )Ct + ηt Kt +1 = (1 − τh,t )Wt ht+ [(1 + (1 − τk,t )(rt − δ)] Kt + It+TRt − τt + πp, tSelo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Model Economy

Model: Firm’s Problem

Nt Yt = At (Nt Kt )θ (Nt ht )1−θNt +1 Kt +1 = (1 − δ)Nt Kt + Nt Xt
At +1 = γt At

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Model Economy

Model: Government Budget

Gt + TRt + It = τc,t Ct + τh,t Wt ht + τk,t (rt − δ)Kt + τt − πb,tGt + TRt = τc,t Ct + τh,t Wt ht + τk,t (rt − δ)Kt + τt − πp,tIt = (1 − τb,t )rb,t BttBt = B1980 +∑ πb,ss =1981

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Model Economy

Stationary Equilibrium Conditions
Given a per capita variable Zt we obtain its detrended counterpart
zt =Zt.
1/(1− θ )At

First order conditions and market clearing conditions combine togive equations to solve for{ct , xt , ht , yt , kt +1 , wt , rt } for each period t.
Computation Objective: Find value for k1 such that sequence
converges to steady state.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44Calibration

Population and Labor Input

Nt = working age population between the ages of 20 and 69
Use actual values for 1981-2013
Use official projections for 2014-2050
Population constant after 2050
ht is employment per working age population multiplied byaverage weekly hours worked divided by 98 (discretionary hours
available per week).

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

National Accounts: Hayashi and Prescott (2002)
Table : Adjustments to National Account Measurements

C =I =G =Y =Private Consumption Expenditures
Private Gross Investment+ Change in Inventories+ Net Exports+ Net Factor Payments from Abroad
Government Final Consumption Expenditures+ General Government Gross Capital Formation+ Government Net Land Purchases− Book Value Depreciation of Government Capital
C +I +G

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Government AccountsPublic health expenditures in Japan are included in Gt .
TRt , includes social benefits (other than those in kind, which arein Gt ,) that are mostly public pensions, plus other current net
transfers minus net indirect taxes.
5% of output is added to TRt since modeling of flat tax rates
ignores deductions and exemptions.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Tax Rates

τh,t , are average marginal labor income tax rates estimated byGunji and Miyazaki (2011).
Last value is 0.324 for 2007 and we assume that this remains
constant thereafter.

τk,t , is constructed following methodology in Hayashi andPrescott (2002).
Last value is 0.3557 for 2010 and we assume that this remains
constant thereafter.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Tax Rates, continued

Tax Rate on Consumption, τc,t
0% 1981-1988
3% 1989-1996
5% 1997-2013
8% 2014
10% 2015 and beyond.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Tax Rates, continued
Consumption Tax Rate
0.10.0501980

1990

2000

2010

2020

2030

2040

2050

Transfer Payments to GNP Ratio
0.3
ττ

0.25

τ0.2
1980

kk

= 0.35= 0.25τ k = 0.30

1990

2000

2010

2020

2030

k= 0.01

2040

2050

2040

2050

Capital Income Tax Rate
0.6
0.4
0.201980

Selo İmrohoroğlu and Nao Sudo

1990

2000

2010

2020

2030

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Technology Parameters

At = Yt /(Ktθ ht1−θ ).
θ = 0.378, which is the average value from 1981-2013.
γt = At +1 /At , comes from the actual data between 1981 and2013.
γt = 1.0151−θ for 2014 and beyond.
δ = 0.0842, which is the average value from 1981-2013.

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Technology and Population Parameters
Depreciation rate
0.09
0.08
0.07
0.06
1980

1990

2000

2010

2020

2030

2040

2050

2020

2030

2040

2050

2020

2030

2040

2050

Population
1.02

10.98
1980

1990

20002010

TFP
1.1

10.9
1980

Selo İmrohoroğlu and Nao Sudo

19902000

2010

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Preference Parameters

Three preference parameters, β, α, ψ.
ψ = 0.5, the Frisch elasticity of labor supply estimated by
Chetty et al (2012).

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Preference Parameters, continued
For β and α, use equilibrium conditions to obtain a value for eachyear, and then average over the sample:
1/(1− θ )(1 + τc,t +1 )γt
ct +1ihβt =(1 + τc,t )ct 1 + (1 − τk,t +1 ) θ yktt++11 − δ−1/ψαt =ht

Selo İmrohoroğlu and Nao Sudo

(1 − τh,t )(1 − θ )yt(1 + τc,t )ct ht

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Calibration of Structural Parameters

Parameterθδβαψ

Selo İmrohoroğlu and Nao Sudo

Value
0.37830.08420.967722.6331
0.5

Data Average
Data Average
FOC, 1981-2013
FOC, 1981-2013
Chetty et al (2012)

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Model versus Data
Consumption, Investment, Output, and Capital Output Ratio
Consumption

Investment

0.7

0.35

0.6

0.3

0.5

0.25

0.4

0.2
ModelData

0.3
0.2
1980

2000

2020

0.15
0.1
1980

Real GNP

2000

2020

Capital-Output Ratio

1.2

31
2.5
0.8
2
0.6
0.4
1980

Selo İmrohoroğlu and Nao Sudo

2000

2020

1.5
1980

2000

2020

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Calibration

Model versus Data
Primary Balance to GNP and Debt to GNP Ratios
Primary Balance
0.10.05
0-0.05-0.1-0.15
1980

1985

1990

1995

2000

2005

2010

2015

2010

2015

Government Debt over GNP
21.5
10.501980

Selo İmrohoroğlu and Nao Sudo

1985

1990

1995

2000

2005

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Steady State Analysis

Long Run Comparison
Reducing the Capital Income Tax RateLower τk from 35%
to 25% starting in 2015, 2 percentage points each yearto 0 starting in 2015

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Steady State Analysis

Long Run Comparison
Reducing the Capital Income Tax Rate

Capital Stock K
Labor Supply H
Output Y
Consumption C
Wage Rate W

Selo İmrohoroğlu and Nao Sudoτk = 0.35
100
100
100
100100τk = 0.30
106.2
100.5
102.6
101.1
102.1

τk = 0.25
112.1
100.9
105.0
102.1
104.0

τk = 0137.6
103.0
114.9
105.3
111.6

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Steady State Analysis

Long Run Comparison
Laffer Curve: Labor Income Tax
ψ = 0.5130

steady state revenue

120
1101009080706050
4000.20.4

0.60.81labor income tax rate

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Steady State Analysis

Long Run Comparison
Laffer Curve: Capital Income Tax
ψ = 0.5120

steady state revenue

110

10090807060

5000.20.4

0.60.8

1capital income tax rate

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Steady State Analysis

Sensitivity to Frisch Elasticity of Labor Supply
Laffer Curve: Labor Income Tax
ψ = 0.1

ψ = 0.5

ψ = 1.0

ψ = 2.0160

steady state revenue

140

120

100

80

60

40

20
0

0.2

0.4

0.6

0.8

1

labor income tax rate

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative ExperimentsSteady State Analysis

Sensitivity to Frisch Elasticity of Labor Supply
Laffer Curve: Capital Income Tax
ψ = 0.1

ψ = 0.5

ψ = 1.0

ψ = 2.0120

steady state revenue

110

1009080

7060

50

40
00.2

0.4

0.6

0.8

1

capital income tax rate

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Projections of Key Indicators
Consumption, Investment, Output, and Primary Balance to Output Ratio
Consumption

Investment

0.7

0.35

0.6

0.3

0.50.25
τ0.4= 0.35

τ = 0.25kτ = 0.30
k0.3
0.2
1950

kτ

2000

k

= 0.01

2050

0.2
0.15
0.1
1950

Real GNP
0.1

1.2

0.05

100.8

-0.05

0.6

-0.1

0.4
1950

-0.15
1950

Selo İmrohoroğlu and Nao Sudo

2050

Primary Balance over GNP

1.4

2000

2000

2050

2000

2050

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Short Run Analysis: Effect on K
Reducing the Capital Income Tax Rate: The Next Ten Years

2013
2014
2015
2016
2017
2018
2019
2020202120222023
Selo İmrohoroğlu and Nao Sudoτk = 0.30
100.0
102.3
103.6
104.3
104.6
104.4
104.3
104.3
104.3
104.2
104.4

τk = 0.25
100.0
102.9
104.7
105.8
106.4
106.6
106.9
107.1
107.4
107.5
107.9

τk = 0.01
100.0
105.3
109.3
112.4
114.8
116.5
118.1
119.6
121.0
122.2
123.4

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Short Run Analysis: Effect on H
Reducing the Capital Income Tax Rate: The Next Ten Years

20132014
2015
2016201720182019
2020
2021
2022
2023
Selo İmrohoroğlu and Nao Sudoτk = 0.30
100.0
105.9
99.7
99.9
99.1
99.0
98.9
99.1
99.2
99.3
99.7

τk = 0.25
100.0
106.8
100.4
100.5
99.6
99.5
99.4
99.5
99.6
99.7
99.3

τk = 0.01
100.0
110.4
103.5
103.4
102.2
101.9
101.5
101.5
101.5
101.4
101.3

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Short Run Analysis: Effect on Y
Reducing the Capital Income Tax Rate: The Next Ten Years

201320142015
2016
2017
2018
2019
2020
2021
2022
2023
Selo İmrohoroğlu and Nao Sudoτk = 0.30
100.0
103.7
100.7
101.3
101.0
101.0
100.9
102.2
101.1
101.2
101.2

τk = 0.25
100.0
104.1
101.3
102.1
101.9
102.1
102.0
101.0
102.4
102.5
102.6

τk = 0.01
100.0
106.3
104.2
105.6
105.9
106.5
106.9
107.5
108.0
108.4
108.7

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Short Run Analysis: Effect on πp /YReducing the Capital Income Tax Rate: The Next Ten Years

20132014
2015
2016
2017
2018
2019
2020
202120222023

τk = 0.35 τk = 0.30
−0.0826 −0.0826−0.0982 −0.0834−0.0704 −0.0691−0.0718 −0.0696−0.0626 −0.0610−0.0648 −0.0632−0.0670 −0.0658−0.0691 −0.0674−0.0711 −0.0690−0.0729 −0.0706−0.0748 −0.0723

Selo İmrohoroğlu and Nao Sudoτk = 0.25−0.0826−0.0824−0.0677−0.0678−0.0591−0.0610−0.0632−0.0645−0.0659−0.0673−0.0688τk = 0.01−0.0826−0.0776−0.0615−0.0600−0.0508−0.0515−0.0526−0.0531−0.0537−0.0543−0.0552

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Quantitative Experiments

Short Run Analysis

Short Run Analysis: Primary Surplus in 2020
What Will It Take? τc = 0.24

τc
20%
24%
25%
30%

Base Slow τk = 0.25 Fast τk = 0.25
−0.0691+0.0340+0.0380−0.0691+0.0044+0.0092−0.0691+0.0090+0.0140−0.0691+0.0340+0.0380

Selo İmrohoroğlu and Nao Sudoτk = 0.35+0.0320+0.0013+0.0060+0.0320

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Sensitivity Analysis

Sensitivity to various assumptions TBD

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Conclusion

Conclusions
What We Did

High debt to output ratio combined with looming public
expenditures due to rapid societal aging
Use the standard growth model tomeasure the impact of a lower capital income tax on theJapanese economy
calculate the needed consumption tax rate to produce a primarybalance in 2020

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44

Conclusion

Conclusions
Long Run Results

Sizable gains in aggregate capital, output and consumption
K rises 12.1% with τk = 0.25 and 37.6% with τk = 0
Y rises 5.0% with τk = 0.25 and 14.9% with τk = 0
H does not change much except for τk = 0 when it increases
3%
C increases 3-5%

Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44Conclusion

Conclusions
Short Run Results

Relative to the baseline transition of no change in the capitalincome tax rate, there are immediate and significant gains inaggregate capitalWith τk scheduled (surprise announcement) to decline to 25%,
capital increases 2.9% in the first year
By the end of the 5th year of reform when τk reaches 25%, theincrease in k is 7%
Y rises 1-2%
There is a significant improvement in primary balance in the firstyear (1.6 percentage points) but the gain erodes fast
Selo İmrohoroğlu and Nao Sudo

December 26, 2014 Canon Institute for Globa
Capital Income Tax Reform and the Japanese Economy/ 44