Presented by Alan Reynolds at "Deregulation in the Global Market Place: Challenges for Japan and the United States in the 21stCentury"
A Keidanren-Cato Institute Symposium, Tokyo, April 6, 1998 .
American economists have been giving policy advice to Japan since the Shoup tax reform commission of 1949. Even then, the advice was not always helpful.
U.S. government officials now tell Japan that larger budget deficits are the key to boosting economic growth and stock prices. Yet the same officials claim that the U.S. economy and stock market have benefitted from much smaller budget deficits.
When looking at tax policy as a separate policy tool, we must get beyond Keynesian "macroeconomics," and the related bad habit of ascribing magical properties to government borrowing. A few years ago, prominent macroeconomists in the U.S. and Japan were absolutely confident that American budget deficits had pushed interest rates and the dollar up, causing trade deficits. Today, much larger budget deficits in Japan are associated with the lowest interest rates in world history, a falling yen, and rising trade surpluses.
A theory that can predict anything can also predict nothing. Fiscal macroeconomics is an unsolvable mystery, something best relegated to a museum. Even the dogma that budget deficits "stimulate" demand (nominal GDP) is just another archaic theory with no shred of evidence.(1) Budget deficits are a consequence of slow economic growth, not a cause of rapid growth. Yet the elusive theory of "fiscal stimulus" still allows politicians to claim that endless public works schemes are a free lunch, rather than a dubious debt service burden on taxpayers.(2)
Japan's nominal GDP growth surged in the late 1980s because the Bank of Japan was buying a lot of securities (see the Appendix: "Money Matters"). Nominal GDP growth slowed after 1991-92 because the monetary base shrank. Growth of aggregate demand depends on monetary policy, not government borrowing. Whether or not supply can keep up with demand, however, is affected by the microeconomic structure, including tax rates.
Any serious look at policy must be based on microeconomics -- all the messy but vital structural details about disincentives and distortions. An improvement in tax policy is not measured by how much revenue is lost, but by how much efficiency and prosperity is gained.
To describe tax policy in macroeconomic terms -- solely by its immediate effect on the budget -- leads to paradoxical conclusions. Many people suspect that the April 1997 increase in Japan's value-added tax contributed to recession.(3) If that is correct, this "tax increase" will surely result in less tax revenue, not more. A macroeconomist may later observe such a loss of revenue and conclude that tax policy has become "stimulative" -- the opposite of what actually happened.
Conversely, if a reduction in the highest, most damaging tax rates results in slightly more rapid economic growth, then it may also result in more tax revenue. It is the impact on the economy that matters. What happens to the budget deficit mainly depends on what happens to the economy, not the other way around.
An efficient tax system is one that raises revenue with the least possible damage to economic progress. With such a system, tax revenues naturally grow as the economy expands.
The marginal tax burden in Japan is unusually high, yet average tax revenues are relatively low. Aside from Social Security, revenues have been falling since 1990, when many new taxes were added. High tax rates and weak revenues are symptoms of an inefficient tax system.
Figure 1 shows that it is not unusual for countries with high tax rates (such as Japan) to collect very little revenue, even in static terms -- as a percentage of GDP, rather than real revenue growth over time. These figures are for the national income tax on individuals (although local taxes are very important in Sweden, Canada, Japan and others). The only countries with high tax rates that collect much revenue are those in which the lowest tax rate is also high, such as the 19% rate in Germany (although even a 25% minimum tax does not work in Turkey). Tax rates above 35-40% never seem to yield much revenue, anywhere.
As the table indicates, the ratio of tax revenues to GDP can be a misleading measure of the actual burden of taxes. Some taxes may be extremely destructive yet yield very little revenue.(4) Just as "prohibitive" tariffs yield no revenue, extremely high tax rates can also be prohibitive, or nearly so, because they (1) seriously discourage the taxed activity, (2) lead to rampant tax avoidance and evasion, and (3) foster capital flight and a "brain drain."
A tax system that suffocates growth of GDP may result in a rising ratio of revenues to GDP even though revenues are growing very slowly in real terms. This is the situation of many Continental European countries. Real tax revenues grow very slowly, but the economy grows even more slowly, so revenues rise as a percentage of stagnant GDP. Yet such governments have little room to increase spending in real terms because revenues have stopped growing in real terms.
Conversely, revenues may appear quite low relative to GDP and yet be growing very rapidly in real terms, because the tax climate is conducive to rapid growth of real GDP. Hong Kong's tax revenues (excluding land sales) grew by 17.8% a year from 1984 to 1996 -- nearly three times as fast as the 7.1% pace of U.S. revenue growth. Yet the ratio of taxes to GDP remains low in Hong Kong because real GDP has increased almost as rapidly as real tax receipts. Government consumption in Hong Kong has long increased by 6% a year, in real terms.
In short, tax policy is not properly described by revenue losses alone, nor even by revenues as a percentage of GDP. We need to look at marginal tax rates on the returns to additional capital, including human capital.
The Shoup Mission
Rather than rely too heavily on economic theory, or on foreign advice, it is often useful for a country to reexamine its own history (and that of its neighbors) to see which policies were followed by prosperity and which were not.()
In the late 1940s, the American Occupation had imposed brutal income tax rates on Japan, as high as 86% on income above Â¥5 million. This was a central part of a severe austerity program, not a plan to promote economic growth. As Edwin Reischauer pointed out at the time, "Steeply graduated income taxes and inheritance taxes have been adopted to prevent in the future the accumulation of . . . concentrations of wealth." But taxes designed to punish additions to income must also punish additions to output -- economic growth. So, Japan set out to free itself from the oppressive Occupation tax regime.
In late 1950, following a similar policy coup in Germany, Japan's highest individual income tax rate was slashed to 55% from 86%. From 1950 to 1974, Japan cut taxes every year (except 1960) often by greatly increasing the income thresholds at which the higher tax rates applied, or by enlarging deductions and exemptions. The taxable income needed to fall into a 60% tax bracket was raised to 3 million yen by 1953, for example, compared with only 300,000 in 1949. The Shoup Commission's net worth tax was also abolished in 1953. The sting of high tax rates was further neutralized by exemptions for interest income and capital gains, deductions from corporate and individual taxes on dividends, a deduction for earnings, and various other holes in the tax base, legitimate and otherwise.(6)
Some deductions were far from neutral, and therefore less desirable than lower tax rates would have been. Yet the continual tax reductions from 1950 to 1974 accomplished two things. First, they greatly reduced effective marginal tax rates. Second, they moved the system a long way toward what is sometimes called a "consumed income tax" or "expenditure tax" -- that is, a system that taxes income only once, regardless of whether the income is saved or devoted to immediate consumption.(7)
American economists were extremely critical of both accomplishments. In 1958, a member of the Shoup Commission, Jerome Cohen, described the tax cuts as "foolhardy from an economic point of view."(8) In 1964, Martin Bronfenbrenner complained that Japan's reductions of the highest tax rates amounted to "a retreat from the equitable policies of the American Occupation."(9)
Tax reduction was considered "foolhardy" precisely because it fostered rapid economic growth. American economists were convinced that Japan would always be plagued with what Bronfenbrenner called "endemic Japanese balance of payments problems." Failing to distinguish between tax rates (which were falling) and tax revenues (which were soaring), the U.S. critics argued on Keynesian grounds that Japan's taxes had to be kept high to suppress economic growth. Otherwise, Japan's trade deficit would supposedly reach "currency crisis" proportions. For the same reason, many U.S. economists were sharply critical of Japan's deep tariff cuts in the 1960s (e.g., by 1975, the effective tariff on autos fell from 40% to 10%, and the tariff on televisions from 30% to 5%).
Bronfenbrenner's remark about Occupation tax rates being more "equitable" was also in the spirit of the times. From about 1938 to 1962, U.S. "public finance" economists were much more concerned about using taxes to prevent people from becoming rich than about any adverse effects on economic growth. An intellectual godfather of the Shoup Commission, Henry Simons, knew perfectly well that "every gain [in] better distribution will be accompanied by some loss in production."(10) But Simons and his followers assigned a low priority to production, believing that income leveling was the primary goal of tax policy.(11)
In the U.S., the postwar emergence of Keynesian macroeconomics destroyed any lingering anxieties about the impact of high tax rates on economic growth. Early postwar predictions of chronic "underconsumption" and "secular stagnation" meant that saving was considered a terrible thing, and therefore an excellent target for confiscatory taxation. After those dire predictions proved false, slow growth was then said to be something that could easily be fixed by printing more government bonds (called "fiscal policy") or more money ("monetary policy"). Attention to tax incentives disappeared until the Kennedy Administration, when it was revived largely because of the embarrassing success of falling tax rates and rising income thresholds in Japan and Germany.
The point of all this history is to emphasize that promoting economic growth in Japan was certainly not the primary goal of the Shoup Commission. Yet the Shoup Commission continues to influence influential Japanese tax specialists who were trained in this early postwar American tradition.
1975-87: Bracket Creep and Public Works
In 1971-73, the U.S. devalued the dollar, pursued an inflationary money policy, and tried to disguise the consequences with price controls. When the dollar goes down, commodities priced in dollars go up. By the fall of 1972, commodity futures prices had already begun to soar, with oil a relative laggard. The end result was the stagflationary swamp of 1974. Japan was an innocent victim.
Although the event was temporary, it had a lasting impact on Japan's economic policies. Japan imposed a corporate surtax in April of 1972 and stopped cutting individual tax rates after 1974, thus allowing inflation, aging and economic growth to push more and more taxpayers into higher tax brackets. There was a major shift in emphasis away from fostering private investment toward "social overhead capital" and "infrastructure improvement."(12) In the quaint language that economists used at the time, endless bracket creep would supposedly generate so much revenue that public works spending would be needed to prevent "fiscal drag."
Figure 2 illustrates the main reason why seemingly high marginal tax rates of 40-70% had not done much damage before 1974. The income thresholds for the highest tax brackets were repeatedly increased by huge amounts, much more than enough to keep far ahead of inflation and rising real incomes.
From 1975 to 1984, by contrast, there were no adjustments of tax thresholds at a time when inflation averaged more than 6% a year. The resulting bracket creep appeared to generate a lot of revenue, but this was partly money illusion. It was not until 1979 that real, inflation-adjusted revenue was again as high as it had been in 1974. Revenues did rise as a percentage of GDP, but that would not have happened if real GDP had not slowed. Whatever its long-term effect on revenues, bracket creep certainly generated more and more tax distortions and disincentives.
In 1984, there was a modest increase in the threshold for the 60% rate, but also an increase in the corporate tax rate. In fiscal 1987, the 60% rate was reduced to 55% and the 65-70% rates to 60%. That was temporarily helpful, contributing to a brief spurt of growth in the economy and in tax receipts.
In April 1989, national tax rates above 50% were ended. But a provision that kept total national and local taxes from exceeding 78% had been eliminated in 1987, leaving combined national and local tax rates as high as 76% even in 1992. The value-added tax was also introduced in 1989, raising marginal rates by three percentage points at all income levels.
Figure 2 shows that even as recently as 1993, the 40% national tax rate still applied to the same nominal income at which a 42% rate had applied back in 1974. If tax thresholds had merely been adjusted for consumer price inflation from 1974 to 1993, not for real wage gains, they should have more than doubled in terms of yen! The latest threshold adjustment finally came close to making up for past inflation with respect to the 50% bracket, but is still inadequate at the 40% rate. All things considered, there has been surprisingly little relief from the highest, most destructive tax rates on individual income, despite appearances to the contrary.
Japan has been quite unique in this respect. Between 1979 and 1986, many countries had cut their highest income tax rates in half -- including the United States, United Kingdom, South Korea, and Singapore. And no country that cut tax rates in half suffered any sustained revenue loss, even as a percentage of GDP. It is not even true that lowering the highest U.S. tax rate from 50% to 28-33% in 1986 was financed by eliminating deductions. Fewer itemized deductions were replaced with a larger standard deduction, but total deductions were not any smaller. Taxable incomes reported by higher-income people were "surprisingly" strong after tax rates came down, and labor force participation increased sharply among their spouses.
As bracket creep was pushing middle-aged Japanese professionals and mid-level managers into tax brackets once intended for the very rich, the burden of "contributions" for Social Security pensions also doubled from 6.2% in 1970 to 12.4% in 1986, and to 14.3% more recently.(13) The entire Social Security tax burden, including public health insurance, reached 25.5% of payroll by 1996. Most of this must be added to marginal tax rates on labor income because, unlike the U.S., there is no maximum contribution to eliminate the marginal burden at high incomes. It is the deadly combination of income tax, payroll tax and VAT that matters, at the margin.
The fact that employees can deduct Social Security taxes from their income tax base is modestly helpful (only employers can deduct payroll taxes in the U.S.). But neutral taxation of savings requires that if contributions are deductible when going into a pension fund, then the funds must be fully taxable when they are later withdrawn. This is the principle behind the original Individual Retirement Account in the U.S.
If contributions to public or private pensions were not deductible, then income going into a pension fund would have already been taxed before it was saved. In that case, withdrawals from the pensions should not be taxed a second time, when the money is taken out. This is the principle behind the new Roth retirement accounts in the U.S.
Either of these neutral treatments of saving would be equivalent to a "consumed income" tax, if applied uniformly without restrictions (such labels are misleading, however, since all taxes fall on the individual owners of factors of production). Such a policy had long been advocated by British economists (Mill, Marshall, Pigou, Kaldor), and by Irving Fisher of Yale. It is in marked contrast with the Haig-Simons concept of "comprehensive" income taxation that inspired Shoup Commission plans. When older economists, in the Haig-Simons tradition, speak of "broadening the tax base," they often mean defining income in ways that ensure that savings will be taxed several times. Some even refer to corporate depreciation as a "tax preference," as though the cost of plant and equipment was not a cost at all, but taxable income. Today, younger U.S. specialists in public economics have moved away from these Haig-Simons ideas that were so fashionable fifty years ago. Most favor neutral tax treatment of saved income, and prefer immediate expensing of plant and equipment.
Japan's system of fully deducting contributions to (public) pensions but not treating pensions as taxable income is not consistent with neutral treatment of savings. To deduct contributions and also exempt withdrawals is too generous toward this specific form of savings (Social Security). Yet Japan's tax policy after 1989 moved back toward multiple levels of taxes on all other forms of savings -- capital gains, dividends and interest income. A policy of tax neutrality for all savings, or at least for all retirement savings, would greatly ease the fiscal strains expected from an aging population. Neutrality requires taxing income from public pensions exactly like any other income (because contributions were deducted), even if pretax benefits have to be increased to sweeten the deal.(14) Applying that same principle to private pensions (deductible going into a pension plan and taxable coming out, or vice-versa) would encourage greater use of private retirement plans and thus ease the excessive dependence on Social Security pensions. This would be a start toward partial or full "privatization" of pensions -- something that should never be a state monopoly.
Because incomes generally rise with seniority, tax burdens tend to be extremely heavy at ages 45-57, then fall sharply at older ages due to the dubious exemption of pension income. Since Japan is aging fast, the combination of superhigh taxes on older workers and none on pensions must push many people into early retirement, whether they like it or not.
Different Policies; Different Results
Before 1975, tax policy greatly reduced effective marginal tax rates and eased the multiple taxation of saved income. Economic growth in Japan (Figure 3) averaged 9.6% a year from 1952 to 1973.
From 1975 to 1987, "bracket creep" and higher Social Security taxes reversed much of the previous progress on marginal tax rates. Economic growth slowed to 4.3% from 1975 to 1991.
After 1989, tax policy also reversed much of the previous progress toward neutral treatment of savings. Tax rates on new capital investments increased (at the level of individual investors). Economic growth slowed to 1.2% from 1992 to 1997. To continue blaming this on the "oil shocks" of the 1970s, as many do, is no longer plausible.(15) Oil has been very cheap for more than a dozen years.
A large increase in the marginal cost of oil can indeed make production of many goods unprofitable. Growth stalls. An increase in the marginal cost of labor or capital can have the same depressing effect. An increase in the marginal cost of government is no different. It reduces the (after-tax) return on investments in physical and human capital -- the primary source of economic growth.
Although the dramatic slowdown of economic growth after 1974 coincided with an equally dramatic change in tax and spending policies, that change in economic policies is rarely blamed for the change in economic results. From 1989 to 1992, Japan added more taxes on sales, land, capital gains, dividends and interest. Yet the dramatic deterioration in economic growth after 1990 is rarely blamed, even in part, on those simultaneous changes in tax policy. The sole exception was the increased VAT of April 1997. Even in that case, however, complaints that this particular tax increase hurt the economy are not often translated into the logical conclusion that rolling-back such a counterproductive tax increase must likewise help the economy.
Figure 4 shows OECD estimates of average effective tax rates on capital and labor in the U.S. and Japan.(16) Before 1985, Japan had much lower tax rates on capital than the U.S. did. Since then, that situation has been reversed -- Japan is now more hostile to capital. Little wonder that Japan's domestic investment is weak, and capital flows out.
It is often said that because Japan's savings exceed domestic investment, the answer is to use tax policy to reduce savings (adding and increasing the VAT on consumption was therefore an odd choice, even from this strangely contractionary point of view). A much better alternative is to roll back some of the recent tax impediments to domestic investment.
Average tax rates on labor were still relatively low in Japan over the 1985-95 period as a whole. But the opposite is true of marginal tax rates on highly skilled salaried people, which are extremely high in Japan. As a practical matter, the complaint that salaried people are more heavily taxed than small business owners, farmers and politicians can only be ameliorated by reducing the marginal burden on salaries.
Rising marginal tax rates on labor and capital are certainly not Japan's only problem. Monetary policy also made an unsettling shift between extremes between 1988 and 1991. Excessive regulation of finance and commerce is another unnecessary obstacle to economic progress. But the likelihood that changes in the microeconomic incentives of tax policy may account for a large part of Japan's longer-term economic slowdown deserves more serious attention than it has been getting. This is not about tax revenues (which are terribly weak). It is about incentives.
"Tax Reform" Took a Wrong Turn
Some Japanese tax specialists really believe the Shoup Commission designed a system that was "pure" in some theological sense. It does not work in practice, but it looks beautiful in theory. Such students of Shoup missionaries must therefore regard the annual tax cuts of 1950-74 as a horrible mistake -- a deviation from the "comprehensive" (yet arbitrary) Haig-Simons definition of taxable income. Hiromitsu Ishi, for example, recently urged that "reform should achieve a return to the Shoup proposals." Indeed, that is exactly the direction that Japan has taken since 1988-89 -- heading back toward Occupation austerity policies in the name of "tax reform."
The Shoup Commission advocated a value-added tax, and urged that income taxes be applied to dividends, interest and capital gains. From 1989 to 1992, "tax reform" in Japan was almost defined as adding a value-added tax and adding income taxes on dividends, interest and capital gains. There was also a curious fascination with the number of tax brackets (which is irrelevant), but too little attention among academic economists to the uncompetitive height of marginal tax rates, and to the declining real income thresholds at which they were applied.(17)
Figure 4 showed that Japan's taxes on capital have become much heavier since all these "tax reforms" were adopted. In one respect, this may seem paradoxical. From 1988 to 1990, the statutory tax on (retained) corporate earnings was reduced from 42% to 37.5%, at the national level. But the corporate tax on earnings paid out as dividends was simultaneously increased from 32% to 37.5%. The net effect left the effective corporate tax virtually unchanged.(18) Although the national corporate tax rate of 37.5% does not appear to be much higher than the U.S. rate, local taxes on corporate profits are much higher in Japan.
The main reason that Japan's tax on capital increased, however, was the new taxes on interest income and realized capital gains of individual investors. After April 1988, individuals who supplied debt capital to businesses (but not to housing) were subjected to a new 20% withholding tax on interest income. A year later, individuals who supplied equity capital to corporations were also subjected to national and local taxes of 26% on capital gains. Although these taxes are collected from individuals, the increased tax wedge raises the cost of capital to businesses.
Punishing Efficient Uses of Land
The 1992 land tax is another new tax on capital, but one designed to achieve a specific purpose. Ishi describes the land tax as "an attempt to seek an effective policy with respect to reducing land prices." Unfortunately, the Bank of Japan had the same goal. If inflicting windfall losses on landowners is a legitimate policy objective, then these policies were extremely effective.
Land had been a very important asset behind Japan's stocks, so deflating land prices deflated stock prices too. The addition of taxes on stockholder capital gains was also bound to be capitalized in lower stock prices. Land and stock were collateral behind many loans, so the goal of "reducing land prices" continues to have unpleasant repercussions on banks and credit.
The actual problem is that capital gains taxes on land sales can be extremely high, while property taxes on land ownership are very low, particularly for farms. The net effect is a powerful "lock in" effect that discourages property sales, and discourages efficient use of a valuable resource. Adding another tax on large business land holdings did nothing to fix this problem, because it continued to impose the lowest tax on the least efficient uses of land (urban farmland) while adding a discriminatory tax on the most efficient uses (big business). The real problem continues to be the prohibitive capital gains tax. Henry George made an overly enthusiastic theoretical case for taxing the appreciation of unimproved land. But the only practical way of doing that is to tax realized capital gains land transactions. Since any such transactions tax is easily avoided by not selling, changing land ownership toward more efficient uses (a process facilitated by "speculation") is thwarted by confiscatory taxes on this particular source of capital gain. Capital gains on land transactions should surely not be taxed at a higher rate than gains on financial claims to land (which is largely what many corporate stocks represent). Also, higher capital gains tax rates on assets held for short periods do not make economic sense for any asset, except perhaps as a very crude way of indexing for inflation. In short, the capital gains tax on land is far too high, and the new land tax is much less efficient than raising the broader property tax.
High Rates, Low Revenues
There are usually two obstacles to reducing excessive tax rates. One is the belief that marginal tax rates of 50% or more actually raise substantial revenue. We have indicated before (in Figure 1) that high individual income tax rates are normally associated with relatively low tax revenues, and with slow growth of revenues. We also noted that several countries which slashed their highest tax rates to 28-40% in the 1980s suffered no revenue losses.
Despite our earlier warnings about expressing tax revenues as a percentage of GDP (rather than as real growth over time), Figure 5 shows that revenues from Japan's Social Security tax increased from 6% of GDP in 1975 to 10.4% in 1995. In the same period, revenues from all other taxes increased more modestly, from 14.9% to 18.1% of GDP. In fact, revenues were no higher in 1995 than they had been in 1980, despite 15 years of bracket creep, a new VAT, and new taxes on interest income, capital gains, and land.
Figure 6 takes a closer look at the nineties. It shows that receipts from individual income taxes declined by 22% from 1990 to 1995. Corporate tax receipts fell even more, thanks to weak profits.
In the nineties, Social Security has been the only significant source of added revenue. All other sources of tax revenue dropped to 18.1% of GDP in 1994-95, down from 22.2% in 1990. That actually understates the problem, because there was also very little growth of GDP.
The prolonged downward trend of income tax revenues after 1990 was certainly not due to any "tax cuts" during these years. On the contrary, 1989 is when the biggest effort to increase taxes began.
Receipts from the VAT have been almost flat and rather small -- about 1.5% of GDP. It is a common mistake to regard revenues from a value-added tax as a net addition to total revenues. Any variety of sales tax must reduce sales, and therefore reduce personal and corporate incomes that would otherwise have been generated in producing and selling goods and services that are no longer marketable (because the VAT has raised their prices). Whether the increased revenues from VAT exceed the lost revenues from income taxes is an empirical question.
Figure 7 switches to a long-run picture of revenues from both income taxes (corporate and individual) and the VAT in real terms, adjusted for inflation. Together, Figures 5 to 7 hammer home a simple point: Japan's total tax revenues have declined in real terms ever since the VAT and various investor taxes were introduced. Without the increase in Social Security tax, which depends on it remaining attractive for employers to employ and for workers to work, the budget would be in much more serious shape than it is. All these ambitious new taxes have been killing revenues.
If taxes were measured solely by their revenue yield, as macroeconomists tend to do, then Japan's numerous and painful new taxes would look like a "tax cut." Such falling revenues from rising taxes might be a run of bad luck. But Canada's experience suggests otherwise. After Canada added a VAT in 1990, revenues from all taxes virtually stopped growing. Revenues rose by 19% from 1990 to 1995 (only 1.2% if measured in U.S. dollars), compared with a 52% rise from 1985 to 1990, and 59% from 1980 to 1985.
Japan's subtraction-method VAT (with exemptions for small firms, and for some important services) is easy to evade. Such a tax will never raise much money. Higher rates will just produce more evasion, and that evasion will result in greatly reduced income and Social Security tax receipts. It would be easier and more effective to allow prefectural and municipal governments to adopt simple retail sales taxes, preferably at rates of their own choosing, in exchange for lower local income tax rates.
When a large package of new taxes is followed by eight years of economic stagnation and falling government revenues, it is time to consider the possibility that some of those tax policies were a mistake. There is nothing wrong with admitting mistakes and then fixing them.
Aside from revenue anxieties, the other major obstacle to any constructive policy change, in both the U.S. and Japan, is the stubborn notion that tax policy can and should "redistribute income."
Taxes do not redistribute income; they just reduce income. If less real income is produced, there is less to distribute.
High marginal tax rates on capital must make capital more scarce and therefore more valuable. Pretax returns to capital rise to adjust for the tax (in a world of mobile capital, after-tax returns cannot possibly remain below the global norm). With less capital per worker, however, there will be less real output per worker, and therefore less real income per worker. Labor thus ends up bearing the burden of taxes ostensibly aimed at affluent owners of capital.(19)
A steeply progressive tax on labor income is mainly a tax on the returns to investments in higher education. This tax makes human capital more scarce than otherwise, and therefore more valuable. Salaries of highly skilled people will command a larger premium (or they will emigrate until that happens). Consumers end up paying this tax, because they must pay more for the artificially scarce services of highly skilled professionals and managers, directly or indirectly.
Distribution tables, which purport to show how various income groups will fare under different tax policies, involve hopelessly static, zero-sum, partial equilibrium incidence assumptions.(20) The first step toward meaningful tax reform is to discard these meaningless statistical exercises.
Minimal First Steps
It would be wonderful to see Japan embrace some sort of fundamental tax reform, perhaps borrowing ideas from Hong Kong or Singapore, but this might take more time than the situation can afford. In the meantime, there are many very constructive steps that could be taken immediately.
1. The highest individual income tax rate should not exceed 40% at the national level. The threshold for the 30% rate should be raised too.
2. The effective corporate tax should also be reduced to no more than 40% (including the enterprise tax) through some combination of lower rates and more rapid depreciation.
3. The VAT could be rolled-back to 3% for at least two years (announcing a return to the 5% rate would shift buying plans forward in time, risking another slump after the increase took effect).
4. The securities transactions tax should be abolished immediately. Phasing it out would provide a risky incentive to delay stock transactions until 1999.(21)
There is much more to do, of course, and many possible ways by which to do it. The Japan Research Institute, among others, has offered several worthy suggestions.(22) The essential point is that marginal tax rates on capital and human capital are much too high in Japan, sapping the entrepreneurial vitality of the economy. The highest tax rates do the most damage to the economy in return for the least revenue. There is little risk in being bold, and great danger in being too timid.
Economic growth requires more and better capital, including human capital. All taxes fall on individual suppliers of labor and capital, including taxes ostensibly levied on corporations or consumption. Even consumption taxes are really production taxes. Taxes on a company's stockholders, workers and consumers hurt business, and taxes on business hurt stockholders, workers and consumers. Excessive tax rates on capital hurt labor by reducing investment and therefore slowing the growth or real output and income per hour of work. Demoralizing tax rates on labor likewise hurt capital by raising reservation wages, shortening lifetime work hours, and reducing the intensity and quality of work.
If Japan continues to embrace the tax and spending policies of Continental Europe and Scandanavia, nobody should be surprised if economic performance becomes as disappointing as it has been in those areas. Without more vigorous economic growth, Japan's future budget problems could become far more difficult. Philosophers are free to debate "equity" all they like. But the serious question to ask about the structure of tax incentives is the question that was at the top of Japan's list in the 1950s: "How will this tax proposal help economic growth?" An economy that is taxed into oblivion will not help anyone -- not the poor, and not even the politicians.
* * * * *
Appendix: Money Matters
Macroeconomics is concerned with the short-term growth of aggregate demand, or nominal GDP. Microeconomics is concerned with longer-term incentives to expand aggregate supply, or real GDP. That distinction led to the 1976 phrase "supply-side" economics -- meaning the application of microeconomics to macroeconomic problems. The "demand side" was not neglected, however, but was properly assigned to the central bank.
The Bank of Japan pursued a very expansionary monetary policy during the so-called "bubble" period, and an extremely restrictive monetary policy since 1991. From 1987 to 1989, reserve money grew by 11.5% a year, and broad money (M2+CDs) by 10.9%. As Figure 8 shows, this expansive monetary policy financed growth of nominal GDP of more than 7% a year from 1988 through 1990.
In 1991-92, the monetary base was actually reduced by 2.8% a year, which was quite remarkable. Broad money then grew at only a 1.2% rate. Growth of nominal GDP slowed to 2.8% in 1992 and to less than 1% from 1993 to 1995. Consumer prices have been falling lately, aside from the one-time effect of the increased VAT in April 1997.
The conventional wisdom is that monetary policy is impotent in Japan -- merely "pushing on a string" -- because nominal interest rates are very low. That is exactly what was said about the Federal Reserve from 1930 to 1933. It was dangerously wrong then, and still is. Interest rates are high in Turkey because the central bank prints too much money. Interest rates are low in Japan for the opposite reason.
In a deflationary situation, shaky banks naturally want to hold more reserves, and people want to hoard more currency. The central bank has to accommodate those liquidity demands before additional bank reserves and currency can have any "reflationary" effect. If the central bank fails to convert enough securities into cash, through the discount window and open market purchases, then people have to liquidate assets and inventories to get cash. To stop such a deflation, the Bank of Japan merely has to purchases as many domestic or foreign securities as necessary, and discount freely (i.e., without rationing access to the discount window) at a penalty rate.
1. William Niskanen writes of "the residual Keynesian perspective of many older economists, based on a theory -- without evidence -- that government deficits increase total demand." -- "Myths About the 1980s," The Wall Street Journal, November 5, 1996.
2. In his 1852 critique of Louis Napoleon's "hot house" economics, even Karl Marx understood that "public works increase the obligations of the people in respect of taxes." Indeed, debt service now accounts for 22% of Japan's national budget, despite the lowest interest rates in world history.
3. When the United Kingdom first introduced a 10% VAT in April 1973, this was promptly followed by two full years of recession in 1974-75. The VAT was increased to 15% in June 1979, followed by another two years of recession in 1980-81.
4. "The problem is that analysts use tax revenue, not tax rates . . . When households evade a high tax, they drive down tax revenue, and so the high-tax experiment is less noticeable in the data." -- William Easterly's comment in Brookings Papers on Economic Activity, 1995:2, p. 421.
Also, Reinhard B. Koester & Roger C. Kormendi, " Taxation, Aggregate Activity and Economic Growth: Cross-Country Evidence on Some Supply-Side Hypotheses" Economic Inquiry, July 1989, pp. 367-86.
6. "By 1956 the total number of special [tax] measures exceeded fifty because the government was very active in the promotion of economic growth through tax devices." Keimei Kaizuka, "The Tax System and Economic Development in Japan," in Richard A Musgrave, Ching-huei Chang & John Riew, eds., Taxation and Economic Development Among Pacific Asian Countries, Westview Press, 1994, p.55
7. "In 1950, a drastic change was enforced to make the income tax less progressive than it was under the influence of the Shoup proposals. . . . The treatment of savings or investment income [became] almost the same as that which would be applied to all savings under and expenditure tax. . . . However, this hybrid developed spontaneously, without any special attempt to avoid the double taxation of savings." Hiromitsu Ishi, The Japanese Tax System, Clarendon Press, 1993, pp. 86 & 97.
9. Martin Bronfenbrenner, "Economic Miracles and Japan's Income-Doubling Plan" in William W. Lockwood, ed., The State and Economic Enterprise in Japan, Princeton University Press, 1964, pp. 536n & 551-52. A more perceptive essay by Hugh Patrick of Yale University attributed Japan's vigorous growth to continual "tax rate cuts," but even Professor Patrick saw Japan as careening "from one balance of payments crisis to another."
10. Henry C. Simons, selection from Personal Income Taxation (1938) reprinted in H.C. Harlan, ed., Readings in Economics and Politics, Oxford University, 1961, p. 303. Simons' influential 1948 book, A Positive Program for Laissez Faire, also advocated breaking-up large enterprises, which was almost adopted in extreme form by Occupation officials until a properly alarmed U.S. Congress stopped them.
11. Referring to Shoup, Vickrey, Pechman and others, Musgrave captured the zeal with which that former generation of tax missionaries spread their gospel: "The comprehensive income tax base thus became the banner of tax reform in the United States, designed to . . provide a global base on which progressive rates could be assessed. . . This movement . . . provided the focus of analysis and delight for a generation of tax economists in the United States." R. A. Musgrave, "A Brief History of Fiscal Doctrine," in A. Auerbach & M. Feldstein, eds., Handbook of Public Economics, Elsevier Science, 1985, Vol. 1, p. 22.
14. "A scheme that subjects the old to global income taxation would be superior to simply using the consumption tax." -- Maria S. Gochoco, comment on Yukio Noguchi, "Aging of Population, Social Security and Tax Reform," in Taktoshi Ito & Anne O. Krueger, eds., The Political Economy of Tax Reform, University of Chicago, 1992, p. 232,
15. Ishi, op. cit., p. 54: "What are the main causes for the sharp rise of fiscal deficits since 1973? . . . First, there was a conspicuous slowdown of Japanese economic growth cause by the two oil crises."
17. Unlike leading groups of academic and think tank economists, who advocated leaving the top national tax rate at 50-60% (while also taxing much more of investment income), Japan's Committee for Economic Development, a business group, made a relatively bold proposal in January 1986 that the combined national and local income tax rate (then 78%) should not exceed 50%. Even the major trade unions advocated reducing progression. M. Homma, T. Maeda & K. Hashimoto, "Japan," in Joseph A. Pechman, ed., Comparative Tax Systems, Tax Analysts, 1987, pp. 429-32.
19. This modern "general equilibrium" analysis of tax incidence is often associated with Joseph Stiglitz, Economics of The Public Sector, Norton, 1988, pp.430-32. But it was well understood by classical, pre-Keynesian economists. Harvard's Sumner H. Slichter, Modern Economic Society, Henry Holt, 1929, p. 743: "To the extent that a tax on capital retards the increase in the supply of capital, it enables capitalists to obtain a higher return on their funds and falls, therefore on others [consumers and wage earners]."
21. There is no legitimate reason to restrict corporate share repurchases, and therefore no reason for making the easing of such restrictions temporary, as has been proposed. Share repurchases create capital gains, which will generate tax revenue and strengthen loan collateral. If the reason for the restriction on repurchases has been to foster dividend payouts, that would be better accomplished by restoring some relief from double-taxation of dividends.