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Tax reforms must sustain positive economic cycle

by Yoshio Nakamura

The Japanese economy is on the path toward a full-scale recovery driven by the private sector. The next major challenge for the nation is to its rebuildfiscal health, which is now the worst among the key industrialized countries.

As a near-term goal, the government needs to achieve a primary balance — a condition where expenditures excluding interest payments and debt redemptions are covered by revenues excluding bonds — or a surplus.

Fortunately, the Japanese economy is now in a positive cycle where improved corporate activities are creating jobs and increasing consumption, which is expanding tax revenue. As a result, the fiscal situation is gradually moving in the direction of a primary balance.

It goes without saying that to restore fiscal health, far-reaching cuts in expenditures and a review of revenue sources are both essential. But the basic policy must be to maintain a robust economic performance and pursue natural increases in tax revenue by expanding economic activity.

The incentives introduced in the annual tax reform of fiscal 2003 are one successful example of such efforts. The incentives were aimed at promoting corporate research and development and investment in information technology. They were the first in a series of fundamental tax reforms launched by the administration of Prime Minister Junichiro Koizumi, and had large effects not only on Japanese industries, but on the Japanese economy as a whole.

Private-sector R&D investment, which had been showing only slight increases prior to the move, started rising by roughly 700 billion yen a year. IT investment by Japanese companies has expanded by around 1 trillion yen annually since fiscal 2003.

What’s noteworthy is that the measures have prompted some of those companies to shift some of their investments back to Japan.

For example, a major electronics manufacturer built a new large-scale, high-tech plant in Japan while shutting down overseas production lines that had become obsolete.

Initially, the incentives for R&D and IT investments were estimated to have cut tax revenue by 1.2 trillion yen. The expansion in corporate activity however has produced a 2 trillion yen gain in corporate tax revenue over the past two years. After jobs and wages subsequently rose, fiscal 2004 saw all three major tax items — corporate tax, income tax and consumption tax — rise simultaneously for the first time in 15 years.

Last week, the tax commission released its tax proposals for fiscal 2006, which included the termination or scaling down of tax credits for R&D and IT investments.

The commission is calling for ending the incentives merely because their original terms are expiring. But we doubt such a simplistic approach will be appropriate.

Given that state coffers have benefited the most from the increase in corporate tax revenue, we believe it would be wiser to maintain tax measures that will beef up the competitiveness of Japanese companies, so as not to hamper the nation’s positive economic cycle.