Funding the corporate tax cut

The Abe administration’s decision to cut corporate taxes as a key feature of its economic growth strategy shelves the key question of how the tax cuts will be financed at a time when the government’s fiscal health is the worst among industrialized economies and households face the prospect of another hike in the consumption tax next year.

Also missing is a clear picture of how the corporate tax cuts will not just reduce the tax burden on businesses but generate new demand and investments to benefit the whole economy.

As consensus on how to pay for the cuts in corporate tax rates appears elusive, an idea is reportedly gaining ground within the administration that anticipated tax revenue gains from the current economic upturn should be used to fill the revenue gap from corporate tax cuts. However, it would not make rational sense to count on revenue gains that are subject to the ups and downs of the economy to finance permanent cuts to corporate tax rates.

Many of the steps featured in Prime Minister Shinzo Abe’s updated growth strategy, formalized by the Cabinet on Tuesday, are policies and steps that have long been called for by big business, including corporate tax cuts.

The plan calls for reducing the effective rate of corporate taxes — national and local taxes combined — from the roughly 35 percent today to at least below 30 percent within several years starting in fiscal 2015.

Corporate tax rates are set in the 20 percent range in many Asian and Western countries, except in the United States, where the rates are even higher than in Japan. Proponents say the tax cuts are essential for Japanese companies to stay internationally competitive, and warn that the high tax burden could drive more companies to shift their operations abroad and discourage foreign firms from investing in Japan.

The problem is how to finance the tax cuts without further straining the government’s fiscal health. A one-percentage- point cut in corporate taxes would create an estimated revenue shortfall of ¥470 billion.

Further cuts in the tax rate, say, to 29 percent, would create a revenue gap of well over ¥2 trillion.

Proponents argue that the tax cuts will generate more corporate business activity, boost the economy and ultimately increase tax revenues for the government.

Still, the ruling Liberal Democratic Party’s Tax Commission has been searching for other tax revenue sources to finance the cuts in the corporate tax rate.

One idea is to even out the impact on tax revenue by widening the scope of taxation on businesses while reducing the tax rate itself. Currently only about 30 percent of Japanese firms pay corporate taxes, which are not imposed on loss-making companies, including many small- and medium-sized businesses. Companies are also allowed to carry over their losses incurred in a business year and deduct the amount from taxable profits in subsequent years. There are also special tax benefits intended to support certain industries or to promote research and development.

Plans to either abolish or scale down some of the special tax measures face resistance from those business sectors that benefit from them, while opposition remains against steps to expand the scope of local taxation according to business size rather than income, because it is feared that loss-making small firms would be more likely to get hit.

All of these questions were left over for discussions of fiscal 2015 tax reform at the end of this year.

The idea of using the tax revenue surplus from increased business activity to pay for the corporate tax cuts would enable the Abe administration to circumvent tough political decisions on current special tax measures that benefit certain sectors. But the administration needs to stop and think whether the government — whose total debt has topped ¥1,000 trillion and continues to rise — can afford a corporate tax cut that is not backed by permanent substitute sources of revenue. The consumption tax rate was raised from 5 percent to 8 percent in April, with another hike to 10 percent planned in October 2015 — supposedly to help sustain the social security system amid the nation’s tight fiscal conditions.

The corporate tax cuts would be meaningless if they only added to the nation’s fiscal woes.

Also in need of scrutiny is the very premise that corporate tax cuts are essential to keeping Japanese firms from shifting their operations overseas — and thus accelerating the hollowing out of domestic industry — and to bringing more foreign investments to this country.

The nation’s major manufacturers have relocated production to where they see promising markets. They do not appear keen on bringing their operations back to Japan even after the yen has weakened against other currencies.

Tax rates are just one of many factors that foreign firms take into account when making investment decisions — along with local market size and the overall cost of doing business, including energy, manpower and real estate expenses.

Despite unanswered questions about funding alternatives, the corporate tax cuts were featured in the growth strategy apparently to impress stock market investors that the Abe administration is serious about removing obstacles to the competitiveness of Japanese businesses.

As the government seeks to find the answers to the funding issues by yearend, it should strive to determine whether the tax cuts will be an effective means of encouraging more investments and generating demand in the Japanese economy, or will simply allow businesses to retain more of their earnings as internal reserves.