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Prime Minister Junichiro Koizumi is seeking tax reform to revive economic vitality, but he wants to limit tax cuts to the extent that they do not exacerbate the budget crisis. In other words, he is opposed to stimulating the economy at the expense of fiscal discipline. So no major tax cuts are planned for fiscal 2003.

The prime minister’s “no revenue, no tax cut” position — which is reflected in tax discussions at the government’s Council on Economic and Fiscal Policy and Tax Commission, stands to reason. If taxes are reduced on a large scale through bond issues, that will only inflate the already bloated government debt — a development that could lead to a further downgrade of Japan’s international credit ratings.

What’s more, long-term prospects for self-sustaining economic growth will become further clouded. So, in principle, tax cuts will have to be matched by spending cuts or tax increases, or both, in ways that will help reinvigorate the economy over the long haul. In this sense, corporate tax reform is of great importance. The prime minister, as well as the Tax Commission, is in favor of introducing a local business tax based broadly on size, not income.

The current business tax is levied on incomes, as is the national corporate tax. So deficit-running companies — their number is huge because of the protracted business slump — do not have to pay these income taxes. The tax panel points out that about seven of 10 firms are not paying taxes, creating a big hole in a source of local-government revenue.

In principle, all companies, including those in deficit, should pay taxes for the administrative services they receive from local governments. In fact, that is the basic idea behind the business tax. The proposed size-based tax would secure stable revenue for local governments, both in good times and bad. Moreover, it would support the ongoing process of devolution, or administrative decentralization.

The Tokyo Metropolitan Government has set a precedent by introducing a similar tax on major banks operating in the capital. Although the bank tax was declared illegal by the Tokyo District Court on the grounds that it targets a selected group of companies, Tokyo has appealed the ruling. The idea of a size-based tax is nothing new. Tax specialists have long maintained that it is unfair for deficit companies to enjoy tax exemption simply because they are not making profit, and that, together with profit-making companies, they should pay taxes for local-government services. Their argument is that all companies should be taxed on the basis of their capitalizations, payrolls and other “extraneous” factors.

As expected, the proposed tax has met objections from the business community, particularly from small firms. According to a plan worked out by the Public Management Ministry (“Somusho”), however, the tax would bring a reduction, not an increase, in the overall corporate tax burden because it would apply across the board at a relatively low rate.

If the plan goes through, the current business tax rate would be cut in half, from 9.6 percent to 4.8 percent. This would mean a tax cut for companies making profits. As a result, the effective corporate tax rate — the national and local tax rates combined — would drop by a few percentage points from the present 40.8 percent, one of the highest levels in the world.

It appears that Mr. Koizumi is trying to use this effective tax cut as a key selling point for the opponents of the proposed levy. He is also calling for tax credits for research and development projects as part of his corporate tax reforms.

The point is that in the long run, size-based taxes will serve as a catalyst for corporate efforts to bolster their cost competitiveness. It need not be seen as a “stick” for businesses. With China rapidly rising as an economic rival to Japan, Japanese companies face a big challenge to trim their extraneous costs, such as payroll and equipment costs.

To be sure, Japan’s economy is showing signs of a mild recovery. But given its underlying weakness, deflation will likely continue for some time. To survive the stiff competition that lies ahead, companies need to become leaner. Extraneous taxes should help businesses improve their cost structure, including high-wage levels.

The worry is that across-the-board taxes would deal a heavy blow to small businesses hit hard by the decade-long economic slump. They deserve temporary relief to ease the impact of the new levy until the economy returns to stable growth. But such a “shock-absorbing” measure must be one that will not deflect the basic thrust of tax reform.

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