Significance of Eliminating Deductions and Creating Child Allowances
Hidetaka Yoneyama
Senior Research Fellow, Economic Research Center
September 8, 2009 (Tuesday)
Eliminating Deductions and Creating Child Allowances
The DPJ’s (Democratic Party of Japan) manifesto proposal to review income tax deductions (abolish the deductions for spouses and dependents from national tax) as a way to fund child allowances is stirring controversy (deductions for spouses eliminated from resident tax (local tax), but deductions for dependents continued). This is because it is clear this proposal would increase the tax burden on certain families without children (taxpaying households with full-time homemakers under 65, or 4% of all households according to DPJ estimates). In other words, the DPJ would not only increase child allowances, but would also shift the tax burden and begin to reform the cost and benefit structure.
The DPJ proposal would transfer income from households without children to households with children. The LDP (Liberal Democratic Party) criticizes this for forcing a particular demographic to shoulder a heavier tax burden, and maintains that all citizens should bear the costs of raising children in the form of a higher consumption tax. Raising the consumption tax would be difficult in the short-term, and given that curbing the declining birthrate is an important issue facing Japan, the DPJ’s proposal will likely garner a degree of approval.
The DPJ’s proposal not only raises the issue of how to fund the child allowances, but also has the potential to significantly shift the traditional burden and benefit structure.
Tax Deduction Frameworks in Europe and the US, and the DPJ’s Proposal
It has long been noted that Japan’s income tax gives large personal allowances such as deductions for spouses and dependents. The result is a high level of minimum taxable income compared to other developed countries, and significant erosion of the taxation base. In addition, because the spouse deduction applies to a high ratio of high income earners, and because the framework is based on income deductions and not tax deductions, the high-income bracket (with its high tax rate) enjoys the greatest benefits. The spouse deduction also gives working wives an incentive to keep income under the applicable amount for the deduction (JPY 1.03 million), inhibiting the supply of labor from married women.
One method to solve these problems is to abolish the spouse and dependent deductions, and provide new benefits to low-income earners who would shoulder the increased burden. Tax deductions with payouts are frequently proposed as a framework for this.
“Tax deductions” refer to a framework where the difference is paid out in the event that applicable tax deductions are more than tax liabilities. For example, a taxpayer with a deduction of 50,000 yen and a liability of 100,000 yen would pay 50,000 yen (100,000-50,000=50,000), while the same taxpayer with a liability of 10,000 yen would receive 40,000 yen back (10,000-50,000=-40,000). Compared to income deductions, which benefit the middle and high-income brackets, tax deductions favor low-income earners. Essential to the introduction of this tax deduction framework, however, is a taxpayer number system with accurate information on individual income.
Tax deductions based on the number of children are a method for incorporating child raising support into this framework (already introduced in Europe and the US). Instead of fixed tax deductions, the amount changes depending on income and the number of children. Specifically, to provide work incentives the tax deductions follow a curb so that deductions are zero for zero income, increase along with income until a certain level, and then gradually begin to fall. Adding tax deductions according to the number of children creates a large deduction curb (no deductions for the high-income bracket).
The DPJ’s proposed policy to abolish the deductions for spouses and dependents and create child allowances would generate a similar effect as the tax deduction frameworks in Europe and the US. Unlike these frameworks that eliminate child tax deductions for high-income earners, however, the DPJ’s proposal sets no income limits and provides allowances based only on the number of children. The frameworks in Europe and the US can serve as a model for the DPJ if it wishes to develop its proposal into something more sophisticated that includes significant reform of income deductions.
Raising the Minimum Wage, and Tax Deductions
By incorporating child raising support measures and making the deduction amount dependent on income, the tax deduction framework maintains work incentives for low-income earners and can be designed to include payouts.
Currently there are two main support measures for low-income earners: a direct support method that helps cover living expenses (welfare), and support through raising the minimum wage. Regarding the former, the eligibility requirements are strict and once welfare is received the incentives to work are weakened. This problem is particularly serious when welfare benefits are higher than income from a low wage job.
As noted in the DPJ’s manifesto, while the necessity of raising the minimum wage is frequently pointed out, this is a life and death matter for companies barely turning a profit. Simply increasing the minimum wage could push struggling companies into bankruptcy and take jobs from low-income earners. The tax deduction framework can also be used as a policy to replace these two problematic support measures for low-income earners.
In summary, the shift from income deductions to tax deductions has the merits of eliminating various problems associated with the income tax burden (current deductions erode the taxation base, benefit high-income earners, and inhibit the supply of labor from married women) while also making it possible to incorporate low-income and child raising support measures.
While the DPJ’s proposal to eliminate deductions and create a child allowance can produce similar effects, to develop it into a more effective framework steps should be taken to introduce both taxpayer numbers and tax deductions.
