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Will a Lower Corporate Effective Tax Rate Lead to Growth?

Hidetaka Yoneyama
Senior Research Fellow

September 28, 2010 (Tuesday)

Will a Lower Corporate Effective Tax Rate Lead to Growth?

Japan’s effective corporate tax that combines national and local taxes is at a globally high level (Japan 40.69%, the U.S. 40.75%, the U.K. 28%, South Korea 24.2%), and the business community in particular has called for a lower corporate tax for some time. The Democratic Party of Japan (DPJ) said nothing of decreasing the effective corporate tax in its manifesto for the Lower House elections last year. After taking power, however, the DPJ has repeatedly noted that economic growth strategies are flawed, and, though offering few specifics, showed a positive stance in its Upper House election manifesto towards lowering the effective corporate tax as part of its growth strategy.

If a lower corporate tax is to contribute to economic growth, it will do so in primarily two ways. First, the heavy corporate tax burden is one factor behind the flight of Japanese companies overseas and the dearth of investment coming into Japan. A lower tax burden would discourage companies from moving overseas and increase inward investment, which would stimulate economic growth. Behind the recently intensifying global race to lower corporate taxes is the competition to attract investment. Second, the high tax burden has left Japanese companies with little room to invest in business; easing this burden would lead to higher capacity investment.

Can these routes help revitalize the Japanese economy? An argument against the first point is that corporate tax is not among the primary factors that affect companies’ location selection. According to a questionnaire survey conducted by the Tokyo metropolitan government in December 2007, companies listed reasons for expanding business overseas (in this case production centers) in the following order: “lower wage costs” (49.7%; multiple choice, same below); “ample supply of manpower” (44.6%); “one part of market expansion” (44.3%). In contrast, only 2.7% cited “lower corporate tax burden” as the reason. In cases excluding production centers, answers were in the following order: “one part of market expansion” (63.2%); “strengthen business relationships” (41.3%); “proximity to affiliated companies” (30.2%). Only 3.6% of respondents listed “lower corporate tax burden.”

Though the local corporate tax rate may not be a deciding factor for Japanese companies when considering an overseas transfer, a low effective corporate tax will make a potential destination country more attractive. In other words, in the event that multiple countries meet the various conditions for overseas expansion, a low corporate tax can indeed be the deciding factor. There are recent cases where major companies have considered corporate tax when selecting an overseas destination for headquarters, production centers, and R&D centers. The competition among emerging countries to attract investment by slashing corporate tax rates indicates that a low effective tax rate is indeed a determining factor.

Can Japan compete? This will be difficult for a country with high labor costs and an unappealing market as a result of population decline. In some cases, however, lowering the effective tax rate could make Japan more attractive: some developed countries are cutting effective tax rates to encourage foreign companies to bring in their headquarters and R&D centers.

If Japan decides to enter the fray, as is requested by METI for tax revisions next fiscal year, tepid moves such as a 5% cut in the effective tax rate will likely prove ineffective; Japan would need to take bold measures such as dropping the rate all the way to 20%, or the level in emerging countries. A drastic cut in a short period of time, however, would be impossible in one national sweep; special zones for lower taxes would need to be created first. Yet, this kind of discussion is currently absent in Japan. Little can be expected in terms of economic stimulation from at most gradual reductions to the average level in major countries.

Can the second route, or higher business investment, jump-start the economy? A lower corporate tax burden would indeed increase companies’ cash flow. Corporate coffers, however, are already full: savings exceed investment among Japanese companies as a whole. In other words, there is no shortage of cash flow for investment; rather, the lack of promising investment opportunities has left companies with excess savings. In this situation, reducing the corporate tax burden is unlikely to lead to higher capacity investment.

Companies’ public burden that includes social insurance costs

So far we have shown a skeptical view regarding economic stimulation as a product of the Japanese economy entering a low corporate tax race. There is also the underlying problem that while Japan’s corporate income tax is high, the government and business owners split the cost of social insurance, so the combined burden of corporate income tax and social insurance costs is low for business owners compared to in the US and European countries. (For example, the “Large Package of Tax Revisions for Fiscal 2010” approved by the Cabinet on December 22.) The Ministry of Finance has long emphasized this point as rationale for resisting a lower corporate tax.

Regarding this argument, METI, which seeks to reduce the corporate effective tax rate, acknowledges that [(corporate income tax + business owners’ social insurance cost burden) / GDP] is comparatively low in Japan, but also notes that [(corporate income tax + business owners’ social insurance cost burden) / social security expenditure] is on par with comparatively high levels in France and Sweden ("Industrial Structure Vision 2010," May 2010). Though a bit cumbersome, let us examine the meaning of this indicator. To simplify, (corporate income tax + business owners’ social insurance cost burden) is called (business owners’ public burden), and the indicator is modified as follows:

  • (corporate income tax + business owners’ social insurance cost burden) / social security expenditure
  • = business owners’ public burden / social security expenditure
  • = (business owners’ public burden/GDP) / (social security expenditure/GDP)

The high level of this indicator shows that, compared to other countries, the numerator (business owners’ public burden/GDP) is high or the denominator (social security expenditure/GDP) is low. In the case of Japan, the indicator is high because, as previously mentioned, the numerator is comparatively low but the denominator is also low. Meanwhile, the numerator is comparatively high in France and Sweden, but the denominator, or social security expenditure as a percentage of GDP, is also high, leaving the indicator at about the same level as in Japan.

Thinking in this way, and as METI asserts, this high indicator does not mean that the effective rate of corporate tax must be lowered to decrease the numerator. Japan’s indicator is comparatively high because the denominator, or social security expenditure as a percentage of GDP, is comparatively low; raising the denominator to a level on par with western countries would lower the indicator. Assertions based on a different indicator brought forward by METI is a bit of a stretch, and the fact remains that the corporate burden in Japan, which includes corporate income tax and social security costs, is low compared to some western countries with generous social security.

The effect of raising 5%

In this way, the public burden of Japanese corporations isn’t particularly high compared to in the US and Europe. In addition, reducing the corporate effective tax rate to the level being currently discussed is likely to have marginal impact. Such a reduction, however, is not meaningless—the current 5% reduction plan would have the following effect.

If necessary, manufacturing companies can lighten their tax burden by moving centers overseas. In contrast, companies that focus on domestic demand are basically confined domestically and have no choice but to accept high Japanese effective tax rates. Looking at the changes in the breakdown of corporate tax revenue by industry (fiscal 1981 to fiscal 2008), the ratio of manufacturing fell dramatically from 45.1% to 30.2%, while among non-manufacturing industries, the service industry surged from 0.4% to 15.0% and the wholesale and retail industry climbed from 18.9% to 19.5%. The entities paying corporate tax in between are primarily non-manufacturing (according to the National Tax Agency). This change is partially related to the shift in the industrial structure towards services, but also shows that it is becoming difficult to increase tax revenue from manufacturing. An even slight decrease in the corporate effective tax rate therefore has the effect of reducing the tax burden of domestic demand-oriented companies. Moreover, these companies are closely connected with consumers, so lowering their tax burden could reduce the amount of tax passed on to consumers.

On the other hand, a 5% reduction of the corporate effective tax rate would translate into 1 trillion yen of lost tax revenue. Combining this reduction with a consumption tax hike is one way to secure a new source for lost tax revenue. It will be difficult, however, to raise the consumption tax in the near future. One option is to lower the effective tax rate after expanding the corporate tax base by abolishing or shrinking the “Act on Special Measures concerning Taxation” (tax incentives) that gives preferential treatment to particular industries. In this case, compensating for a lower corporate effective tax rate by removing tax incentives related to research and development would in essence be a tax increase on manufacturing companies with high capacity investment, potentially rendering the tax cut meaningless. In contrast, widening the tax base in this manner would, from the perspective of domestic-demand oriented industries with little capacity investment, eliminate the corporate tax imbalance among industries under the current tax system. Yet, ending R&D tax incentives that enhance the competitiveness of the manufacturing industry just to lower the effective tax rate is to put the cart before the horse. Discussion on decreasing the effective tax rate for the sake of domestic-demand oriented companies is, in fact, lukewarm at best.

Is a dramatic reduction possible?

If moves to lower the corporate effective tax rate were to begin in earnest, they would likely be accompanied with a higher consumption tax as only expanding the taxation base would produce limited revenue. This point is related to the problem of whether companies’ value added tax should be done primarily with corporate tax. Considering the potential for companies to flock to low tax countries, and, in doing so, creating the perpetual risk of a low tax war, there is rationale behind the notion of decreasing the frequency of taxation at the corporate stage while increasing the frequency of taxation at the stage of value added being distributed to consumers. Taxation of consumers occurs at the stage of either income or consumption, and taxation at the consumption stage seems certain to become the main framework in the future.

The logic of raising the consumption tax for the sake of a lower corporate tax, however, carries the image of victimizing consumers in favor of companies and will be hard for the general public to accept. Reducing corporate tax without raising the amount that companies distribute to consumers is problematic in that only the tax burden of consumers increases. Keeping this in mind, the issue becomes how to rectify the balance between corporate and consumption tax to prevent the flight of companies overseas.

In the end, discussion on lowering the corporate effective tax rate in Japan has hit a wall in the sense that even a 5% reduction is fiscally tricky and a dramatic reduction will present even greater difficulties. Japan, however, does not shoulder a particularly high corporate public burden among major countries, and entering a low-tax race with emerging countries is not necessarily in Japan’s interests. In addition, the manufacturing industry enjoys many benefits of tax incentives under the current system such as R&D tax breaks. Even without lower corporate effective tax rates, there has also been a recent focus on the superiority of domestic brands and increasing domestic production of high value-added products. Current discussion on reducing the corporate effective tax rate tends to emphasize the competitive advantage in terms of location that such a reduction will bring, but level-headed discussion is needed on whether the effects will really be worth such a move.