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1 PRI Discussion Paper Series (No.02A 29) Comparison of Japanese and U.S. Tax Base and Changes of Tax Base in Japan For use at the IMF conference Policy Recearch Institute,Ministry of Finance,Japan Vice President Shigeki Morinobu The vie s expressed in this paper are those of the authors and not those of the Ministry of Finance or the Policy Research Institute TEL

2 Comparison of Japanese and U.S. Tax Bases and Changes of Tax Base in Japan For use at the IMF conference Shigeki Morinobu Vice President, Policy Research Institute, Ministry of Finance, Japan 1. Introduction One of the focal points of the tax reforms now being discussed by the government s Tax Commission and the Council of Economic and Fiscal Policies is a review of the income tax base. In this paper, I would like to examine how the Japanese personal income tax has undergone changes reflecting the transformation of the economy and society and discuss possible problems that may arise in the future. 2. Present State of the Personal Income Tax Burden in Japan In order to highlight the present state of the Japanese personal income taxes, the proportion of income tax in the tax systems of advanced countries are compared. The proportions are 32% (national and local taxes combined) in Japan, 53% in the United States, 42% in Germany, 33% in the U.K., and 27% in France. The weight of personal income tax is light in the Japanese tax system as compared with those in the European tax systems that have indirect taxes deeply built into them. 1 This fact is not necessarily well known. Next, the ratios of personal income tax revenues (national and local taxes) to national income (SNA base) of the countries are compared. The ratio is 6.8% in Japan (in FY2002), 14.2% in the United States (1997), 13.9% in the U.K. (1999), 12.8% in Germany (1999), and 11.2% in France (1999). The personal income tax burden in Japan is about half the amount in other Group of Five countries. The personal income tax burden on a typical household with an annual employment income(wage and salaries) of 10 million is 0.86 million yen in Japan, 1.67 million yen in the United States, 2.72 million yen in the U.K., 2.13 million yen in Germany, and 0.99 million yen in France. The minimum taxable income of an employment income earner s household with 1 OECD Statistics,

3 two children is 3.84 million yen in Japan, 3.15 million yen in the United States, 1.38 million yen in the U.K., 3.83 million yen in Germany, and 2.98 million yen in France. 3. Examination of Personal Income Tax Base (1) Comparison and estimation method of tax base We have so far compared the actual state of the Japanese personal income tax with those in other countries in various ways. But, they do not necessarily reveal in what part of the Japanese income tax system the problem lies. So, we have looked for the problem by comparing tax bases (taxable income), a basic element that along with the tax rate determines the level of tax burden, with national income that shows the economic scale of a country. 2 Specifically, in order to measure the magnitude of the tax base on a macroeconomic level, we have calculated the ratio of the tax base to the receipt of the household sector, that is to say, we obtained the total income of the household sector from the National Accounts (SNA statistics) and extract non-taxable portions using tax statistics from the total income. 3 The relationships between the receipts of the household sector and items not included in taxable incomes or the final tax base are shown in Figure 1. It classifies non-taxable items into Social security-related deductions, 4 (Various) deductions from income, and Other non-taxable incomes. (2) Comparison of Japanese and U.S. tax bases Figure 1 and Figure 2 show the tax base in Japan and the United States estimated in the above method based from statistics for FY1997 in the case of Japan and for 1996 in the case of the United States. The tables show that the ratio of tax base to receipt of the household sector in 2 There are not much differences in the nominal rate of income tax among the countries: 10~37% in Japan, 10~38.6% in the United States, 10~40% in the U.K., 20~48.5% in Germany, and 7.5~52.75% in France (Japan and the U.S. figures do not include local taxes). 3 For Japan, used National Accounts, Economic Planning Agency, National Tax Agency s Annual Statistics, Results of Sample Survey for Self-assessed Income Tax, and Results of the Statistical Survey of Actual Statistics for Salary in the Private Sector National Tax Agency, and for the United States, used National Income and Product Account of the United States and Statistics of Income. 4 Employers social security contributions that are deductible at the enterprise level, deductible social insurance premiums, and deductible public pensions, etc. 2

4 the United States is 53.2% and in Japan it is 27.4%, or nearly half that of the United States. The main causes that create the difference of as much as 25.8 percentage points are: Difference in deductions from income (10.3 points) Difference in Social securities that are not included in the tax base, such as social security contributions (3.6 points) (And, Differences in receipts not calculated as income (5.1 points), such as imputed rents. However, we omit these differences as they are due to the fact that housing prices in Japan are higher than in the United States.) (a) Deductions from income The reasons for the difference in deduction from income can be divided into personal exemptions and employment income deductions. As for the former, a total of 12.7% of the tax base is omitted in Japan due to the existence of various exemptions, such as basic deduction, exemption for spouse, special exemption for spouse, exemption for dependents, and special exemption of dependents, while, in the United States, there is only one personal exemption and only 8.1% is omitted. (Difference of 4.6 points) As for the necessary expenses of employment income earners, while the employment income deduction in Japan omits 15.4% of the tax base, the standard deduction and itemized deduction in the United States omit a total of 13.0%, resulting in a difference of 2.4 points. Moreover, the itemized deduction in the United States includes exemptions that are not directly related to the expenses of employment income earners, such as interest deductions for housing loans and exemptions for donations to charity organizations. If such exemptions are excluded, the necessary expenses of U.S. employment income earners come to 6.7%, or about half as much as in Japan. This shows that the employment income deduction in Japan is substantial in scale from the standpoint of the expenses of employment income earners. (b) Social securities that are not included in the tax base The 3.6-point difference in the Social securities that are not included in the tax base can be divided into (i) the portion related to pensions and (ii) other social securities, such as medical expenses. The difference in the pension-related portion comes from the difference in tax on 3

5 pensions between Japan and the United States. In both public pension and the corporate pension (employees pension fund) in Japan, the portions contributed by corporations are deductible and thus tax-exempt at the stage of contribution (entrance). As for the portions contributed by individuals, deduction for social insurance premiums (income deduction) is applicable. When the pension funds are being managed, they are tax-exempt. Moreover, there is an extraordinarily high level of deductions for public pensions, etc. at the stage of pension payments (exit) and, therefore, pensioners are virtually tax-exempt. As a result, there is a total of 11.2% erosion of the tax based: 4.0% at the entrance and 7.2% at the exit. On the other hand, in the U.S. public pension and corporate pension, the portions contributed by individuals are not tax-exempt at the stage of contribution, although the portions contributed by corporations are deductible just as in Japan. However, employers contributions based on a 401K plan (payroll savings plan) are tax deferrable and tax-exempt while they are being managed, resulting in a 2.3% omission of the tax base. (Although this system is originally designed to make the entrance tax-exempt, it is statistically viewed as the exit in the United States.) On the other hand, with regard to public pensions, the ratio of benefits to be included in income is decided depending on the level of income and it is virtually tax-exempt at the stage of pension payments (exit) as in Japan. As a result, there is a 5.1% omission of the tax base at the exit, bringing the total omission to 7.4%, or 3.8 points lower than in Japan. (3) Changes of personal income tax base in Japan Next, let s take a look at the changes of tax base since Roughly speaking, the tax base remained stable from 1980 to 1989, expanded from 1991 to 1992, shrank sharply in 1995 and now remains at about the 1995 level. Although there were tax cuts in 1984, 1987, 1988 and 1989 and a hike and creation of income deduction during the 1980s, the tax base as a whole showed no major changes, as the fast growth of income was reflecting the rapid economic growth during the bubble economy. 6 In late 1980s, tax base expanded mainly because of the decline of 5 During this period, there were a hike in basic, spouse, and dependent deductions and employment income deduction in 1984, a hike of deduction for spouse and creation of special deduction for spouse in 1987, a hike of basic, dependent, spouse, and special spouse deductions in 1989, and a hike of basic, dependent, spouse and special spouse deductions in Since the tax base in this Paper is the ratio of personal income minus deductions from income (fixed exemption amounts multiplied by the number of persons covered) to the 4

6 the personal exemption. During the 1990s, the tax base decreased sharply in and after 1994 because of the tax cut under the fiscal policy. When we compare the tax base of 1998 to 1980, there is only slightly change, but it should be noted that their contents are sharply different. (See Figure 3 and Figure 4) (a) Social securities that are not taxable Social securities that are not taxable increased 9.8 points from 1980 to 1998, with social security benefits accounting for 6.9 points of the increase and employers social security contributions and deductions for social insurance premiums accounting for 3.4 points. They constitute the largest factor reducing the tax base. They have been consistently increasing since the beginning of the 1990s, reflecting movements toward social security reforms in the 1990s. In particular, the expansion of benefits and the introduction of a complete wage indexation as a result of the reform of the employee pension insurance and national pension plans decided in FY1989 and the Gold Plan welfare program for elderly people had a major impact. (b) Personal exemptions -- basic deductions, exemption for dependents, exemption for spouse Deductions from income, on the other hand, decreased 7.8 points, contributing to expansion of the tax base. Personal exemptions basic deductions, exemption for dependents, exemption for spouse have been on a long-term decreasing trend. The exemption for dependents, in particular, has been decreasingly sharply. While the basic deduction decreased only slightly from 7.7 % to 5.2 % in 18 years, the exemption for dependents decreased by nearly half from 7.4 % to 3.8 % during the same period. The decrease of exemptions for dependents stands out in the 1980s. This reflects a structural change in the Japanese economy and society, such as decreasing number of children and an increase in the number of working women. The exemption for spouse, which stood at 4 % in FY1980, began a slight downward trend and decreased to 1.6 % in FY1998. Even with the special exemption for spouse, which was created in 1987, the exemption for spouse decreased to 2.9. This is due to the increase in the number of working women. personal income, it tends to increase as income increases as a result of economic growth. 5

7 (c) Employment income deduction The ratio of employment income deduction to the receipts of the household sector had consistently decreased until FY1988. This is because the level of employment income deduction had been kept almost unchanged, except at the time of a revision in FY1984, while the level of income had been rising. However, the ratio of the amount of employment income deduction to the receipts of the household sector has been on a rising trend since FY1994. This can be attributed to slow growth in income due to the sluggish economy and an increase in the number of working women. Employment income deduction is basically calculated at a rate of 40~5% depending on the amount of earned income. However, since the deduction rates are retrogressively structured, under which the rate declines as income increases, the rate of deduction rises when the growth of income is stagnant. The increase in the number of working women increases the number of workers with employment income deductions, and thus raises the ratio of deductions. (In this case, the ratios of the exemption for spouse, special exemption for spouse, and exemption for dependents decrease, as such women are removed from these exemptions.) (4) Estimation of future tax bases What impact will the rapid aging of the population have on the income tax base in Japan? According to Social Security Toward the 21 st Century (October 2000), a report issued by the Prime Minister s advisory council studying an ideal social security system, the amount of pension benefits, which stood at 41 trillion yen on the FY2000 budget basis, is estimated to come to 53 trillion yen in FY2005, 67 trillion yen in FY2010, and 99 trillion yen in FY2025, and the ratio of the amount to national income is estimated to rise steadily to stand at 11%, 12%, 13.5%, and 15%, respectively. Meanwhile, social security contribution is forecast to rise to 14.5%, 16%, 17.5%, and 21.5%, respectively. If we estimate the future income tax base in Japan by using figures 7, it will come to 29.4% in FY2000, 25.8% in FY2005, 22.3% in FY2010, and 14.2% in FY2025. It shows that Japan s income tax base will steadily decrease over the next 20 years or so under the current system that makes savings for pension plans and pension payments tax-exempt. The Japanese income tax is about to melt down. (See 7 We assumed that deductions from income are constant. 6

8 Figure 5) 4. Points at Issue in the Review of the Tax Base Such a large decrease in the personal income tax base will lower the ratio of income tax in the tax structure (and raise the ratio of consumption tax), resulting in a lowering of tax s role as an income redistributer, one of the most important roles of taxes. Due to the existence of various kinds of deductions from income, it will also harm the principle of horizontal equity that imposes a different tax rate on the households with same the amount of income depending on whether or not the household has a full-time housewife and/or school-age children. Moreover, the existence of various deductions applied only to elderly persons will harm the intergeneration equity, resulting in undue burdens on middle-aged workers and in emasculating the vitality of the Japanese economy and society. From the standpoint of simplification as well, the current tax system that is very complicated due to various special taxation measures needs to be reformed. What are the issues points at in reviewing the tax base? First, the relationship between social security and the tax structure, especially between pensions and the tax structure. Japan s pension system is a pay-as-you-go system, under which social insurance premiums paid (this year) by active workers finance pension benefits (this year) to the recipients. And one-third of the basic pension is tax sources. In addition, the burden at the stage of contributions (entrance) is deductible from the tax base due to deduction for social insurance premiums, and pension benefits (exit) are virtually tax-exempt due to the high-level of deduction for public pensions, etc. They have created a problem of intergeneration inequality in the tax and pension systems. And the high level of deduction for public pensions including allowance for the elderly, etc. has caused inequality within the same generation and an unbalance of tax burdens throughout the life cycle. 8 Of large industrial countries, Japan, France and Germany (to a certain extent) 8 Above all, the deduction for public pensions, etc. have not only caused an omission of the tax base, but also created intergeneration inequality in that the minimum taxable income of the public pension-receiving household of a married couple aged 65 years or older is about 3.54 million yen, while that of the household of an active married couple is about 2.20 million yen. In addition, the high level of deductions for public pensions, etc. have extremely lowered the tax burden on elderly persons having pensions and other income other than pensions, creating a problem of inequality within the same generation of the aged and a problem of smoothing the tax burden throughout a life cycle. 7

9 have made pension contributions tax-exempt, but there are no such system in the United States nor the U.K. Though an income exemption system is in place in these five countries, most of them limit the exemption to a certain extent. In any case, the current Japanese system that exempts tax both at the stage of contribution and benefit payments needs to be reviewed. The next issue is the treatment of the expenses of employment income earners. In Japan, about 30% of income on average is deductible from income under the standard deduction system called an employment income deduction. The Japanese system of employment income deduction is peculiar in that it has an element of adjustment with other incomes such as business income in addition to an element of expenses related to duties of salaried workers. With salaried workers now accounting for about 80% of total working population, there is a question if adjustment with other incomes is really necessary. Against the background of the sluggish economy and stagnant growth of income, the relatively huge amount of employment income deductions has come to stand out as mentioned before. Given that we cannot expect a sharp growth in income, it is necessary to revamp the current system of employment income deduction and the level of deduction from the standpoint of preventing the tax base erosion. No other industrial countries has such a generous system of standard deductions. In the United States, salaried employees can choose either standard deduction or actual amount deduction for necessary expenses under the self-assessed tax declaration system. However, the level of standard deduction in the United States is very small as compared with that in Japan, prompting about 30% of the taxpayers to choose actual-amount deduction. Reduction of the standard deduction system in Japan, therefore, would open the way for self-assessed tax declaration, under which taxpayers themselves determine their own income and tax amounts. Third, the problem of how to assess the tax credit that has been adopted by many countries. To begin with, one of the most important roles of the tax system is redistribution of income. The system, therefore, should be designed in tandem with social security expenditures. Specifically, it is important to implement measures effectively and efficiently by balancing the merits and demerits of the three systems social security benefits, tax credit and income deduction. Tax credit is designed to adjust the tax amount calculated by applying a tax rate to 8

10 taxable income, that is to say, to deduct the tax amount. On the other hand, income deduction is designed to deduct a certain amount from income from the standpoint of adjusting taxpayers ability to pay. The tax credit system is advantageous to middleand low-income earners, while the income deduction system is advantageous to high-income earners with a high marginal tax rate. From the standpoint of preventing the erosion of the tax base, it can be said that the tax credit system is superior to the income deduction system. Unlike these tax measures, social security benefits result in expenditures and they are earmarked in a budget every year and deliberated in the Diet. It is possible to provide social security benefits to only targeted persons who really need the benefits. On the other hand, the tax measures tend to expand the scope of their targets and are inefficient in terms of budget. Moreover, once they are institutionalized, they tend to be viewed as vested interests. The idea of integrated management of tax and social security is most advanced in the United States, where earned income tax credit and even earned income benefits (negative income tax) have been institutionalized. Under the system in place, the benefits are provided to poor (working) families as a tax deduction (earned income tax credit). Such countries as the U.K., France and the Netherlands 9 have also introduced the idea of integrated management of social security and tax system in order to implement efficient social policies. The present state of the Japanese income tax system can hardly be viewed as well organized. For one thing, a tax credit system concerning earned income has yet to be introduced. For another, there are many income deduction systems designed for welfare purposes that can be more efficiently managed by expenditure measures. Among them are addition for old parents in the same residence (100,000 yen), special 9 The U.K. introduced a system of tax deduction for workers households in 1999 in place of household allowances. Under the system, a household whose family members work more than a fixed number of hours is provided with a tax deduction and when the total income of the household exceeds a certain amount, the deduction is reduced. The Netherlands abolished income deduction and instead introduced Labor Income Tax Credit as part of the tax reform of 1999, reducing the tax burden on low-income earners. Under the system of Labor Income Tax Credit, a worker earning an income is provided with a tax credit in proportion to the income and when the income exceeds a certain level, the credit levels off. The system has increased the take-home pay of unskilled workers (part-time workers). Since unemployment allowances were at a high level, there was a risk of moral hazard of people choosing unemployment instead of work. However, a cut in unemployment allowances and the introduction of a policy to provide a tax credit even to full-time housewives have enhanced incentives to work. 9

11 addition for physically handicapped persons in the same residence (350,000 yen), and deduction for certain physically handicapped persons (400,000 yen) Revamping the tax base will reduce the income deduction, leading to a sharp increase in the tax burden on low-income earners. To mitigate this change, it would be necessary to explore the best mix of social security expenditures, tax credits, and income deductions. Finally, the fact that Japanese personal income tax deductions are much larger than in other industrial countries has something to do with introductions of the consumption tax. The tax reforms implemented in FY1988 (the Comprehensive Tax Reform) and in FY1994 were designed to revise the ratio of direct and indirect taxes by introducing and raising the consumption tax and at the same time reducing personal income tax. As a way to cut taxes, it was necessary to raise the minimum taxable income in order to ease the regressive nature of the consumption tax for low income earners. This led to the erosion of the income tax base. 10 In the future Japanese tax reform discussion, in the light of the difference in the function and role of consumption tax and income tax, a further reduction of the tax base that might result in the disruption of the role of income tax should be avoided by all means. Reference materials Honma, Masaaki, Toshihiro Ihori, Naozumi Atoda, Junki Murayama (1984) Disparity of Income Tax Burden in Different Line of Business, Quarterly Modern Economy, No. 59 Ishi, Hiromitsu (1981) Disparity of Tax Coverage in Different Line of Business 10 With regard to the Comprehensive Tax Reform and the FY1994 tax reform, we have studied cut in the tax rate and hike of various deductions (hike of the minimum taxable income) from the aspect of reduced revenues. The reduced revenues caused by cuts in tax rates and the reduced revenues caused by hikes of various deductions showed a ratio of 4 to 3 in FY1988 (the Comprehensive Tax Reform) and a ratio of 2 to 1 in FY1994, showing that a considerable amount of the reduced revenues were used to raise various deductions. When a tax reform is to be implemented, the amount of tax increase/decrease for different income groups are often talked about. However, out of political considerations of the regressive nature of consumption tax, the government tended to choose raising the minimum taxable income as a way of cutting taxes to give consideration to middle- and low-income earners. I surmise that this has resulted in raising the minimum taxable income and reducing the tax base in Japan. 10

12 Quarterly Modern Economy, No. 42, p Kaizuka, Keimei (1973) Tax Base of Income Tax System in Takehisa Hayashi and Keimei Kaizuka eds, Japan s Public finance, University of Tokyo Press Morinobu, Shigeki (2001)Japanese Tax System PHP Shinsho Morinobu, Shigeki, Satoko Maekawa (2000) Comparative Analysis of Income Tax Base with the U.S., Zeiken Vol. 15, No. 4 Morinobu, Shigeki, Satoko Maekawa (2001) Estimation of Japanese Income Tax Base using Macro Statistics,Financial Review No. 57 Park, T.S. (1996) Relationship Between Personal Income and Adjusted Gross Income, Survey of Current Business, May Park, T.S. (1998) Comparison of BEA Estimates of Personal Income and IRS Estimates of Adjusted Gross Income, Survey of Current Business, November Slemrod, J. and J. Bakija (1996) Taxing ourselves: a citizen s guide t the great debate over tax reform, Cambridge, MIT Press 11