Monday, August 20, 2007

SHOULD JAPAN REALLY INCREASE TAXES?

The latest IMF's published conclusions regarding Japan's overall assessment directly noted the aim to broaden the taxation by tax hikes as means of combating the financial pressures of Japan's ageing population, with unfunded net financial liabilities growing incredibly faster than the GDP and tax revenues. The IMF concluded:


"Most Directors considered that given the size of the task at hand, additional revenue measures will be needed, including for base broadening. They indicated that revenue measures could be best identified in the context of a broad reform of the tax system that addresses the challenges posed by Japan's aging society and globalization. Among possible measures, increasing the consumption tax has the benefit of being less detrimental to growth and equitable across generations. Some Directors, however, viewed the authorities' focus on expenditure adjustments as broadly appropriate at this juncture..."

Source: IMF Executive Board Concludes 2007 Article IV Consultation with Japan Public Information Notice (PIN) No. 07/96 (link).


In 2006, Japan's GDP grew by 2,2 percent led mainly by Japan's growing export contribution to the annual GDP growth and investments, continuing to strenghten Japan's operating position in the global economy. Annual inflation passed quarterly fluctuations with falling GDP deflator but counter-cyclical price indices continuing to grow. The recent Economy Report by the Bank of Japan panels the scope of indicators showing the moderate conditions of the full capacity of Japan's economy; near-term outlook remains favorable with 2,6 percent growth rate in 2007 and 2,0 percent growth rate in 2008. Regarding, the medium-term outlook, Japanese economy is projected to grow by 1,7 percent.

Depending on combating inflation pressures and financial outlook (recently announced lending rates favored stock market increases). The Japanese experience, however, shows a continually-adjusted decline in central bank's discount rate, as an alternative to an aggravated risk from pushed money supply growth. Dropping the interest-rates to historic lows, resulted in a timid deflation trap with continually-prolonged falling prices. With low borrowing costs, the economy is heavily relied on investment, pushing the output increases closer to sustainable edge. However, the Bank of Japan, namely the governor, has recently aimed for interest-rate increases. However, it is important for monetary policy to stay accomodative to productivity and non-inflationary output shocks. After years of deflation, Japanese inflation peaked the positive rate in 2007. With no signs of tight inflation pressures, the financial stability and the investors' confidence continue to Japan's favorable external position.

For instance, capital flows picked up sharply, showing the outward-oriented attitude of Japanese investors. The stimulus from capital flows sustained growing receipts from foreign assets. Low market volatility and widening differentials between interest rates, motivated private holdings to focus on debt securities.


Net Receipts from Foreign Assets


Source: IMF; Japan, Selected Issues (link)

As an industrialized country, Japan faces a highly volatile risk emerging from ageing population. According to the estimates, Japan will face the highest share of population over 65, 29,6 percent by 2030. The population in the upper part of age pyramid is highly dependent on welfare-services. With frequently exposed future labor market turmoil and shortages of labor supply, the unfunded net financial liabilities are growing, exceeding the annual output respectively. Generous social security accounts based on the redistribution of accumulated contribution payments, have nevertheless created a high proportion of risk and liability burden. As it can be see from the chart below, Japan has one of the highest rates of net financial liabilities refered to intergenerational accounts, closely approaching 100 percent of the GDP. In the long-term perspective, Shimasawa (2004) has composed baseline scenarios of generational wedge on macroeconomic indicators and pension contribution rate, showing the latter could nearly double by 2050.


Due to the robustness of the agony of ageing population, the formation of human capital is essential to competitive growth rates in the international perspective, also to cope an ageing crisis. On the other hand, robust fiscal reforms and intergenerational measures could significantly ease the burden of the ageing wedge. The question, refering to the IMF's proposal of detrimental taxation to boost revenues, is whether higher taxes would really result in equitable social security accounts through the generations? Japan already has a punitive and internationally uncompetitive tax regime with statutory 41,9 percent corporate income tax rate and 32,2 effective tax rate on capital, which is one of the highest tax rates in the industrialized world (Mintz, 2006). Japan's top individual income tax rate is 37 percent for the income exceeding $18,000,000 YEN. The distribution of tax rates on individual income is marginally progressive starting with 10 percent income tax rate on earnings amounted up to $3,000,000 YEN and ending with a 37 percent rate on earning exceeding $18,000,000 YEN (link).


Government Net Financial Liabilities as % of the GDP in Selected Countries


Source: OECD, Economic Outlook


Tax hikes on consumption, price controls and imposed tax duties on certain consumption products, in addition to extensive taxation of individual income, usually result in the emergence of black market where prices are free of double-taxation, such as value-added tax and special unit duties, and determined by supply and demand. Seeking new revenue through extensive taxation would distort the market performance and, ceteris paribus, burden the real sector by limiting the capacity of the business cycle to absorb the benefits given by the current favorable position of Japanese economy, operating closer to full capacity. Throughout broadening measures to impose new taxes, tax evasion would spread and revenue would be more probable to decline, further pushing Japan's ageing agony to spread intensively when the revenue to match-up the net financial liabilities pertained by public sector wouldn't grow.

Baseline Scenarios following Population ageing in Japan

Source: Manabu Shimasawa, Population ageing, policy reform and endogenous growth in Japan: a computable overlapping generations approach, April 2004

(link)

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