## 1. Tax Structure in the G7 Countries, 2004

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### Introduction
- Purpose: review and discuss key features of Japan’s corporate income tax relative to other G7 countries and raise issues to inform ongoing tax debate in Japan.
- Scope: outline macro-fiscal background, summarize main features of Japan’s corporate income tax, present diagnostics, discuss key issues going forward, and conclude.

### Macro-fiscal background
- Japan faces substantial macroeconomic, structural, and fiscal challenges, including an urgent need for fiscal consolidation after 15 consecutive years of budget deficits.
- Government gross debt stood at about 180 percent of GDP by the end of 2006.
- Fiscal burden from population aging is more substantial and will occur faster than in most OECD countries.
- Tax structure observations (2004, OECD Revenue Statistics, 2006):
  - Tax revenues are low compared with other G7 countries, except for the United States.
  - Japan’s VAT rate is 5 percent compared with an average of 18 percent in the other G7s (excluding the United States and Canada).
  - Revenue from the corporate income tax is a little less than 4 percent of GDP and is broadly in line with other G7 countries (hence a larger share of total revenues in Japan).

### Key features of Japan’s corporate tax
- Statutory and local rates:
  - Standard central government corporate income tax rate: 30 percent.
  - Progressive prefectural “enterprise tax” with a standard top rate: 9.6 percent (deductible from the central government tax as well as from the enterprise tax itself).
  - Inhabitants tax (surtax on central government corporate tax) levied at prefectural and municipal levels at 2006 standard rates of 5.0 and 12.3 percent, respectively.
  - All-in typical marginal rate: about 40 percent.
  - Variation by locality:
    - Enterprise tax may be increased by up to a factor of 1.1.
    - Inhabitants tax may be increased by up to 6.0 and 14.7 percent, respectively, in prefectures and municipalities.
  - Reduced central rate: 22 percent applies to companies with capital of less than 100 million yen (and income below 8 million yen).
  - Reduced local rates apply to small- and medium-sized enterprises with capital less than 100 million yen.
- Depreciation and incentives:
  - Tax incentives are limited and often temporary.
  - Long-standing incentives include modestly accelerated depreciation (increased initial depreciation and accelerated depreciation) for “blue return” taxpayers and “tax free reserves” for some small family-owned businesses and special projects.
  - Tax credits or preferences for R&D, energy conservation, pollution control, and SMEs.
  - Treatment of asset classes:
    - Buildings: straight line depreciation only; useful tax life currently 50 years.
    - Machinery and equipment: straight line, declining balance or other approved methods.
  - Carry-forward period for losses: 7 year carry-forward period (recently extended from 5 years).
  - Tax consolidation rules: require 100 percent ownership (compared with 80 percent in the United States).

### The 2007 tax measures for business and capital income (Box 1)
- Key elements on corporate/capital income included in the 2007 budget:
  - Increasing the depreciation rate used under the declining balance option (example: rate increased from 20.6 percent to 25 percent for machinery with a 10 year life).
  - Increasing the share of capital expenditures allowable for tax deduction from 95 to 100 percent.
  - Extending temporary tax cuts for dividends and capital gains by one year.
  - Shortening the depreciation period for high-tech manufacturing equipment to 5 years (examples: equipment used for production of semiconductors, plasma and liquid crystal display panels).
  - Tax relief measures for SMEs, including:
    - A full exemption from the taxation of internal reserves for businesses with total liabilities of less than 100 million yen.
    - A 2-year extension of existing tax breaks and incentives.
- Observations:
  - The 2007 depreciation rules place Japan ahead of most other G7 countries in generosity for machinery.
  - For buildings, Japan’s useful tax life of 50 years is longer than in many countries (example: 39 years in the United States).

### Diagnostics of the corporate income tax
- Statutory combined rate and effective taxation:
  - The statutory rate, at about 40 percent (all-in typical marginal), is on the high side despite reductions over the past two decades.
- Revenue productivity:
  - Japan’s corporate revenue productivity: 0.096.
  - G7 average corporate revenue productivity: 0.092.
  - Interpretation: Japan’s productivity slightly above G7 average, indicating a relatively broad base (noting caveats about cross-country comparisons).
- Depreciation allowances and tax base:
  - Depreciation allowances for buildings are less generous in Japan than elsewhere, contributing to a broader tax base.
- Effective tax rates and distortions:
  - In combination with the relatively high statutory rate, Japan’s less generous treatment of some depreciation implies higher marginal and average effective tax rates (METRs and AETRs) than in most other G7 countries.
  - Higher METRs and AETRs represent more substantial distortions—disincentives to undertake marginal investments and barriers for multinational firms’ location decisions—than those of other G7 countries.
- Residence vs source taxation:
  - Importance of residence principle (taxation of worldwide income, as in Japan, the United States and the United Kingdom) versus source principle (taxation of domestic income only, as applied by the other G7 countries) for investment and location decisions.

### Box 2 — Marginal and Average Effective Tax Rates: definitions, patterns, and implications
- Definitions:
  - AETR: ratio of the present value of the taxes that will be paid in relation to a particular project to the present value of the pre-tax profit it will yield.
  - METR: proportionate difference between the pre-tax return on a project that just yields the required after-tax rate of return and that required return itself (expressed as a proportion of the former).
  - Analytical relation: the AETR is a weighted average of the METR and the statutory rate.
- Economic intuition:
  - AETR influences location decisions.
  - METR influences the intensive margin of investment.
- Empirical patterns and Japan-specific developments:
  - Over the past two decades Japan’s corporate tax developments follow the G7 pattern: lower rates and broader bases.
  - Japan (and Germany) have shown convergence from above towards levels of AETRs and METRs found in the rest of the G7.
  - One main change in Japan: top corporate tax rate lowered from around 50 to around 40 percent in the late 1990s.
  - 1998 base-broadening: tightening of depreciation rules for industrial buildings (disallowing other methods than straight line).
- Composite taxation of dividends:
  - Personal tax on dividends: 10 percent final withholding (lower than elsewhere).
  - Corporate share of total composite taxation of dividends in Japan: 87 percent (the remaining 13 percent is personal income tax).
  - Corporate share in other G7 countries: about 70 percent on average (OECD Tax Database).
  - Temporary dividend and capital gains tax cut: tax rate lowered from 20 to 10 percent in 2003; cut set to expire in December 2007 (capital gains) and March 2008 (dividends), with a government proposal for a one year extension.
    - If dividend tax reverts from 10 to 20 percent, Japan’s composite tax rate on dividends will increase from 46 to 52 percent.
- Local corporate tax context (2006 data):
  - The local corporate tax rate is about 11.5 percent on average.
  - Only Germany (17 percent) and Canada (14 percent) have higher subnational rates among G7; the United Kingdom does not levy local corporate income taxes.
- Financing distortion and METR magnitudes (Japan):
  - Plant and machinery financed by equity or retained earnings are taxed at marginal rates of about 28 percent (corporate taxes only).
  - Marginal investment financed by debt is subsidized by a negative METR of about 40 percent.
  - Consequences: tax bias toward debt financing; increased vulnerability to adverse business cycles; potential discrimination against start-ups often financed by new equity.
- Trade-offs: METR versus AETR and the capital-expensing case:
  - Capital-expensing extreme: 100 percent deductibility in year of expenditure (cash-flow tax) would lower the METR to 0 (corporate tax only).
  - Revenue-neutral design implication: lowering METR via more generous allowances requires raising statutory rate (and AETR) to keep revenue unchanged; vice versa for lowering statutory rate.

### Options to reduce financing distortions
- Potential policy approaches:
  - Move towards an allowance for corporate equity (ACE) system.
  - Maintain relatively low personal tax rates on dividends and capital gains to reduce double taxation.
  - Integrate corporate and personal income tax by allowing tax credits at the individual level (complex and raises international complications).
  - Limit interest deductibility (as done in Germany and Denmark).
- Trade-offs: ACE versus tighter interest deduction limits; international and legal constraints complicate integration.

### Treatment of SMEs
- SMEs in Japan:
  - Taxed at about 30 percent, some 10 percentage points less than the standard rate.
  - Japan applies limited preferential investment treatment for SMEs (accelerated depreciation and expensing of minor capital items).
  - Definition for tax purposes: firms with capital less than 100 million yen.
- International comparators:
  - United States allows immediate write-off within a limit of about US$125,000 (FY2007 proposal envisaged increasing to US$200,000).
- Policy considerations:
  - Objective: spur SME investment and ease cash-flow constraints.
  - Possible approach: allow significantly accelerated depreciation or immediate expensing of all SME capital spending (perhaps excluding land and buildings), while possibly raising SME tax rate to the standard rate to keep revenue neutral.
  - Caveats: local government financing and vertical externalities—raising central rates for SMEs could spur competition within Japan and affect local revenues.

### International tax regime considerations
- Japan currently taxes on a residence basis with credits for foreign taxes paid and allows “tax sparing.”
  - Tax sparing amplifies the effect of host country tax incentives on Japanese FDI decisions.
- Debate on moving to territoriality:
  - Issues: effects on inward and outward FDI, competitiveness, tax avoidance (inversions, transfer pricing, thin capitalization), and tax revenue.
  - Moving to territoriality could place downward pressure on Japan’s statutory corporate rate but could improve competitiveness of Japanese firms abroad.
  - International ramifications: a Japanese move to territoriality could increase tax competition in recipient countries of FDI, though effects would be smaller than a U.S. shift (U.S. does not allow tax sparing).
  - Repatriation dynamics are uncertain: temporary repatriation surges may not indicate permanent increases in domestic investment.

### Policy trade-offs and a way forward (key recommendations and questions)
- Broad conclusion: Japan’s corporate tax system is broadly in line with other G7 countries; distortions appear manageable; little need for radical reform. Nonetheless, AETRs and METRs are slightly higher than in other G7 countries, suggesting scope for adjustment.
- Policy design goals: promote growth, investment and competitiveness in a revenue neutral manner.
- Elements to consider:
  - Address the tax rate/tax base nexus: can this be changed to better meet government objectives without loosing revenue?
  - Decide strategic focus: attract multinationals (favor lower AETRs via base broadening and rate reduction) versus spur domestic SME investment (favor lower METRs via more generous allowances).
  - Reduce distortions between debt and equity financing (ACE, integration, or limits on interest deductibility).
  - Reconsider the international tax regime (residence vs territoriality) and implications of tax sparing.
  - Account for local government finance impacts when changing central corporate tax policy; consider alternative local government funding to stabilize local revenues.
- Specific policy instruments mentioned:
  - Phased statutory rate reductions to limit windfall gains and revenue losses.
  - Accelerated depreciation or immediate expensing for SMEs as an efficient, targeted means to improve cash flow and lower METR.
  - Consider ACE systems or tighter limits on interest deductibility to mitigate debt bias.
  - Evaluate international implications of moving from residence-based taxation to territoriality.
- Concluding checklist of questions for reform deliberation:
  - Is there scope for changing the tax rate/tax base nexus to more effectively address the government’s objectives without loosing revenue?
  - Should the main focus be on attracting multinationals or spurring domestic investment by SMEs—or could both be achieved at the same time?
  - Could the tax rules be made more neutral in terms of corporate financing and investment?
  - Should the international tax regime be reconsidered?

### Key quantitative points cited
- Government gross debt: about 180 percent of GDP (end-2006).
- VAT rate in Japan: 5 percent.
- Average VAT rate in other G7s (excl. US and Canada): 18 percent.
- Corporate income tax revenue in Japan: a little less than 4 percent of GDP.
- Standard central government corporate income tax rate: 30 percent.
- Enterprise tax top rate: 9.6 percent.
- Inhabitants tax 2006 standard rates: 5.0 percent (prefectural) and 12.3 percent (municipal).
- All-in typical marginal rate: about 40 percent.
- Enterprise tax increase factor: up to 1.1.
- Inhabitants tax possible increases: up to 6.0 percent (prefectures) and 14.7 percent (municipalities).
- Reduced central rate for small companies: 22 percent (capital < 100 million yen and income < 8 million yen).
- Carry-forward period: 7 year (recently extended from 5 years).
- U.S. carry-forward period cited for comparison: 20 year.
- Tax consolidation ownership requirement in Japan: 100 percent (U.S. comparison: 80 percent).
- Example depreciation rate change in 2007: machinery 10 year life declining balance increased from 20.6 percent to 25 percent.
- Capital expenditure deduction share increased from 95 to 100 percent.
- Depreciation period for certain high-tech manufacturing equipment shortened to 5 years.
- SME liability threshold for full exemption of internal reserves: less than 100 million yen.
- Corporate revenue productivity: Japan 0.096; G7 average 0.092.

*Source: _wp0870 - 1. Tax Structure in the G7 Countries, 2004; Box 2. Marginal and Average Effective Tax Rates (extracted content).*

### 1. Tax Structure in the G7 Countries, 2004 .............................................................................

### 1. Tax Structure in the G7 Countries, 2004

### Introduction
- Purpose: review and discuss key features of Japan’s corporate income tax relative to other G7 countries and raise issues to inform ongoing tax debate in Japan.
- Scope: Sections outline macro-fiscal background, summarize main features of Japan’s corporate income tax, present diagnostics, discuss key issues going forward, and conclude.

### Macro-fiscal background
- Japan faces substantial macroeconomic, structural, and fiscal challenges, including an urgent need for fiscal consolidation after 15 consecutive years of budget deficits.
- Government gross debt stood at about 180 percent of GDP by the end of 2006.
- Fiscal burden from population aging is more substantial and will occur faster than in most OECD countries.
- Tax structure observations (2004, OECD Revenue Statistics, 2006):
  - Tax revenues are low compared with other G7 countries, except for the United States.
  - Japan’s VAT rate is 5 percent compared with an average of 18 percent in the other G7s (excluding the United States and Canada).
  - Revenue from the corporate income tax is a little less than 4 percent of GDP and is broadly in line with other G7 countries (hence a larger share of total revenues in Japan).

### Key features of Japan’s corporate tax
- Statutory and local rates:
  - Standard central government corporate income tax rate: 30 percent.
  - Progressive prefectural “enterprise tax” with a standard top rate: 9.6 percent (deductible from the central government tax as well as from the enterprise tax itself).
  - Inhabitants tax (surtax on central government corporate tax) levied at prefectural and municipal levels at 2006 standard rates of 5.0 and 12.3 percent, respectively.
  - All-in typical marginal rate: about 40 percent.
  - Variation by locality:
    - Enterprise tax may be increased by up to a factor of 1.1.
    - Inhabitants tax may be increased by up to 6.0 and 14.7 percent, respectively, in prefectures and municipalities.
  - Reduced central rate: 22 percent applies to companies with capital of less than 100 million yen (and income below 8 million yen).
  - Reduced local rates apply to small- and medium-sized enterprises with capital less than 100 million yen.
- Depreciation and incentives:
  - Tax incentives are limited and often temporary.
  - Long-standing incentives include modestly accelerated depreciation (increased initial depreciation and accelerated depreciation) for “blue return” taxpayers and “tax free reserves” for some small family-owned businesses and special projects.
  - Tax credits or preferences for R&D, energy conservation, pollution control, and SMEs.
  - Treatment of asset classes:
    - Buildings: straight line depreciation only; useful tax life currently 50 years.
    - Machinery and equipment: straight line, declining balance or other approved methods.
  - Carry-forward period for losses: 7 year carry-forward period (recently extended from 5 years).
  - Tax consolidation rules: require 100 percent ownership (compared with 80 percent in the United States).

### The 2007 tax measures for business and capital income (Box 1)
Key elements on corporate/capital income included in the 2007 budget:
- Increasing the depreciation rate used under the declining balance option (example: rate increased from 20.6 percent to 25 percent for machinery with a 10 year life).
- Increasing the share of capital expenditures allowable for tax deduction from 95 to 100 percent.
- Extending temporary tax cuts for dividends and capital gains by one year.
- Shortening the depreciation period for high-tech manufacturing equipment to 5 years (examples: equipment used for production of semiconductors, plasma and liquid crystal display panels).
- Tax relief measures for SMEs, including:
  - A full exemption from the taxation of internal reserves for businesses with total liabilities of less than 100 million yen.
  - A 2-year extension of existing tax breaks and incentives.
- Observations:
  - The 2007 depreciation rules place Japan ahead of most other G7 countries in generosity for machinery.
  - For buildings, Japan’s useful tax life of 50 years is longer than in many countries (example: 39 years in the United States).

### Diagnostics of the corporate income tax
- Statutory combined rate and effective taxation:
  - The statutory rate, at about 40 percent (all-in typical marginal), is on the high side despite reductions over the past two decades.
- Revenue productivity:
  - Japan’s corporate revenue productivity: 0.096.
  - G7 average corporate revenue productivity: 0.092.
  - Interpretation: Japan’s productivity slightly above G7 average, indicating a relatively broad base (noting caveats about cross-country comparisons).
- Depreciation allowances and tax base:
  - Depreciation allowances for buildings are less generous in Japan than elsewhere, contributing to a broader tax base.
- Effective tax rates and distortions:
  - In combination with the relatively high statutory rate, Japan’s less generous treatment of some depreciation implies higher marginal and average effective tax rates (METRs and AETRs) than in most other G7 countries.
  - Higher METRs and AETRs represent more substantial distortions—disincentives to undertake marginal investments and barriers for multinational firms’ location decisions—than those of other G7 countries.
- Residence vs source taxation:
  - The paper notes the importance of whether a tax system is based on residence principle (taxation of worldwide income, as in Japan, the United States and the United Kingdom) or the source principle (taxation of domestic income only, as applied by the other G7 countries) for investment and location decisions.

### Key quantitative points cited
- Government gross debt: about 180 percent of GDP (end-2006).
- VAT rate in Japan: 5 percent.
- Average VAT rate in other G7s (excl. US and Canada): 18 percent.
- Corporate income tax revenue in Japan: a little less than 4 percent of GDP.
- Standard central government corporate income tax rate: 30 percent.
- Enterprise tax top rate: 9.6 percent.
- Inhabitants tax 2006 standard rates: 5.0 percent (prefectural) and 12.3 percent (municipal).
- All-in typical marginal rate: about 40 percent.
- Enterprise tax increase factor: up to 1.1.
- Inhabitants tax possible increases: up to 6.0 percent (prefectures) and 14.7 percent (municipalities).
- Reduced central rate for small companies: 22 percent (capital < 100 million yen and income < 8 million yen).
- Carry-forward period: 7 year (recently extended from 5 years).
- U.S. carry-forward period cited for comparison: 20 year.
- Tax consolidation ownership requirement in Japan: 100 percent (U.S. comparison: 80 percent).
- Example depreciation rate change in 2007: machinery 10 year life declining balance increased from 20.6 percent to 25 percent.
- Capital expenditure deduction share increased from 95 to 100 percent.
- Depreciation period for certain high-tech manufacturing equipment shortened to 5 years.
- SME liability threshold for full exemption of internal reserves: less than 100 million yen.
- Corporate revenue productivity: Japan 0.096; G7 average 0.092.

*Source: _wp0870 - 1. Tax Structure in the G7 Countries, 2004*

### Box 2. Marginal and Average Effective Tax Rates

### _wp0870 - Box 2. Marginal and Average Effective Tax Rates

### Definitions and analytical relation
- The average effective tax rate (AETR) is the ratio of the present value of the taxes that will be paid in relation to a particular project to the present value of the pre-tax profit it will yield.
- The marginal effective tax rate (METR) is the proportionate difference between the pre-tax return on a project that just yields the required after-tax rate of return and that required return itself (expressed as a proportion of the former).
- Analytical relation: the AETR is a weighted average of the METR and the statutory rate.
- Economic intuition:
  - AETR influences location decisions (investors prefer locations with lower proportion of pre-tax profit taken in tax).
  - METR influences the intensive margin of investment (higher METR reduces the amount of investment by raising the pre-tax return required).

### Empirical patterns in the G7 and Japan-specific developments
- Over the past two decades Japan’s corporate tax developments follow the G7 pattern: lower rates and broader bases.
- Japan (and Germany) have shown convergence from above towards levels of AETRs and METRs found in the rest of the G7.
- One main change in Japan: top corporate tax rate lowered from around 50 to around 40 percent in the late 1990s.
- A key base-broadening measure in Japan: 1998 tightening of depreciation rules for industrial buildings (disallowing other methods of depreciation than straight line); bases for plant and machinery remained largely unchanged.
- Composite taxation of dividends (corporate plus individual) in Japan is broadly in line with the rest of the G7 in 2006, but with distinctive composition:
  - Personal tax on dividends: 10 percent final withholding (lower than elsewhere).
  - Corporate share of total composite taxation of dividends in Japan: 87 percent (the remaining 13 percent is personal income tax).
  - Corporate share in other G7 countries: about 70 percent on average (OECD Tax Database).
  - Implication: as investors become more multinational or tax-exempt, the corporate tax share gains importance and Japan’s relative position on overall taxation of dividends may deteriorate.
- Temporary dividend and capital gains tax cut: tax rate lowered from 20 to 10 percent in 2003; the cut is set to expire in December 2007 (capital gains) and March 2008 (dividends), with a government proposal for a one year extension.
  - If dividend tax reverts from 10 to 20 percent, Japan’s composite tax rate on dividends will increase from 46 to 52 percent.
  - The United States also applied a temporarily lower rate (15 percent) on capital gains and dividends (through 2010).

### Key quantitative illustrations and tax distortions
- Local corporate tax context:
  - The local corporate tax rate is about 11.5 percent on average (2006 data).
  - Only Germany (17 percent) and Canada (14 percent) have higher subnational rates among G7; the United Kingdom does not levy local corporate income taxes.
- Financing distortion and METR magnitudes (Japan):
  - Plant and machinery financed by equity or retained earnings are taxed at marginal rates of about 28 percent (corporate taxes only).
  - Marginal investment financed by debt is subsidized by a negative METR of about 40 percent.
  - Consequences: tax bias toward debt financing (deduction for interest but not for dividends or retained earnings); increased vulnerability to adverse business cycles; potential discrimination against start-ups often financed by new equity.
- Cross-investment distortions:
  - Japan applies somewhat higher METRs on industrial buildings than on plant and machinery.
  - Policy remedy would be faster depreciation of buildings, but this requires revenue offsets.

### Trade-offs: METR versus AETR and the capital-expensing case
- Traditional view: METR is critical for cost of capital and investment margin; AETR has no effect when firms are immobile.
- Newer evidence: AETR matters for location when firms are internationally mobile (firms shift infra-marginal profits to lower AETR locations).
  - Empirical studies find substantial effects of AETRs on location decisions (Devereux and Griffith, 1998; Mooij and Ederveen, 2003), though results vary (Hajkova and others, 2006).
- Capital-expensing extreme:
  - 100 percent deductibility in year of expenditure (cash-flow tax) would lower the METR to 0 (corporate tax only).
  - Under immobile firms, infra-marginal returns can be taxed heavily to offset revenue loss.
  - Under internationally mobile firms, taxing infra-marginal returns is limited and base-narrowing measures are likely revenue reducing.
- Revenue-neutral design implication: lowering METR via more generous allowances requires raising statutory rate (and AETR) to keep revenue unchanged; vice versa for lowering statutory rate.

### Options to reduce financing distortions
- Potential policy approaches:
  - Move towards an allowance for corporate equity (ACE) system, as Belgium has done.
  - Maintain relatively low personal tax rates on dividends and capital gains to reduce double taxation.
  - Integrate corporate and personal income tax by allowing tax credits at the individual level (complex and raises international complications; international trend has moved away from integration).
  - Limit interest deductibility (as done in Germany and Denmark) — “the opposite” of ACE.
- Trade-offs: ACE versus tighter interest deduction limits; international and legal constraints complicate integration.

### Treatment of SMEs
- SMEs in Japan:
  - Taxed at about 30 percent, some 10 percentage points less than the standard rate.
  - Japan applies limited preferential investment treatment for SMEs (accelerated depreciation and expensing of minor capital items).
  - Definition for tax purposes: firms with capital less than 100 million yen.
- International comparators and SME allowances:
  - United States allows immediate write-off within a limit of about US$125,000 (FY2007 proposal envisaged increasing to US$200,000).
  - Other countries apply varying thresholds and preferential treatments.
- Policy considerations:
  - Objective: spur SME investment and ease cash-flow constraints.
  - Possible approach: apply relatively high AETRs and relatively low METRs to non-mobile business activity — i.e., use investment allowances rather than low rates.
  - Specific proposal: allow significantly accelerated depreciation or immediate expensing of all SME capital spending (perhaps excluding land and buildings), while possibly raising SME tax rate to the standard rate to keep revenue neutral.
  - Caveats: local government financing and vertical externalities—raising central rates for SMEs could spur competition within Japan and affect local revenues.

### International tax regime considerations
- Japan currently taxes on a residence basis (worldwide income) with credits for foreign taxes paid and allows “tax sparing” (full absorption of host country tax incentives).
  - Tax sparing amplifies the effect of host country tax incentives on Japanese FDI decisions.
- Debate parallel to U.S. discussion on moving to territoriality:
  - Issues include effects on inward and outward FDI, competitiveness, tax avoidance (inversions, transfer pricing, thin capitalization), and tax revenue.
  - Moving to territoriality could place downward pressure on Japan’s statutory corporate rate (easier to avoid domestic taxation by relocation), but could improve competitiveness of Japanese firms abroad.
  - International ramifications: a Japanese move to territoriality could increase tax competition in recipient countries of FDI, though effects would be smaller than a U.S. shift (U.S. does not allow tax sparing).
  - Repatriation dynamics are uncertain: temporary repatriation surges (as in the 2005 U.S. experience) may not indicate permanent increases in domestic investment.

### Policy trade-offs and a way forward (key questions and recommendations)
- Broad conclusion: Japan’s corporate tax system is broadly in line with other G7 countries; distortions appear manageable; little need for radical reform. Nonetheless, AETRs and METRs are slightly higher than in other G7 countries, suggesting scope for adjustment.
- Policy design should aim to promote growth, investment and competitiveness in a revenue neutral manner.
- Elements to consider:
  - Address the tax rate/tax base nexus: can this be changed to better meet government objectives without losing revenue?
  - Decide strategic focus: attract multinationals (favor lower AETRs via base broadening and rate reduction) versus spur domestic SME investment (favor lower METRs via more generous allowances).
  - Reduce distortions between debt and equity financing (ACE, integration, or limits on interest deductibility).
  - Reconsider the international tax regime (residence vs territoriality) and implications of tax sparing.
  - Account for local government finance impacts when changing central corporate tax policy; consider alternative local government funding to stabilize local revenues.
- Specific policy instruments mentioned:
  - Phased statutory rate reductions to limit windfall gains and revenue losses.
  - Accelerated depreciation or immediate expensing for SMEs as an efficient, targeted means to improve cash flow and lower METR.
  - Consider ACE systems or tighter limits on interest deductibility to mitigate debt bias.
  - Evaluate international implications of moving from residence-based taxation to territoriality.

- Concluding checklist of questions posed for reform deliberation:
  - Is there scope for changing the tax rate/tax base nexus to more effectively address the government’s objectives without loosing revenue?
  - Should the main focus be on attracting multinationals or spurring domestic investment by SMEs—or could both be achieved at the same time?
  - Could the tax rules be made more neutral in terms of corporate financing and investment?
  - Should the international tax regime be reconsidered?

*Source: _wp0870 - Box 2. Marginal and Average Effective Tax Rates (extracted content).*

### REFERENCES

### _wp0870 - REFERENCES

### Bibliographic entries
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- Chirinko, Robert S., Steven M. Fazzari, and Andrew P. Meyer, 1999, “How Responsive is Business Capital Formation to its User Cost: An Exploration with Micro Data,” Journal of Public Economics, Vol. X.
- Dalsgaard, Thomas, and Masaaki Kawagoe, 2000, “The Tax System in Japan: A Need for Comprehensive Reform,” OECD Economics Department, Working Paper No. 231.
- De Mooij, Ruud A., and Sjef Ederveen, 2003, “Taxation of Foreign Direct Investment: A Synthesis of Empirical Research,” International Tax and Public Finance, Vol. 10 (November).
- Devereux, Michael P., and Rachel Griffith, 1998, “Taxes and the Location of Production: Evidence from a Panel of U.S. Multinationals,” Journal of Public Economics, Vol. 68(3).
- Devereux, Michael P., Rachel Griffith, and Alexander Klemm, 2002, “Corporate Income Tax Reforms and International Tax Competition,” Economic Policy, Vol. 35 (October).
- Feldstein, Martin, 2006, “The Effects of Taxes on Efficiency and Growth,” National Bureau of Economic Research, Working Paper No. 12201.
- Hajkova, Dana, Giuseppe Nicoletti, Laura Vartia, and Kwang-Yeol Yoo, 2006, “Taxation, Business Environment and FDO Location in OECD Countries,” OECD Economics Department, Working Paper No. 502.
- Haufler, Andreas, and Guttorm Schjelderup, 2000, “Corporate Tax Systems and Cross-Country Profit Shifting,” Oxford Economic Papers, Vol. 52.
- Hines, James R., 2001, “Tax Sparing and Direct Investment in Developing Countries,” in International Taxation and Multinational Activity, ed. by James R. Hines (Chicago: University of Chicago Press).
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