## 1. Statutory Corporate Income Tax Rate in Japan, as of April 2014

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### I. Introduction — purpose and organization
- Recent reforms reduced statutory CIT rates but Japan’s statutory CIT rate remains among the highest in the OECD and Asia.
- Japanese government announced intent to reduce the statutory CIT rate to below 30 percent in its revised growth strategy in June 2014.
- Key contextual factors making CIT reform distinct in Japan:
  - Deflation → firms repaid debt and accumulated cash via retained earnings; a CIT rate cut could help unlock cash by encouraging investment and raising wages.
  - Ageing → medium-term growth potential challenge; CIT reform can help attract investment and offset ageing.
  - Tight fiscal constraints → extraordinarily high public debt complicates financing of CIT cuts.
- Paper contributions and reform options analyzed:
  - Identifies structural weaknesses in Japan’s CIT and assesses economic and fiscal impact of a CIT rate cut (updates Dalsgaard, 2008).
  - Concludes CIT rate reduction likely boosts investment and wages but is insufficient to be self-financing.
  - Options under tight fiscal constraints: (1) CIT rate cut financed by other fiscal measures outside the CIT; (2) base-broadening measures within the CIT; (3) introducing an allowance-for-corporate-equity (ACE).
- Organization:
  - Section II: CIT structure and distortions.
  - Section III: impact of CIT rate cut on investment and growth.
  - Section IV: fiscal impact using elasticity estimates of corporate taxable income.
  - Section V: wider reform options including tax mix shifts, base broadening, and ACE.
  - Section VI: conclusion.

### II. Japan’s corporate income tax distortions — key findings
- System complexity and statutory rates:
  - CIT rates vary by firm size, income level and region; complex system of differing rates.
  - Overall adjusted CIT burden (after enterprise-tax deductibility and repeal of special reconstruction tax in April 2014) ranges:
    - From 21 percent (income up to ¥4 million for small corporations in standard local tax areas) to almost 36.3 percent (small corporations with income over ¥25 million in Tokyo).
  - Large corporations (capital over ¥100 million; ~1 percent of corporations) face:
    - Around 35.6 percent in the Tokyo area.
    - Around 34.5 percent in areas applying the standard local rate.
  - Large corporations also face a local tax of 0.48 percent of annual value added and 0.2 percent of capital, even when recording losses.
  - Adjusted rate (standard) examples in April 2014 table: 21.4, 23.2, 36.0, 32.4, 33.5, 34.6.
  - Adjusted rate (Tokyo) examples in April 2014 table: 22.1, 23.9, 37.1, 33.4, 34.5, 35.6.
  - Historical/international context:
    - CIT rates fell from around 50 percent before 1990 to around 40 percent by 2012; since April 2014 around 35 percent for larger companies.
    - OECD average statutory CIT rate is 25.5 percent (2014 reference).
    - Unweighted 2014 average for a group of 11 Asian countries is 25 percent.
    - G7 (excluding Japan) average CIT rate in 2013 is slightly above 30 percent.
    - United States overall CIT rate (for an average US State) is 39 percent.

- High effective tax rates and depreciation generosity:
  - Japan’s METR and AETR in 2012 are relatively high compared with many countries (Figure 2; Figure 3 shows lower net present value of depreciation for Japan).
  - Depreciation for buildings and intangibles is relatively less generous; machinery depreciation METR is lower than in India, China and Indonesia.
  - Changes since 2012: lower CIT rate and special immediate depreciation of qualifying investment reduced METR; reduction of declining-balance depreciation from 250 to 200 percent of depreciation under straight-line increased METR.

- Significant debt bias:
  - Interest deductibility but not equity remuneration creates incentive to use debt finance.
  - Difference in cost of capital for equity versus debt is highest among G7 for Japan (Figure 4).
  - Personal tax system applies uniform rates to dividends (from listed firms), interest and capital gains—does not offset corporate debt bias.
  - Empirical evidence:
    - Meta-analysis (De Mooij, 2011): a 10 percentage-point higher CIT rate increases debt/asset ratio by between 2 and 3 percent on average.
    - For Japan, Kunieda, Takahata and Yada (2011) find smaller effects between 1 and 2 percent.
  - Recent behavior: many Japanese firms reduced leverage ratios by repaying debt and accumulating cash; debt bias may re-emerge with stable growth and moderate inflation.

- Arbitrage and SME distortions:
  - Unincorporated SME business income taxed under progressive PIT rates from 5 to 45 percent, plus local income tax of 10 percent and enterprise tax between 3 and 5 percent.
  - Owner-directors can be paid director’s remuneration taxed as wage income → arbitrage between labor and capital income.
  - Figure 5: marginal tax lowest when profits distributed as wages (director’s remuneration); difference up to 18 percent for incomes between ¥8 and ¥12 million.
  - Large wage income deduction in the PIT contributes to incorporation and allocation of profits as director’s wages.

- Multinational arbitrage and reforms:
  - Pre-2009: worldwide system with deferral; 2009 reform shifted toward exemption: 95 percent of foreign dividends received by Japanese parent exempt if ownership ≥ 25 percent.
  - Effects:
    - Hasegawa and Kiyota (2013): affiliates that paid dividends before 2009 increased repatriations after reform.
    - Feld et al. (2013): reform increased number of acquisitions abroad by 31.9 percent.
  - Risks: revenue foregone from repatriation taxes; increased incentives to shift income to low-tax locations.
  - Anti-avoidance: since 2010 stricter transfer-price documentation; thin-capitalization rules since 1992 complemented in 2012 by earnings-stripping rule (deny deductions for net interest to related parties when it exceeds 50 percent of income); 2010 CFC reform taxes passive income from low-tax jurisdictions (effective tax rate ≤ 20 percent) when more than 10 percent owned by Japanese resident.

- Revenue performance and volatility:
  - CIT revenue-to-GDP ratio between 2008 and 2012 averaged 3.3 percent for Japan.
  - OECD average in that period: 3 percent; other G7 average: 2.6 percent (Figure 6).
  - Central government CIT revenue-to-GDP ratio: 2.9 percent in 2006 → 1.3 percent in 2009 without significant reforms.
  - Ueda, Ishikawa, and Tsutsui (2010) estimate structural CIT revenue-to-GDP ratio in 2010 at 2.4 percent.
  - Example static revenue productivity in 2010 at central statutory rate of 30 percent: revenue productivity measured as CIT revenue in percent of GDP divided by the CIT rate is 0.08 → each percentage-point CIT rate generates around 0.08 percent of GDP in structural revenue terms.
  - Static revenue cost example preserved: a reduction in the CIT rate by 1 percentage point involves a static revenue cost of approximately ¥400 billion, or 0.08 percent of GDP.

### III. Economic benefits of a corporate tax rate reduction — overview and channels
- Main purpose analyzed: increase investment via lower CIT rate (analysis isolates effect of rate cut alone).
- Aggregate growth evidence and magnitudes (selected estimates):
  - Lee and Gordon (2005): 10 percentage-point lower CIT raises annual GDP growth by between 0.6 and 1.1 percent.
  - Mertens and Ravn (2013): 10 percentage-point lower CIT raises real GDP per capita after one year by 6 percent.
  - Arnold et al. (2011): shifting 1 percent of total tax revenue from CIT toward consumption/property taxes increases GDP in the long run by 2 percent.
  - Japan Center for Economic Research (2014): a 10 percent reduction in the Japanese CIT rate would boost economic growth by 0.5 percent annually.
  - Cabinet Office (CAO, 2010): reducing the CIT burden by 1 percent of GDP (≈12 percentage points) raises GDP over 5 years by 1 percent relative to baseline.
  - IMF/GIMF and Keen et al. (2011): revenue-neutral shift away from CIT raises GDP in the long run by approximately ½ percent.
  - Contrasting results include estimates of small or insignificant growth effects in some studies; effects are sensitive to econometric specification and country heterogeneity.

- Investment channels from a CIT rate cut:
  1. Lower user-cost-of-capital → margin investment increases.
  2. Increased cash-flow for credit-constrained firms → raises investment.
  3. Attracting FDI → increases capital stock.

- Investment elasticities and Japan-specific evidence:
  - International/influential estimates:
    - Hassett and Hubbard (2002): consensus elasticity between −½ and −1.
    - Arnold et al. (2011): CIT reduction 35 → 30 percent reduces user cost by 2.8 percent and raises investment by 1.9 percent (elasticity ≈ ⅔).
    - Vartia (2008): similar CIT reduction raises investment by 1–2.6 percent (elasticity ⅓–1).
    - Chirinko (2002): elasticity of substitution between labor and capital between 0.3 and 0.4 → cost-of-capital elasticity ≈ −½.
  - Japan-specific estimates generally smaller:
    - Tachibanaki (1997): elasticities much smaller than international literature.
    - Uemura and Maekawa (2000): 1999 CIT cut increased investment by 0.2 percent per 1 percentage-point cut.
    - Uemura (2004) and Kang (2014): tax variables show limited or insignificant effects on investment in Japan.
  - Box 1 simulation (static general equilibrium with labor market interactions):
    - A 5 percentage-point CIT rate cut (not revenue neutral) expands investment by between 1½ and 3 percent in the long run.
    - Output rises by between ½ and 1 percent.
    - Wages are 1½ percent higher in the new equilibrium.

- Cash-flow and FDI channels (quantified exemplars for a 5 percentage-point cut):
  - Cash-flow effects: matter for credit-constrained/new firms; empirical Japan evidence mixed (Uemura (2004), Kang (2014)).
  - FDI:
    - De Mooij and Ederveen (2008): semi-elasticity of FDI to AETR is −3.2 (10 percentage-point lower AETR → 32 percent higher FDI stock).
    - ZEW (2012): Japan’s central government CIT cut in April 2012 from 30 to 28.1 percent reduced AETR by 1.6 percentage points.
    - Extrapolation in text:
      - A 5 percentage-point CIT cut → reduces AETR by 4.2 percentage points → raises inward FDI by 13.4 percent (using −3.2 semi-elasticity).
      - Current inward FDI stock = 3.4 percent of GDP = 2.1 percent of total private capital stock (total private capital stock estimated at 160 percent of GDP).
      - Assuming 60 percent of extra FDI is greenfield → higher FDI raises total capital stock by ≈ 0.2 percent (13.4 × 0.021 × 0.6).
  - Aggregate expected investment impact from a 5 percentage-point CIT cut (scaled in text):
    - Cost-of-capital channel: ≈ 1½ percent.
    - Cash-flow effects: ≈ ½ percent.
    - Inward FDI: ≈ ¼ percent.
    - Total approximate investment impact: ≈ 2¼ percent.
    - Scaled to a 12 percentage-point reduction (static revenue cost of 1 percent of GDP): expected investment effect ≈ 5½ percent.

- Productivity and wage incidence:
  - Theory: if capital is internationally mobile, incidence of CIT falls partly on workers via lower wages; if CIT taxes rents, owners bear incidence.
  - Empirical evidence (UK, Germany): workers bear between 45 and 75 percent of CIT incidence (Arulampalam et al., 2012; Fuest et al., 2013).
  - Implication for Japan: a CIT cut could raise wages; Box 1 simulations show wages 1½ percent higher for a 5 percentage-point cut.

### IV. Fiscal cost of a corporate tax cut — methods and evidence
- Approach: elasticity-of-taxable-income (ε) framework:
  - Revenue identity R = τ × B.
  - ε ≡ d ln B / d ln τ captures base response to rate changes.
  - Static example: a 1 percentage-point CIT rate reduction → static revenue cost ≈ ¥400 billion, or 0.08 percent of GDP.
  - Dynamic (long-run) revenue effect factor depends on (1 + ε): sufficiently large negative ε could make a CIT cut self-financing.

- Laffer-curve considerations:
  - Cross-country regression literature finds revenue-maximizing CIT rates between 16 and 42 percent, most around 30 percent (Devereux (2007), Clausing (2007), Brill and Hassett (2007)) → implies rates above 30 percent could be on declining slope.
  - Critique: including country fixed effects can render tax-rate coefficients insignificant; Kawano and Slemrod (2012) show revenue-maximizing rates can rise to 75 percent with fixed effects.
  - Paper therefore relies on micro-elasticity-based approach rather than Laffer-inference.

- Elasticity estimates — synthesis (Box 2 summary):
  - Definitions:
    - Semi-elasticity ε_s measures change in base from one percentage-point change in rate; relates to ε via ε_s = −τ × ε / (1 − τ).
    - After-tax earnings elasticity η relates via η = (1 − τ) × ε.
    - Numerical transformations use τ = 35 percent for Japan.
  - Selected empirical findings (transformed to ε where reported):
    - Gruber and Rauh (2007) US micro: ε ≈ 0.2 (various specifications).
    - Bruce, Deskins & Fox (2008) federal and state US: semi-elasticities reported and transformed.
    - Dwenger & Steiner (2008) Germany: ε between −0.3 and −0.5.
    - Devereux, Liu and Loretz (2014) UK: companies around £300k → ε = 0.16 (kink and size effects discussed).
    - Heckemeyer & Overesch (2013) meta-analysis (MNC subsidiary studies, 23 studies, 231 estimates): consensus semi-elasticity capturing income shifting (including debt shifting) ≈ −0.8 (10 percentage-point lower CIT → 8 percent higher reported profit); without debt shifting effect is about two-thirds of −0.8.
  - Synthesis statement: the largest ε in Box 2 is −0.5; most estimates between −0.1 and −0.3; ε tends to be larger for SMEs and MNCs and larger for local CIT than federal CIT in the US.
  - Japan-specific considerations: low stocks of inward/outward FDI and low estimated elasticities for investment and corporate debt in Japan may imply a relatively low ε → long-run fiscal costs closer to upper bound.

- Dynamic/general-equilibrium feedback:
  - Elasticity-based estimates do not capture GE effects (changes in firm numbers, FDI, employment, GDP growth, subsequent PIT and consumption tax revenues).
  - Literature examples:
    - Mankiw and Weinzierl (2006): long-run feedback effect on revenue for capital income taxes ≈ 50 percent.
    - Nutahara (2013) for Japan: capital tax rate close to top of Laffer curve → dynamic scoring effects close to 100 percent.
    - Hiraga (2011) for Japan: 5 percentage-point CIT cut will increase CIT revenue by around 50 percent in the long run.
    - Ganelli and Tervala (2014): New-Keynesian two-country model → long-run dynamic scoring effects of income taxes ≈ 22 percent.
    - CAO (2010) for Japan: increase in the CIT by 1 percentage point of GDP ultimately improves primary balance by 0.84 percentage point of GDP → macro-level ε of −0.16.
  - Policy practice: dynamic scoring controversial; authorities often keep GDP fixed when estimating revenue effects.

- Table-summary (scaled example for a 12 percentage-point CIT rate cut; static revenue loss = 1 percent of GDP):
  - Expected cumulative effects of a 12 pp CIT cut:
    1. Debt-equity ratio: International evidence −3 percent; Japanese evidence −1¾ percent.
    2. Investment: International evidence +8½ percent; Japanese evidence +5½ percent.
    3. Income shifting by MNCs: International evidence +10 percent; Japanese evidence (not reported).
    4. Income shifting by SMEs: International evidence +10 percent; Japanese evidence (not reported).
    5. Corporate taxable income: International evidence +10 and 30 percent of static revenue loss; Japanese evidence (not reported).
  - Static CIT revenue loss of 12 pp rate cut: Approximately −1 percent of GDP.
  - Dynamic CIT revenue loss of 12 pp rate cut: Between −0.7 and −0.9 percent of GDP (depending on ε assumed; examples in text: with ε = −0.1 or −0.3, long-run fiscal cost for 12 pp cut ranges between 0.9 and 0.7 percent of GDP).

### V. Policy implications and reform options — selected recommendations
- Timing and implementation:
  - Big-bang implementation vs phased approach:
    - Big-bang eliminates uncertainty and avoids intertemporal tax planning.
    - Gradual approach reduces short-term revenue losses and windfall gains on sunk past investments; credible pre-announcement can stimulate current investment.

- Revenue-neutral reform away from CIT — strengthen consumption taxes:
  - Each percentage point consumption tax increase ≈ ¥2.5 trillion, or 0.5 percent of GDP.
  - A 2 percentage-point higher consumption tax (yielding 1 percent of GDP) would allow a reduction in the CIT rate by approximately 12 percentage points as part of a revenue-neutral reform.
  - Distributional considerations: lower CIT benefits accrue disproportionately to higher incomes; some CIT incidence falls on labor (higher wages), offsetting regressivity; targeted transfers can mitigate regressivity.

- Improve local public revenue sources:
  - Recurrent property tax preferred for local revenues.
  - Share of local tax revenue from property tax in comparator countries: UK and Australia 100 percent; Canada 90 percent; US 75 percent; France 53 percent.
  - In Japan, only 30 percent of local tax revenue comes from recurrent property tax.
  - Replacing decentralized local CITs with immovable property taxes could provide stable local revenue and encourage national growth.

- CIT base broadening options:
  - Base broadening may increase METR and deter marginal investment; leaner depreciation allowances can deter investment in simulations.
  - Scope for leaner depreciation in Japan limited: buildings and intangibles less generous than in Germany and France; machinery more generous in Japan than Germany.
  - Cutting tax incentives:
    - Japan has 93 tax incentives at central government level.
    - Estimated revenue cost of these incentives is 0.2 percent of GDP (central government level in 2012).
    - Some incentives (R&D, temporary wage-increase credits) may be justified; many may be inefficient—number could be significantly reduced after cost-benefit analysis.
  - Tighter loss offsets:
    - Accumulated losses increased since early 2000s.
    - For 27 percent of profit-making firms, taxable income was fully offset by carried losses; >20 percent of total taxable income washed away.
    - Share of companies with tax payable in Japan is 28 percent (53 percent for large firms) vs 44 percent in Germany, 52 percent in UK, 54 percent in Korea and US.
    - Japan’s loss-carry-forward period is 9 years; since 2011 annual offset for large corporations limited to 80 percent of current profit.
    - Tighter loss-offset rules reduce revenue forgone but may deter risk taking and hurt investment via lower expected returns and cash-flow effects.
  - Stricter thin capitalization/interest deductibility:
    - Japan denies deductions for net interest to related parties when they exceed 50 percent of income (earnings-stripping rule).
    - Other countries cap interest deductibility at 30 percent of income for large companies (Germany, Italy, Spain); France deducts only 75 percent of interest and caps interest rate at annual average loan rates.
    - Stricter rules protect tax base but may raise cost of debt-financed investments and reduce FDI attractiveness; apply where abuse indications exist.

- SME treatment and dividend taxation:
  - Central government CIT rate for SMEs: 19 percent for incomes below ¥8 million (temporarily reduced to 15 percent until 2015) — special treatments create distortions.
  - Proposal: replace progressive PIT schedule on dividends with a flat 20 percent tax on all dividends to improve neutrality across capital income.
    - Example arithmetic preserved: With a 35 percent CIT rate and 20 percent dividend tax → combined burden on dividend income = 48 percent (0.35 + 0.20 × (1−0.35) = 0.48).
    - If CIT reduced from 35 to 30 percent, increasing dividend tax from 20 to 25 percent generates much the same overall tax burden on distributed profits as current CIT with 20 percent dividend tax.
  - Reducing the wage deduction:
    - Tajika and Yashio (2005) estimate revenue loss due to the wage income deduction used by individual businesses = ¥720 billion or 30 percent of the PIT they would pay without the deduction.
    - Rationalizing the wage deduction reduces arbitrage between remuneration forms and expands PIT/CIT bases.

- Allowance for Corporate Equity (ACE):
  - ACE provides a deduction for a notional return on equity (e.g., proxied by government bond yield), taxing only rents.
  - Properties and benefits:
    - Neutralizes debt-equity distortion; METR becomes zero; CIT becomes a tax on rents.
    - Makes depreciation and inflation irrelevant for marginal investment decisions.
    - Experience in countries (Belgium, Brazil, Italy) shows reductions in leverage and increases in equity.
  - Fiscal cost and mitigation:
    - Tentative calculation: a full ACE in Japan would involve an average budgetary cost per year of 9.4 percent of current CIT revenue (De Mooij, 2012).
    - Mitigation: apply ACE only to incremental equity (Italy’s March 2012 approach) to reduce short-run fiscal costs while preserving incentives.
  - CGE evidence (De Mooij and Devereux, 2011) for EU:
    - EU-wide ACE financed by VAT → investment + almost 6 percent; GDP + almost 2 percent.
    - If financed by higher CIT rate → investment +5 percent; GDP +1.8 percent.
  - Trade-offs: ACE reduces METR and debt bias efficiently; lower CIT rate reduces profit-shifting incentives for MNCs and may attract profitable FDI. For a large economy like Japan, ACE’s principal gains likely remain compelling.

### VI. Conclusions — summary of recommendations
- Japan’s CIT generates large distortions in investment, financing choices and income shifting.
- A lower CIT rate is expected to mitigate distortions, help unlock corporate cash reserves, and modestly raise growth and wages; a rate cut is unlikely to be self-financing.
- Given tight fiscal constraints, compensating measures are required:
  - Raise consumption tax (revenue transfer) or other non-CIT measures to finance CIT reduction.
  - Targeted base-broadening within CIT (reduce inefficient incentives, tighten loss-offsets) while recognizing potential adverse effects on METR and marginal investment.
  - Rationalize SME treatment (move toward a single uniform CIT rate; remove SME rate distortions where not justified).
  - Adjust dividend taxation and wage-deduction rules to reduce arbitrage and restore neutrality.
  - Consider ACE (especially incremental ACE) as a high-efficiency reform to eliminate debt bias and lower METR with phased fiscal costs.
- Preferred strategy: comprehensive reform combining rate reduction with revenue measures and structural CIT base reforms to maximize investment stimulus per yen of revenue loss.

*Italic: Content extracted from _wp14138 (IMF working paper excerpt).*

### 1. Statutory Corporate Income Tax Rate in Japan, as of April 2014 .........................................5

### 1. Statutory Corporate Income Tax Rate in Japan, as of April 2014 .........................................5

### Major sections
- 1. Statutory Corporate Income Tax Rate in Japan, as of April 2014 .........................................5
- 2. Summary of Estimated Effects of Lower CIT Rate by 1 Percent of GDP ..........................26

### Figures (listed)
- 1. Statutory General Government CIT Rates .............................................................................6
- 2. Effective Marginal and Average Corporate Tax Rate, 2012 .................................................7
- 3. Net Present Value of Depreciation, 2012 ..............................................................................7
- 4. Cost of Capital by Financing Measure, 2012.........................................................................9
- 5. Tax Burden for Different Types of SMEs ...........................................................................10
- 6. CIT Revenue in OECD Countries, 2012..............................................................................13
- 7. Tax Expenditures in the CIT ................................................................................................28
- 8. Loss Carry Away .................................................................................................................29
- 9. Personal Income Tax Rate on Earned Dividends, 2013 ......................................................31

### Boxes (listed)
- 1. CIT, Investment, and Output: A Back-of-the-Envelope Calculation ..................................17
- 2. Estimates of the Elasticity of Corporate Taxable Income ...................................................22

*Source: _wp14138 - 1. Statutory Corporate Income Tax Rate in Japan, as of April 2014 .........................................5 (PDF chapter/section).*

### References .............................................................................................................

### _wp14138 - References .............................................................................................................

### I. INTRODUCTION
- Recent reforms to Japan’s corporate income tax (CIT) have reduced rates but the statutory CIT rate remains among the highest in the OECD and Asia.
- Japanese government announced intent to reduce the statutory CIT rate to below 30 percent in its revised growth strategy in June 2014.
- Key economic contexts making CIT reform distinct in Japan:
  - Deflation has induced corporations to repay debt and accumulate cash reserves through retained earnings; CIT reform could help unlock this cash by encouraging investment and raising wages.
  - Ageing poses a medium-term challenge to growth potential; eliminating distortions and attracting investment via CIT reform could offset ageing impacts.
  - Tight fiscal constraints due to Japan’s extraordinarily high level of public debt require consolidation that may conflict with CIT cuts.
- Paper contributions:
  - Identifies key structural weaknesses in Japan’s CIT to guide medium-term reform aimed at eliminating distortions.
  - Assesses economic and fiscal impact of a CIT rate cut; updates and expands Dalsgaard (2008) with more quantitative focus. Conclusion: CIT rate reduction will likely bring investment and wage benefits but is insufficient to be self-financing.
  - Discusses options under tight fiscal constraints: (1) CIT rate cut financed by other fiscal measures outside the CIT; (2) base-broadening measures within the CIT; (3) introducing an allowance-for-corporate-equity (ACE).
- Organization:
  - Section II: current CIT structure and distortions.
  - Section III: impact of CIT rate cut on investment and growth.
  - Section IV: fiscal impact using elasticity estimates of corporate taxable income; finding that a rate cut is unlikely to be self-financing.
  - Section V: wider reform options including tax mix shifts, base broadening, and ACE.
  - Section VI: conclusion.

### II. JAPAN’S CORPORATE INCOME TAX DISTORTIONS

A. High Statutory Tax Rate(s)
- Japanese CIT rates vary by firm size, income level and region, yielding a complex system of differing rates.
- Overall CIT burden (adjusted for deductibility of local enterprise taxes and after repeal of special reconstruction tax in April 2014):
  - Ranges from 21 percent (for income of up to ¥4 million earned by small corporations located in an area applying the standard local tax rate) to almost 36.3 percent (for small corporations with income over ¥25 million in the Tokyo area).
  - Large corporations (capital over ¥100 million; ~1 percent of corporations) face:
    - Around 35.6 percent in the Tokyo area.
    - Around 34.5 percent in areas applying the standard local rate.
  - Large corporations also face a local tax of 0.48 percent of annual value added (including profits, wages, and interest) and 0.2 percent of capital, even when they record losses.
- Table 1 (as of April 2014) highlights central and local components; adjusted rates (standard/Tokyo) include enterprise-tax deductibility effects:
  - Adjusted rate (standard) examples: 21.4, 23.2, 36.0, 32.4, 33.5, 34.6 (as shown in table rows).
  - Adjusted rate (Tokyo) examples: 22.1, 23.9, 37.1, 33.4, 34.5, 35.6 (as shown in table rows).
- Historical and international context:
  - CIT rates in Japan fell from around 50 percent before 1990 to around 40 percent by 2012; since April 2014 the rate is around 35 percent for larger companies.
  - OECD average statutory CIT rate is 25.5 percent (2014 reference in text).
  - Unweighted 2014 average for a group of 11 Asian countries is 25 percent.
  - G7 (excluding Japan) average CIT rate in 2013 is slightly above 30 percent.
  - United States overall CIT rate (for an average US State) is 39 percent.

B. High Effective Tax Rates
- Effective tax burdens on investment (not just statutory rates) determine investment distortions.
- Marginal effective tax rate (METR) depends on tax base elements: depreciation allowances, inventory valuation, interest deductibility, investment tax credits.
- International comparisons (2012) suggest Japan imposes relatively large marginal investment distortions:
  - Japan’s METR and average effective tax rate (AETR) are shown as relatively high in Figure 2 (ZW E source).
  - Depreciation schemes in Japan are less generous than in most other countries (Figure 3 shows lower net present value of depreciation for Japan).
- Qualifications to high-METR finding:
  - Low interest rates and low inflation in Japan reduce the METR relative to other countries in practice; international METR comparisons use uniform parameters and may not capture these differences.
  - Not all METRs are high in Japan: METR for machinery is lower than in India, China and Indonesia; depreciation for buildings and intangibles is relatively less generous.
  - Changes since 2012 have modified Japan’s METR: lower CIT rate and special immediate depreciation of qualifying investment reduced METR; reduction of declining-balance depreciation from 250 to 200 percent of depreciation under straight-line increased METR.
- Inframarginal distortions:
  - Average effective tax rate (AETR) also high in Japan suggesting large distortions in inframarginal investment choices.

C. Significant Debt Bias
- Deductibility of interest but not equity payments creates tax incentive to use debt finance.
- Difference in cost of capital for equity versus debt is highest among G7 countries for Japan (Figure 4).
- Personal tax system does not offset corporate-level debt bias: Japan applies uniform rates to dividends (from listed firms), interest and capital gains.
- Empirical estimates on debt bias:
  - Meta-analysis (De Mooij, 2011) consensus: a 10 percentage-point higher CIT rate increases ratio of debt to assets by between 2 and 3 percent on average.
  - For Japan, Kunieda, Takahata and Yada (2011) find smaller effects between 1 and 2 percent.
- Recent firm behavior:
  - Many Japanese firms have significantly reduced leverage ratios by paying back debt and accumulating cash reserves—debt bias may be less immediate but could re-emerge with stable growth and moderate inflation.

D. Arbitrage and Distortion for SMEs
- CIT as a PIT backstop: if business income taxed less than wage income, incentive exists to supply labor via corporate form and distribute income as capital income.
- In Japan:
  - Unincorporated SME business income taxed under progressive PIT rates ranging from 5 to 45 percent.
  - Local income tax of 10 percent (4 percent prefectural, 6 percent municipal) and enterprise tax between 3 and 5 percent apply to the self-employed.
  - Closely held corporations face CIT and dividend tax when profits are distributed.
  - Owner-directors can pay director’s remuneration taxed as wage income; no special rules, enabling arbitrage between labor and capital income.
- Figure 5 comparisons for SME marginal tax burdens (non-incorporated PIT; incorporated with dividends; incorporated with director’s remuneration):
  - Marginal tax lowest when profits are distributed as wages (director’s remuneration) compared to distribution as dividends or non-incorporated business at all income levels.
  - Difference as large as 18 percent for incomes between ¥8 and ¥12 million.
- Contributing factor: large wage income deduction in the Japanese PIT encourages incorporation and allocating profits as director’s wages.
- Tajika and Yashio (2005) find large distortions in SME payout decisions.

E. Arbitrage and Distortion for Multinationals
- Pre-2009: Japan taxed foreign-source income on a worldwide basis with deferral for retained profits by foreign subsidiary; repatriation tax applied on dividends with foreign tax credit.
- 2009 reform: shift toward exemption system (territorial taxation) — 95 percent of foreign dividends received by Japanese parent exempt if ownership ≥ 25 percent; foreign tax credit system remains for other foreign-source income and when ownership conditions not met.
- Effects:
  - Hasegawa and Kiyota (2013): Japanese affiliates that paid dividends before 2009 increased repatriations after reform; firms that did not pay dividends showed no change.
  - Feld et al. (2013): reform increased number of acquisitions abroad by 31.9 percent.
- Costs/risks:
  - Revenue foregone from repatriation taxes.
  - Increased importance of foreign tax rates for Japanese parents (final taxes), raising risks of income shifting to low-tax locations (transfer-pricing manipulation, debt shifting, relocation of intangibles).
- Anti-avoidance measures strengthened:
  - Since 2010: stricter transfer-price documentation requirements.
  - Thin-capitalization rules in place since 1992 complemented in 2012 by earnings-stripping rule denying deductions for net interest to related parties when it exceeds 50 percent of income.
  - 2010 CFC reform: passive income of a foreign affiliate in a low-tax jurisdiction (effective tax rate ≤ 20 percent) subject to current taxation in Japan when more than 10 percent owned directly or indirectly by Japanese resident.

F. Revenue Performance
- CIT revenue-to-GDP ratio:
  - Between 2008 and 2012, average was 3.3 percent for Japan.
  - This is higher than OECD average of 3 percent and higher than other G7 countries’ average of 2.6 percent (Figure 6).
- Volatility:
  - Central government CIT revenue-to-GDP ratio was 2.9 percent in 2006, declined to 1.3 percent in 2009 without significant reforms.
  - Ueda, Ishikawa, and Tsutsui (2010) estimate structural CIT revenue-to-GDP ratio in 2010 at 2.4 percent.
- Revenue productivity example:
  - At a central government statutory rate in 2010 of 30 percent, revenue productivity measured as CIT revenue in percent of GDP divided by the CIT rate is 0.08, i.e., each percentage-point CIT rate generates around (text ends mid-sentence in source).

*Italic source attribution: Content extracted from _wp14138 - References .............................................................................................................*

### 0.08 percent of GDP in structural revenue terms. In today’s terms, this is approximately

### _wp14138 - 0.08 percent of GDP in structural revenue terms. In today’s terms, this is approximately

### III. ECONOMIC BENEFITS OF A CORPORATE TAX RATE REDUCTION — Overview
- Main purpose: strengthen the economy by increasing investment via a CIT rate cut (analysis focuses only on effects of a lower CIT rate, not offsetting revenue measures).
- Effects considered: investment responses, tax arbitrage (income shifting) discussed elsewhere, aggregate growth, investment channels, productivity/wages.

### A. Aggregate Growth Effects — Evidence and Magnitudes
- Cross-country and macro studies report a wide range of estimated growth effects from CIT cuts:
  - Lee and Gordon (2005): a 10 percentage-point lower CIT rate raises the annual growth rate of GDP by between 0.6 and 1.1 percent.
  - Mertens and Ravn (2013): a 10 percentage-point lower CIT rate raises real GDP per capita after one year by 6 percent.
  - Arnold et al. (2011): shifting 1 percent of total tax revenue (approximately ⅓ of a percent of GDP) from the CIT toward consumption and property taxes increases GDP in the long run by 2 percent.
  - Japan Center for Economic Research (2014): a 10 percent reduction in the Japanese CIT rate would boost economic growth by 0.5 percent annually.
  - Cabinet Office (CAO, 2010): a reduction in the CIT burden by 1 percent of GDP (allowing a reduction by approximately 12 percentage points) will raise GDP over a period of 5 years by 1 percent compared to the baseline.
  - IMF/GIMF and Keen et al. (2011): an equivalent shock yields a similar effect; a revenue-neutral shift away from the CIT would raise GDP in the long run by approximately ½ percent.
- Contrasting evidence and caveats:
  - Easterly and Rebelo (1993) and Mendoza, Milesi-Ferretti, and Asea (1997) find no significant effects of tax variables on growth in some specifications.
  - Xing (2012) shows tax-growth rankings are not robust; long-run growth effect of a 1 percent revenue shift from CIT to consumption ranges from +1.8 percent to −0.3 percent across regressions (overall average 0.7 percent).
  - Acosta-Ormaechea and Yoo (2012): for 69 countries, the CIT is not more harmful to growth than the PIT; a 1 percent of GDP shift from income to consumption taxes raises annual growth by only 0.1 percent.
- Interpretation:
  - Results are contentious and sensitive to econometric specification, country heterogeneity, and tax base design.
  - Macroeconomic models often cannot capture tax-design nuances (e.g., ACE systems) that materially affect growth outcomes.

### B. Effects on Investment — Channels and Estimates
- Three investment channels from a CIT rate cut:
  1. Lowering the user-cost-of-capital → stimulates margin investment.
  2. Increasing cash-flow for credit-constrained firms → raises investment.
  3. Attracting foreign direct investment (FDI) → increases capital stock.
- Investment at the margin — elasticities and country evidence:
  - Hassett and Hubbard (2002): consensus elasticity between -½ and -1 (1 percent reduction in cost of capital boosts investment by 0.5–1 percent).
  - Arnold et al. (2011): reduction in CIT from 35 to 30 percent reduces user cost of capital by 2.8 percent and increases investment by 1.9 percent (elasticity ≈ ⅔).
  - Vartia (2008): similar CIT reduction boosts investment by between 1 and 2.6 percent across industries (elasticity between ⅓ and 1).
  - Chirinko (2002): elasticity of substitution between labor and capital between 0.3 and 0.4, consistent with cost-of-capital elasticity ≈ -½.
  - Japan-specific evidence:
    - Tachibanaki (1997): estimated elasticities generally much smaller than international literature.
    - Uemura and Maekawa (2000): 1999 CIT rate cut increased investment in Japan by only 0.2 percent per 1 percentage point CIT cut.
    - Uemura (2004) and Kang (2014): tax variables show limited or insignificant effects on investment in Japan.
  - Box 1 simulation (static general equilibrium with labor market interactions):
    - A 5 percentage-point CIT rate cut (not revenue neutral) expands investment by between 1½ and 3 percent in the long run.
    - Output rises by between ½ and 1 percent.
    - Wages are 1½ percent higher in the new equilibrium.
- Investment and cash flow:
  - Business cash flow is generally buoyant in Japan, but cash-flow effects matter for credit-constrained or new/innovative firms.
  - Hoshi, Kashyap, and Scharfstein (1991): cash flow has significant but smaller impact for firms with strong bank relationships.
  - Uemura (2004): cash flow has positive and statistically significant impact on investment in 8 out of 13 industries in Japan.
  - Kang (2014): coefficient implies a 5 percentage-point CIT rate reduction increases investment by 0.4 percent (ceteris paribus).
- Foreign Direct Investment:
  - De Mooij and Ederveen (2008) meta-analysis (427 elasticities): consensus semi-elasticity of FDI to the AETR is −3.2 (a 10 percentage-point reduction in AETR increases stock of FDI on average by 32 percent).
  - UNCTAD (2013): between 2010–2012, 60 percent of Japanese inward FDI was greenfield and 40 percent M&A.
  - ZEW (2012): Japan’s CIT cut at central government level in April 2012 from 30 to 28.1 percent resulted in a decline in the AETR by 1.6 percentage points.
  - Extrapolation in text:
    - A 5 percentage-point CIT rate cut → reduces the AETR by 4.2 percentage points → raises inward FDI by 13.4 percent (using semi-elasticity −3.2).
    - Current stock of inward FDI in Japan = 3.4 percent of GDP, equivalent to 2.1 percent of total private capital stock (total private capital stock estimated at 160 percent of GDP).
    - Assuming 60 percent of extra FDI is greenfield, higher FDI inflow raises total capital stock by approximately 0.2 percent (13.4 x 0.021 x 0.6).
- Aggregate expected investment impact from a 5 percentage-point CIT cut:
  - Cost-of-capital channel: approximately 1½ percent.
  - Cash-flow effects: around ½ percent.
  - Inward FDI: another ¼ percent.
  - Total approximate investment impact: approximately 2¼ percent.
  - Scaled to a 12 percentage-point reduction (static revenue cost of 1 percent of GDP): expected investment effect would be 5½ percent.

### C. Effects on Productivity and Wages — Incidence Considerations
- Incidence theory and evidence:
  - If CIT taxes economic rents, owners bear the burden; if capital is internationally mobile, incidence shifts to workers via lower labor productivity and wages.
  - Empirical evidence:
    - Arulampalam et al. (2012) and Fuest et al. (2013): workers bear between 45 and 75 percent of the incidence of the CIT in the UK and Germany.
  - Implication for Japan:
    - If similar incidence applies, a CIT cut could raise wages and be attractive given sluggish wage growth in Abenomics.
- Productivity:
  - Vartia (2008) and Arnold et al. (2011) find evidence for positive effects of a lower CIT on total factor productivity.
  - Potential channels include entrepreneurship (Cullen and Gordon, 2007), though empirical evidence on entrepreneurship effects is ambiguous.

### IV. FISCAL COST OF A CORPORATE TAX CUT — Overview
- Focus: expected fiscal implications and potential for dynamic scoring (behavioral responses of the tax base to a CIT rate cut).
- Scope of dynamic effects: investment, debt bias, income shifting.

### A. Signs of Laffer Effects?
- Literature using cross-country regressions finds inverse-U (Laffer) shapes for CIT revenue vs. rates:
  - Devereux (2007), Clausing (2007), Brill and Hassett (2007): revenue-maximizing CIT rates estimated between 16 and 42 percent, most around 30 percent → suggests rates above 30 percent could be on the declining slope.
  - With a Japan CIT rate of 35 percent, these results would imply reducing the CIT could be more than self-financing.
- Critiques:
  - Kawano and Slemrod (2012): including country fixed effects renders tax coefficients insignificant and can suggest revenue-maximizing rates of 75 percent or higher; they caution that the revenue-rate relationship is tenuous.
- Conclusion: Laffer-curve inference is sensitive to specification and omitted base-measure variables; the paper adopts micro-elasticity-based approach instead.

### B. Fiscal Impact Using the Elasticity of Taxable Income
- Revenue identity and elasticity framework:
  - CIT revenue R = τ × B (τ = CIT rate; B = CIT base).
  - Change in revenue from a rate change depends on tax elasticity of the CIT base (ε ≡ d ln B / d ln τ).
  - Static impact: the direct mechanical revenue change from rate change (no base change).
  - Example for Japan (static cost): a reduction in the CIT rate by 1 percentage point (i.e. a −1/τ percent change in the rate interpreted in context) involves a static revenue cost of approximately ¥400 billion, or 0.08 percent of GDP.
- Dynamic revenue impact:
  - If the CIT base expands (ε < 0) following a rate reduction, dynamic effects reduce the long-run revenue cost.
  - The factor (1 + ε) determines net long-run revenue effect per yen of CIT cut; sufficiently large negative ε could make a CIT cut self-financing.
- Determining ε:
  - ε should capture investment responses, changes in corporate finance, and taxable-income shifting (MNC profit shifting and SME base adjustments).
  - Empirical estimates of these components are reviewed in Box 2 (not included here).

*Source: IMF working paper text (excerpt)._

### Box 2. Estimates of the Elasticity of Corporate Taxable Income

### Box 2. Estimates of the Elasticity of Corporate Taxable Income

### Definitions and transformations of elasticities
- Studies use different elasticity measures:
  - Semi-elasticity of the CIT base (ε_s), measuring change in the tax base in response to a one percentage-point change in the CIT rate. It relates to ε as: ε_s = −τ × ε / (1 − τ).
  - Effect of a one percent change in after-tax earnings on taxable income (η), related to ε by η = (1 − τ) × ε.
- Numerical transformations using a Japanese CIT rate of 35 percent:
  - ε_s implies numeric mapping to ε: (example transformation indicated in text: with a Japanese CIT rate of 35 percent, it implies [transformed values present in source]).
  - Transforming η into ε for Japan: with τ = 35 percent we can transform η into ε: (transformation indicated in text).

### Empirical estimates (selected findings)
- Gruber and Rauh (2007) — micro data for US firms: estimate of ε ≈ 0.2 in different specifications.
- Bruce, Deskins & Fox (2008):
  - Federal US CIT: ε_s estimates reported and transformed in text to ε values (original estimates provided in source).
  - State-level US CIT: larger semi-elasticity attributed to income shifting between states.
- Dwenger & Steiner (2008) — German firms: expressed in terms of ε, estimates range between −0.3 and −0.5.
- Devereux, Liu and Loretz (2014) — UK:
  - Companies around £300 thousand: ε = 0.16.
  - Companies at a kink of £10 thousand: transformed values reported in source.
- Heckemeyer & Overesch (2013) — meta-analysis of MNC subsidiary studies (23 studies, 231 estimates):
  - Consensus semi-elasticity capturing all income shifting (including debt shifting) is −0.8: a 10 percentage-point lower CIT rate is associated with an 8 percent higher reported profit.
  - Without debt shifting, effect is about two-thirds of −0.8.

### Synthesis of empirical evidence
- The largest estimate of ε in Box 2 is −0.5; most estimates are between −0.1 and −0.3.
- Elasticity tends to be:
  - Somewhat larger for SMEs and for MNCs than for other firms.
  - Larger for local CIT than for federal CIT in the US.
- Fiscal cost implications for Japan:
  - With a long-run elasticity of taxable income of either −0.1 or −0.3, a cut in Japan’s CIT rate by 12 percentage points would involve a long-run fiscal cost in the range between 0.9 and 0.7 percent of GDP, compared to a static revenue loss of 1 percent of GDP.
  - Caveats for Japan: low stocks of inward and outward FDI may imply Japan’s tax base is less vulnerable to profit shifting by MNCs; low estimated elasticities for investment and corporate debt in Japan might imply a relatively low value of ε, meaning long run fiscal costs are closer to the upper bound of 0.9 percent of GDP.

### General equilibrium (dynamic) effects
- Elasticity-based estimates are comprehensive but do not capture general equilibrium effects from CIT rate reductions (e.g., changes in number of firms, inward FDI, employment, GDP growth, subsequent PIT and consumption tax revenues).
- Examples from literature (reported results):
  - Mankiw and Weinzierl (2006): long-run feedback effect on revenue for capital income taxes is 50 percent (neoclassical growth model).
  - Trabant and Uhlig (2011): similar results for the US and larger effects for Europe.
  - Nutahara (2013) for Japan: reports capital tax rate close to the top of the Laffer curve, i.e. dynamic scoring effects close to 100 percent.
  - Hiraga (2011) for Japan: reports that a 5 percentage point CIT rate cut will increase CIT revenue by around 50 percent in the long run.
  - Ganelli and Tervala (2014): New-Keynesian two-country model reports long-run dynamic scoring effects of income taxes around 22 percent; short-run effects might be negative.
  - CAO (2010) simulations for Japan: an increase in the CIT by 1 percentage point of GDP will ultimately improve the primary balance by 0.84 percentage point of GDP, consistent with a macro-level ε of −0.16.
- Policy practice: dynamic scoring is controversial due to empirical uncertainties and modeling assumptions. It is common for authorities to keep GDP fixed when estimating revenue effects.

### Table summary (expected effects of a 12 pp CIT rate cut; scaled to replicate a 12 percentage point CIT rate reduction with a static revenue loss of 1 percent of GDP)
/1 Expected effects, based on evidence presented in Sections III and IV. All effects are scaled so as to replicate a reduction in the CIT rate of 12 percentage points, with a static reduction in tax revenue by 1 percent of GDP.

- Expected effect of a 12 pp CIT rate cut on (Effect size, cumulative):
  1. Debt-equity ratio: International evidence −3 percent; Japanese evidence −1¾ percent.
  2. Investment: International evidence +8½ percent; Japanese evidence +5½ percent.
  3. Income shifting by MNCs: International evidence +10 percent; Japanese evidence (not reported).
  4. Income shifting by SMEs: International evidence +10 percent; Japanese evidence (not reported).
  5. Corporate taxable income: International evidence +10 and 30 percent of static revenue loss; Japanese evidence (not reported).
- Static CIT revenue loss of 12 pp rate cut: Approximately −1 percent of GDP.
- Dynamic CIT revenue loss of 12 pp rate cut: Between −0.7 and −0.9 percent of GDP.

### Policy implications and reform options for Japan (selected)
- Timing of reform:
  - Big-bang implementation vs phased approach:
    - Big-bang eliminates uncertainty and avoids intertemporal tax planning.
    - Gradual approach reduces short-term revenue losses and reduces windfall gains on sunk past investments. Credible pre-announcement can help stimulate current investment.
- Revenue-neutral reform away from CIT — strengthening consumption taxes:
  - Each percentage point consumption tax increase is estimated to yield around ¥2.5 trillion, or 0.5 percent of GDP.
  - A 2 percentage-point higher consumption tax (yielding 1 percent of GDP) would allow for a reduction in the CIT rate by approximately 12 percentage points as part of a revenue-neutral reform.
  - Distributional considerations: lower CIT benefits may accrue disproportionately to higher incomes; some CIT incidence falls on labor (higher wages), which can offset regressivity of consumption tax increases. Targeted transfers to low-income households can mitigate regressivity.
- Improving local public revenue sources:
  - Recurrent property tax is considered a preferred local revenue source.
  - Shares of local tax revenue from property tax in other countries: UK and Australia 100 percent; Canada 90 percent; US 75 percent; France 53 percent.
  - In Japan, only 30 percent of local tax revenue comes from recurrent property tax.
  - Replacing decentralized local CITs with immovable property taxes could provide more stable and fair local revenue and encourage national growth.
- CIT base broadening to finance rate reduction:
  - Base broadening can increase METR and may deter investment by shifting tax burden toward marginal projects.
  - Leaner depreciation allowances:
    - Scrapping depreciation allowances in exchange for rate reduction tends to deter investment in simulations for Europe and the US.
    - Scope for leaner depreciation in Japan is limited: current depreciation of buildings and intangibles is less generous than in Germany and France; US and France have more generous depreciation for machinery; Japanese depreciation for machinery is more generous compared to Germany and some regional countries.
  - Cutting tax incentives:
    - Japan has 93 tax incentives at the central government level (among the highest in a group of advanced economies).
    - Overall estimated revenue cost of these incentives is relatively modest at 0.2 percent of GDP (refers to revenue foregone at the central government level in 2012).
    - Some incentives (e.g., R&D, temporary wage-increase credits) may be justified; many may be inefficient, distort production, or serve special interests. The number of incentives could be significantly reduced after cost-benefit analysis.
  - Tighter loss offsets:
    - Accumulated losses have increased since the early 2000s.
    - For 27 percent of profit-making firms, taxable income was fully offset by carried losses; more than 20 percent of total taxable income was thus washed away.
    - Share of companies with tax payable in Japan is only 28 percent (53 percent if limited to large firms), compared with 44 percent in Germany, 52 percent in the UK, and 54 percent in Korea and the US.
    - Japan’s loss-carry-forward period is 9 years; many advanced countries have at least 5 years, some allow indefinitely. Since 2011, annual offset of past losses for large corporations in Japan is limited to 80 percent of current profit.
    - Tighter loss offset rules can reduce revenue forgone but may deter risk taking and negatively affect investment via lower expected returns and cash-flow effects.
  - Stricter thin capitalization (interest deductibility) rules:
    - Japan denies deductions for net interest paid to related parties when they exceed 50 percent of income (earning stripping rule).
    - Other countries’ stricter rules cited: Germany, Italy, Spain cap interest deductibility at 30 percent of income for large companies; France allows large firms to deduct only 75 percent of interest (including for external debt) and further restricts related-party debt; France also caps interest rate at a maximum of the annual average loan rates applied by banks.
    - Stricter rules could protect the tax base but may raise the cost of debt-financed investments and reduce FDI attractiveness; stricter rules should be considered where indications of abuse exist.
- Eliminating special treatment of SMEs:
  - Central government CIT rate for SMEs in Japan is 19 percent for incomes below ¥8 million (temporarily reduced to 15 percent until 2015). (Text continues beyond supplied excerpt.)

*Italic: Source — _wp14138 - Box 2. Estimates of the Elasticity of Corporate Taxable Income (excerpt) — original IMF content as provided.*

### 25.5 percent above that. The revenue forgone due to the reduced rate is estimated at

### _wp14138 - 25.5 percent above that. The revenue forgone due to the reduced rate is estimated at

### Progression in the Corporate Income Tax (CIT)
- Local enterprise taxes apply progressive rate structures in company income; 10 OECD countries apply progressive CIT rate structures while 23 OECD countries have a single, flat CIT rate.
- Progression in the CIT is generally undesirable for equity and efficiency:
  - Legal entities cannot bear ultimate incidence of taxation; only human beings can, so linkage to redistribution is moot.
  - Reduced CIT rates can be regressive if ultimate beneficiaries are wealthy business owners.
  - Reduced CIT rates for SMEs can be distortionary by discouraging firm growth and discriminating against investment where it is most profitable.
- Special tax treatment for SMEs may only be justified where SMEs face specific market failures (e.g., credit constraints) or entry barriers (e.g., market power).
- Moving towards a single, uniform CIT rate can yield important benefits in Japan and raise additional revenue.

### Reforming Dividend Taxation
- The total tax burden on capital income from SMEs depends on the combined burden of the CIT and the tax on dividends; this burden is already higher than that of the PIT (Figure 5).
- A higher CIT rate for SMEs magnifies distortions; a reduced CIT rate for SMEs is not the best way to address labor–capital income tax distortions.
- Policy proposal: replace the progressive PIT schedule on dividends with a flat 20 percent tax on all dividends to improve neutrality across capital income (dividends from listed companies, interest income, capital gains).
- Example calculation preserved exactly:
  - With a 35 percent CIT rate, the combined burden on dividend income would become 48 percent (0.35 + 0.20 x (1−0.35) = 0.48).
- If the CIT rate is reduced, rebalance overall tax burden between labor and capital income to minimize arbitrage and distortion:
  - Two avenues: reduce the PIT on labor income (costly; significantly increases the fiscal deficit) or increase the tax rate on dividends (recovers some revenue loss).
  - Example preserved exactly: If the CIT rate were reduced from 35 to 30 percent, an increase in the dividend tax rate from 20 to 25 percent generates much the same overall tax burden on distributed profits as the current CIT with a dividend tax rate of 20 percent.
- International context: the current Japanese dividend tax rate of 20 percent is relatively low (Figure 9).
- Economic impact of higher dividend tax on investment depends on competing views:
  - Traditional view: dividend taxes increase burden on new equity and reduce investment.
  - New view: mature firms finance marginal investments by retained earnings; dividend taxes get capitalized in share prices but have no impact on marginal investment.
  - Empirical evidence is inconclusive; possibly the new view applies more to mature firms and the traditional view to younger ones—so higher dividend taxes may have at least some adverse effect on investment.

### Reducing the Wage Deduction
- Tajika and Yashio (2005) argue the favorable wage income deduction in the PIT induces many SMEs to incorporate and distribute income as wage payments (e.g., to owner-directors), resulting in many SMEs reporting losses for the CIT.
- Preserved numeric estimate: Tajika and Yashio (2005) estimate that the revenue loss due to the wage income deduction used by individual businesses is ¥720 billion or 30 percent of the PIT they would pay without the deduction.
- Rationalizing the wage deduction system is essential to:
  - Reduce arbitrage between forms of remuneration.
  - Boost revenue from both the PIT (by expanding its base) and the CIT (by discouraging wage payments of corporate SMEs).
- Alignment of tax treatment across legal forms is recommended to neutralize differences; if corporations remain more heavily taxed than non-corporate businesses, consider taxing underlying shareholders transparently (e.g., along lines of S-corporations in the US).

### Allowance for Corporate Equity (ACE)
- A lower CIT rate provides tax relief on rents (returns in excess of minimum required), which does not affect behavior when rents are location specific; more targeted reforms can better reduce investment distortions.
- ACE overview:
  - Provides a deduction for a notional return on equity, in practice at something like the yield on government bonds.
  - Base: book value of equity minus equity participations in other firms (to avoid duplication).
  - Transforms the CIT into a system neutral with respect to marginal investment: tax is on returns in excess of the normal return; METR becomes zero and CIT becomes a tax on rents.
  - Makes depreciation rules and inflation irrelevant to investment decisions.
  - Eliminates debt bias by making CIT neutral with respect to debt–equity choice.
- Experience: countries with ACE include Belgium, Brazil, and Italy; evidence indicates reduction in leverage ratios.
- Revenue cost and mitigation:
  - Tentative calculation preserved exactly: a full ACE in Japan would involve an average budgetary cost per year of 9.4 percent of current CIT revenue (De Mooij, 2012).
  - Mitigation: apply ACE only to incremental equity (Italy’s 2012 route), reducing short-run fiscal costs while preserving economic benefits.
- CGE model evidence (De Mooij and Devereux, 2011) for the EU:
  - If European-wide ACE financed by an increase in the VAT: investment increases by almost 6 percent and GDP expands by almost 2 percent.
  - If financed by a higher CIT rate: investment rises by 5 percent and GDP expands by 1.8 percent.
  - Conclusion: ACE, by targeting tax relief to lowering the METR and eliminating debt bias, is more efficient in stimulating investment than a CIT rate reduction; similar principles may hold for a large economy such as Japan.
- Trade-offs: benefits of ACE should be weighed against benefits of a lower CIT rate (smaller profit shifting incentives for MNCs; possibly larger attraction for profitable FDI). For a large economy these effects may not overturn ACE’s principal gains.

### Conclusions and Policy Recommendations
- Japan’s current CIT creates large distortions on investment, debt structures, and income shifting.
- A lower CIT rate is expected to mitigate distortions and, in the short run, can help unlock large corporate cash reserves even if implemented gradually. Long-run growth impact is expected to be positive but modest.
- Given tight fiscal constraints, compensating fiscal measures are needed to finance a CIT rate cut; a rate cut is unlikely to be self-financing.
- Policy package considerations:
  - Further increase in the consumption tax is beneficial for efficiency but raises distributional concerns.
  - Scope for base broadening within the CIT is limited and may undo investment effects of a rate cut.
  - Elimination of some tax incentives and special SME treatment could yield efficiency gains and simplify the CIT.
  - Higher dividend taxes and a lower wage deduction can compensate for revenue losses from a lower CIT rate and restore neutrality in taxation of SMEs.
  - Various local CITs could be replaced by more efficient recurrent immovable property taxes to provide local communities with more stable revenue.
  - Comprehensive reform is the preferred strategy to address weaknesses in Japan’s current CIT.
- ACE appeal for Japan:
  - Reduces METR to zero, providing large incentive for firms to increase investment.
  - When applied to incremental equity, fiscal costs incur gradually, maximizing investment stimulus per yen of tax relief.

*Source: IMF Working Paper content (excerpt provided).*

### APPENDIX I. ALLOWANCE FOR CORPORATE EQUITY

### APPENDIX I. ALLOWANCE FOR CORPORATE EQUITY

### Model Design of an ACE
- Objective: supplement interest deductibility in the CIT with a deduction for the notional return on equity to neutralize the debt-equity distortion.
- ACE base options:
  - Entire equity stock.
  - Incremental base: the increase in the equity stock relative to some base year (roughly new equity issues plus retention of after-tax profits, relative to the base year).
- Adjustments to the equity base:
  - Subtract equity participations in other firms to avoid duplication.
  - Deduct participations in foreign companies, since foreign equity returns are not subject to domestic taxation (applies under exemption and approximates worldwide systems with deferral and foreign tax credit on distribution).
  - Dividends received from foreign companies add to the equity base insofar as they are reinvested.
- Negative ACE allowance:
  - If equity value minus participations becomes negative (e.g., holding companies financed primarily with debt), the ACE becomes an addition to the CIT base rather than a deduction, offsetting interest deductibility and removing tax incentives to finance acquisitions by debt rather than equity.
- Administrative and transitional features:
  - Calculation of taxable profit under an ACE may be done as under the current CIT using financial accounts data on dividends, new share issues, and share acquisitions.
  - Possible to introduce a full-blown ACE system from one year to the other; choice required on determination of the initial equity base:
    - If last year’s equity base is used, ACE is granted on the entire equity stock.
    - If initial equity base is set equal to zero, the system is incremental and maximizes boost to equity-financed investment per unit of revenue lost.
- Choice of imputed rate of return:
  - Full neutrality requires imputed rate equal to shareholders’ discount rate for future ACE tax savings, which depends on riskiness of those savings.
  - If tax law allows full loss offsets, shareholders discount at the risk-free rate; thus set notional rate equal to the risk-free rate (e.g., proxied by government bond interest rate).
  - In practice, loss offsets are limited (carryforward limits, no interest, unutilized losses on exit), introducing risk—largely bankruptcy risk—which is reflected in firms’ borrowing rates.
  - Setting the imputed rate equal to the interest on the company’s long term debt would presumably ensure rough neutrality.
  - For administrative simplicity, a common notional rate must be used for all companies; average interest on corporate bonds is a natural benchmark in countries with a developed corporate bond market.

### Neutrality Properties of an ACE
- ACE neutralizes debt-bias.
  - An allowance for corporate capital (ACC) also obtains neutrality by eliminating interest deductibility and granting a deduction for the normal return on all capital, but ACC involves a more significant overhaul and transitional issues (e.g., treatment of pre-existing debt).
  - If the notional return is applied to both interest receipts and interest paid, ACC effectively leaves banks untaxed.
- ACE renders the CIT neutral with respect to marginal investment decisions.
  - By allowing deduction for both interest and the normal rate of return on equity, ACE charges no tax on projects with a return that matches the cost of capital.
  - The effective marginal tax rate is therefore zero and the CIT becomes a tax on economic rents, which in principle does not distort the scale of investment.
- ACE offsets investment distortions from differences between economic depreciation and tax depreciation.
  - Accelerated depreciation reduces book value of assets in tax accounts and thereby reduces the ACE in later years; this offsets earlier depreciation benefits in present-value terms.
  - The present value of the sum of depreciation allowance and the ACE allowance is independent of the depreciation rate used for tax purposes.
  - Therefore, neutrality of an ACE with respect to investment holds irrespective of depreciation allowances in the tax system.

### ACE in Practice
- Croatia (1994–2000):
  - Operated a profit tax charged on equity income in excess of an imputed ‘normal’ return (rate of ‘protective interest’, PI).
  - Notional rate applied to the book value of equity was equal to 5 percent, plus the rate of increase of industrial product prices.
  - In mid-2000, the overall rate was 11.2 percent.
  - If the PI resulted in a tax loss, it could be carried forward for up to five years–with interest added to it at the PI rate.
- Brazil (1996):
  - Introduced a variant allowing notional interest (JCP) to be deducted from the taxable base, but only if equity returns were paid out to shareholders.
  - JCP is calculated as the long-term interest rate set by the government multiplied by the net assets of the company.
  - Purpose: to “equalize the taxation of the many types of capital income” and to address inflationary distortions.
- Italy (1998–2002 Partial variant; March 2012 incremental ACE):
  - 1998–2002: Applied a partial variant called the Dual Income Tax; notional interest on equity was not fully tax deductible but qualified for a reduced CIT rate of 19 percent instead of the normal 37 percent.
  - The Italian system was incremental: only post-reform equity qualified for the lower tax rate; overall tax rate could not fall below a minimum of 27 percent.
  - March 2012: Introduced an incremental ACE labeled “aid to growth”:
    - Grants deduction corresponding to an assumed ‘notional return’ on qualifying equity increases contributed after the fiscal year 2010 (“new equity”).
    - Deduction of notional return is fixed at 3 percent for the first three years of application.
    - For subsequent years, the rate will be determined annually by the Ministry of Finance on the basis of the average return on Italian public debt securities, potentially increased by an additional 3 percent to compensate for business risk.
    - Any notional return that exceeds net taxable income of the relevant year is carried forward and can be used to offset the net taxable income of any subsequent tax period.
    - ACE applies also to sole proprietorships and partnerships, where an allowance is granted for the entire stock of equity, rather than its increment since 2010.
    - Acquisitions in related companies that could lead to duplication of the allowance are excluded.
- Belgium (introduced 2006):
  - ACE called the ‘deduction for risk capital’ or ‘notional interest deduction’ (NID).
  - NID allows companies to deduct from taxable income a ‘notional interest’ equal to risk capital multiplied by the notional interest rate.
  - The Belgian government intended the NID to create a positive climate for economic activity development.
  - The National Bank of Belgium (2008) shows a spectacular increase in equity of Belgian companies after introduction of the NID.

*Source: APPENDIX I. ALLOWANCE FOR CORPORATE EQUITY (excerpt).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14138.pdf_