Chapter 5
PERSONAL INCOME TAX : OTHER PROBLEMS
A. Taxation of High Income.
The present Japanese income tax system is superficially a very progressive one. The actual result, however, is somewhat different. There are many ways in which the wealthy taxpayer may legally different. There are many ways in which the wealthy taxpayer may legally avoid much of the income tax, through the so-called "loopholes". Also, we have the impression that the administration of the law in the top ranges of income has been relatively ineffective, or at least uneven. Hence many, perhaps most, of the individuals with large incomes are taxed at only a fraction of what the progressive rate schedule seems to indicate. On the other hand, occasional instances arise where seriously excessive burdens have been imposed through overassessment of taxpayers, or even at times merely through the strict application of the law to cases not contemplated when it was enacted.
Among the more serious loopholes in the present law are the exclusion of 50 per cent of capital gains from taxable income, the lack of adequate restraints on the accumulation of earnings in corporations, the flat rates applicable to distributions in liquidation, and the flat rates applicable to certain types of interest, as well as to other forms of income. These loopholes have been adequately closed in the various recommendations made elsewhere in this report. But securing adequate progression is more than a matter of having an adequate law; it requires also that that law be administered effectively. Otherwise, beyond a certain point further increases in rates or the closing of loopholes add little or nothing to the progressivity of the tax. The result is merely more evasion and a progressive deterioration of taxpayer morale. Moreover, some of the methods used to evade taxes may be wasteful and hence seriously interfere with the attainment of maximum levels of production. Consequently, in an overzealous attempt to shift the tax burden away from the lower classes, the resources available to them are actually diminished.
We conclude that the present top income tax rates in Japan are now much too high in relations to current standards of compliance and enforcement. It is possible that a reduction in these rates, through securing better compliance, would of itself secure a larger revenue from these income classes.
The result would then be an increase rather than a decrease in the real degree of progression, even without any change in methods of administration. In any case, such a reduction of rates is an essential step in securing the greater vigor of administration that is required if substantial improvement in the degree of progression is to be attained. The baneful effects of the various devices restored to for tax evasion purposes outweigh the slight amount of increased progression that is at present attained by the top rates in practice.
These remarks apply even when the national income tax rates are considered by themselves. To them, however, must be added the rates of the local inhabitant's tax, which we recommend be strengthened and used exclusively by the cities, towns, and village (Chapter II [# 2] ).
A decision as to whether a given rate is too high or not will always require the exercise of judgement. However, there are two specific considerations that help in forming such a judgement.
The first is the average amount of error in the assessment of income. For example, if we can be reasonably sure that in practically all cases the error in estimating the income for tax purposes is less than 5 per cent, then top rates of 80 per cent or perhaps even 90 per cent may be tolerable. However, it is our impression that at present errors of 10 per cent or 20 per cent in assessing the largest incomes are almost the rule, and errors of 50 per cent or more are not uncommon. Given these degrees of underassessment, a rate of 80 per cent rather than, say 60 per cent produces only a minor improvement in progressivity compared with the evasion and the increased difficulty of administration. For example, if a certain taxpayer's actual incomes of 20 million yen is assessed at only 10 million yen, an increase in the tax rate from 60 per cent to 80 per cent decreases the income left to this taxpayer by only one seventh. But it cuts in half the income after tax of the honest taxpayer.
On the other hand, suppose that, in the attempt to achieve a higher average progression, arbitrary overassessments are sometimes made, so that an occasional taxpayer with seven million yen income is overassessed at ten million yen. For such a taxpayer, raising the rates on the assessed income from 60 per cent to 80 per cent means moving from a situation where this taxpayer has at least one million yen left after the tax to one where his tax exceeds his income by one million yen. Under these conditions the administration of the tax tends to deteriorate, so that in the long run higher rates may mean less real progression.
The second consideration is the incentive afforded for avoidance or evasion of the tax. A 50 per cent tax rate on income is equal to a 100 per cent rate on the amount retained by the taxpayer, while a 67 per cent rate on income is 200 per cent on the amount retained, and 75 per cent on income is 300 per cent on the amount retained. This means, for example, that if a corporation is to give an official a net increase in salary of 10,000 yen it will cost only 20,000 yen if the rate is 50 per cent, but 30,000 yen or 40,000 yen if the rate is 67 per cent, or 75 per cent. Under a 75 per cent on individual incomes, the corporate official may much prefer that the corporation spend 40,000 yen on entertainments and other perquisities for him, rather than pay him the same amount in salary. Aside from the tax element, the salary would of course be preferred, since it has the advantage that it can be spent in whatever way the recipient pleases. The company official may consider these perquisities to be worth only a third of what they cost the corporation. Still, receiving the 40,000 yen perquisite is better than getting the 40,000-yen salary, paying the income tax, and retaining only 10,000 yen. If the tax rate is reduced to 67 per cent, the corporate official may consider it to be about an even choice between receiving a certain amount of additional compensation in the form of outright salary or in the form of entertainment and other perquisites, and if the tax rate is only 50 per cent, the corporate official may well prefer the salary increment, even though, after tax, he will have only half the money that it would cost the corporation to give him the alternative, tax-free perquisities.
In cases like this, pushing up the rate of income tax not only loses revenue, but induces wasteful expenditure that does not give as much satisfaction to anyone as would a smaller amount of resources put at the free disposal of the taxpayer. It will always be difficult to check this type of evasion or avoidance, since the line between proper business expenses and personal expenses is impossible to fix with precision.
Other means of avoidance develop under the pressure of high rates. For example, a taxpayer may arrange to take a part of his salary in the form of a loan, with the tacit understanding that it need never be repaid. But if the tax rate is as low as 50 per cent, he may prefer to pay the tax rather than risk liability to repay the loan if the corporation gets into difficulties, or risk investigation by tax officials.
In short, we are of the opinion that under present conditions in Japan it is unwise to push the income tax rate much, if any, above 50 per cent. At least, if the rates do rise substantially higher, they should do so only over ranges of income where the number of taxpayers is small enough to permit of a very through investigation and assessment of each taxpayer subject to these higher rates.
Nevertheless, we cannot be satisfied with the degree of high-level progression in the tax system that is reflected by nothing much more than an income tax that is limited to a 50 or 60 per cent top rates. Every progressive tax system worthy of the name must provide a substantial obstacle to the accumulation of huge fortunes that threaten to concentrate the control of the economic system in the hands of a few wealthy individuals. This is a danger of particular significance to Japan. Unless such accumulations are prevented by the tax system, they are almost certain to arise, sooner of later.
An improved form of succession tax (Chapter 8) will be helpful, but is scarcely enough by itself. Its effect is felt only over a long period of time.
The most satisfactory solution to the problem posed here involves the imposition of an annual, low-rate tax on the net worth of well-to-do individuals. An individual's net worth is the excess of the sum of his assets over the sum of his liabilities. A progressive tax on net worth, at rates ranging from 1/2 of 1 per cent to 2 1/2 or possibly 3 per cent, could be given a high exemption so that it would take effect only where the income tax rate schedule levels off. In effect, this tax would fill the gap left by the reduction in the top rates of the income tax. Although it would be a tax "on" capital, it would be light enough so that it would not have to be paid out of capital. The taxpayer could normally pay both it and the national and local (inhabitant's tax) income taxes out of his current year's income.
Such a net worth tax would not be subject to most of the difficulties that militate against the retention of the high rates of income tax.
First, and most important, the combination of income tax and net worth tax would have far less effect on incentives and on production and investment than would an income tax designed to have the same degree of progression standing alone. The net worth tax must be paid whether or not any income is received, or whether or not any effort is made. Therefore, an individual will not be able to decrease his current net worth tax liability by refusing to invest, or refusing to exert himself. The only method open to him is the risky one of outright evasion, by hiding some of his assets, To be sure, if a taxpayer does procure an additional income, and saves it, he may later have to pay an increased net worth tax, but this effect is remote, and in the meantime he can spend the extra income and avoid the tax entirely. Even if he does not spend it, he will in the meantime have enjoyed the use of the funds. This is graphically illustrated by the fact that an income tax of 110 per cent would leave the taxpayer with an incentive actually to avoid earning income or investing profitably, whereas the combination of an income tax of 50 per cent and a net worth tax of 9 per cent, (which would produce the same total tax if it is assumed that the income is 15 per cent of capital) would still leave the individual with a very substantial incentive to increase his income, since he will be able to retain half of it. We do not of course propose such a combination of rates, but the example illustrates the difference.
A further advantage of a net worth tax over increasing the top rates of the income tax is that the net worth tax is a superior and more selective means of preventing the growth of undue concentration of economic power. Control over the economy is more nearly related to the ownership of wealth than to the receipt of income. Indeed, even very large incomes received as salary, or as royalties for a popular novel, or the like, do not represent the same danger to the preservation of democracy as would a comparable income derived from securities or other property. The taxpayer with the latter type of income will pay more, if the net worth tax is in effect, than the taxpayer with earned income. Hence the effect of the tax system will be concentrated where it is most needed.
The net worth tax also offers a solution to the problem of coordinating the national tax with the local inhabitant's tax, which is based in large part on net income. If there are very high top rates in the national tax schedule, the addition of the local rates often brings the combined burden up to levels where the national or local administration breaks down. The freedom of the localities to impose rates of their own choosing must then be severely restricted, if the combined burden at the margin is not to become excessive or even to exceed 100 per cent. In principle, this difficulty can be met through the deduction of the local tax in computing the base for the national tax, or vice versa. However, if the deduction is to be made on an accrual basis, this solution adds some complication; while for taxpayers, who are on a cash basis of accounting, it is only partially effective in cases where income fluctuates from year to year. If there is a net worth tax, however, so that the top rates in the national income tax can equitably be kept down to 50 per cent or 60 per cent, even fairly substantial local taxes on incomes will still produce a combined burden of well under 100 per cent. There is then little or no need for one tax to be deducted in computing the other.
A net worth tax has an other important advantage over the income tax in that it gives an automatic tax discount to uncertain income. If two individuals each have 1,000,000 yen income a year from investments, but one has it all in the best quality of corporate bonds, or governmental bonds, while the other gets his income from an investment with an uncertain future, the capital value of the former individual's holding will be greater. He will pay more net worth tax, but only the same income tax.
Also the net worth tax require a contribution to government expenses from those who merely hoard their wealth in an unproductive form that yields no income. The income tax fails to reach this kind of economic power.
We have considered the administrative problems of administering a net worth tax, and have concluded that they are not serious enough to make the tax unavailable. The point at issue is not what it takes to administer the net worth tax, but whether it is more or less difficult to administer the net worth tax than it is to administer income tax rates going up to 60, 70 and 80 per cent. One is a substitute for the other, not an addition to the other. We should certainly not recommend lowering the top income tax rate to 50 or 55 per cent (national tax) if a net worth tax were not available.
The reasons why the additional administrative burden that would be caused by a net worth tax are not excessive include the following:
Firstly, the net worth of wealthy individuals ought to be calculated every year even in the absence of a net worth tax. For in that case the high personal income tax rates should remain, and experience amply shows that effective administration of a high-rate income tax on wealthy individuals requires a statement from them, not only of their incomes, but also their assets. This helps prevent evasion through unreported capital gains, and it uncovers at least a part of black market income. Even in the United States, where illegal income is not so large a problem as in Japan, the failure to require an annual balance sheet from every individual is one of the weakest links in the enforcement chain with respect to large incomes.
It follows, therefore, that the net worth tax calls for little if any more in the way of information from the taxpayer than a high-rate income tax ought to require.
Secondly, it is going to be necessary to revalue real estate in connection with other taxes. Land and depreciable assets must be revalued for purposes of the "land and house" tax, roughly at first, but more carefully each year (Chapter 12). Depreciable assets of the larger unincorporated business firms will be permitted to be revalued for gaining higher depreciation (so will such assets of corporations, but the net worth tax would not affect corporations). A necessary aftermath of any great inflation is a large amount of revaluation. Therefore, even such small additional valuation as might be called for under a net worth tax would be easier of achievement, owing to the necessity of valuing many assets for other tax purposes.
The imposition of a tax on net worth will indeed induce some taxpayers to make greater efforts to falsify their returns of assets ad liabilities than they would if the statement were for income tax. But some taxpayers will react the other way, because they would be affected more by the income tax. In general, however, the existence of a net worth tax would induce more hiding of money assets and other assets that do not directly produce income. Also, the fact that the net worth figures are subject directly to tax would make more important the degree of accuracy in valuation.
There would undoubtedly be some attempts at evasion of the net worth tax for a time as wealthy individuals tried to stock up on 100-yen bank notes and precious stones. But as a percentage of total assessable net worth, this would be small. An intelligent taxpayer can soon see that hoarding does not pay. If he can get 8 per cent by investing his money rather than hoarding it, and if the top income tax rate is 60 per cent, he will loss money if he hoards in order to escape a net worth tax unless the rate of tax is more than 3.2 per cent.
Finally, effective administration of a gift and death tax (in the form of accessions tax -- see Chapter 8) requires careful valuation of all types of assets when they pass by gift or inheritance. The availability of these valuation data should materially ease the additional load caused by the net worth tax.
In summary, then, if the net worth tax were being considered in isolation, the administrative difficulties should give pause. But as an addition to an existing system, and as a substitute for a high rate portion of the income tax, the net additional difficulties that it causes are not great -- and they may even be a minus quantity.
Moreover, whatever administrative effort is put on the net worth tax is sure to be of some benefit in administering the other taxes. There is a two-way channel of benefits. For example, if the income tax examiner compares a taxpayer's net worth at the beginning of a year with that at the beginning of the following year, the difference must represent either gifts or bequests received during the year (minus gifts made during the year), or the excess of income over personal expenditures during the year, or a change in the value of the assets themselves.
Thus an annual listing of the assets and liabilities of the taxpayer will furnish an excellent means of obtaining an approximate check on the accuracy of his reporting of gifts and income. Also, if in any year a taxpayer fails to list an asset in his net worth return, the later discovery of the asset in his net worth return, the later discovery of the asset in his possession, or of other property exchanged for it, will permit the tax assessor to assume an unreported amount of income, or an unreported gift, or an unreported asset in previous returns. Thus with this interlocking of the three taxes, the taxpayer who fails to report any gifts, assets, or income is very likely sooner or later to find himself with an embarrassing discrepancy to explain to the tax assessor.
Administration of the net worth tax is like administration of high rates of income tax in that it depends largely on the will of the tax authorities to administer without fear or favor, and on the realization by the wealthy citizens of the community that, under modern conditions, they are going to be required, one way or the other, to contribute a large share of their incomes to providing collective benefits through government expenditure, and are not going to be permitted to accumulate huge fortunes that put the community at the economic mercy of a few.
The net worth tax is not a new tax, untested elsewhere. In recent years it has been utilized by at least two Swiss cantons, and it was a feature of the German tax system after the first World War.
We recommend that an annual, low-rate tax be imposed on the net worth of individuals whose net worth exceeds 5 million yen. Until experience has been gained under this tax, the exemption should be kept at this high level, to lessen the number of taxpayers to be assessed, and the rates should be kept fairly light. We recommend the following schedule:
| Net Worth Bracket (yen) | Rate of Tax |
|---|---|
| Less than 5 million | Exempt |
| 5 million to 10 million | 0.5 per cent |
| 10 million to 20 million | 1.0 per cent |
| 20 million to 50 million | 2.0 per cent |
| above 50 million | 3.0 per cent |
Thus on a net worth of 12 million, the tax would be nothing on the first 5 million yen 25,000 yen on the next 5 million yen, and 20,000 yen on the remaining 2 million yen, a total tax of 45,000 yen, or an average rate of 0.375 per cent.
All the individuals with net incomes greater than 500,000 yen should be required to file statements of assets and liabilities, to assist in the administration of the income tax and the accessions tax.
The yield of the tax will not be substantial, at least for the next few years, and in the restricted form here proposed. Although in the absence of any direct experience it is difficult to estimate the yield of such a tax with much certainty, it is quite possible that under the rates recommended above the yield may at first be as little as 2 billion yen a year. However, this fact is not in itself a reason for not taxing the few wealthy taxpayers one way or another. Moreover, as economic recovery progresses in Japan, accumulation and concentration at the higher levels can be expected to increase notably. The net worth tax builds primarily for the future, but it must be enacted now if experience with it is to perfect it for the future, and, especially, if the path toward the future is to be unhindered by the distorting economic effects of the only alternative to such a net worth tax, namely, very high income tax rates in the top brackets.
For the time being, our recommendations rely on the net worth tax only to the extent of reducing the top national income tax rate to 55 per cent. As more experience is gained with the net worth tax and as its reliability as a tax is demonstrated, we recommend that the income tax rates be reduced to a maximum of 45 per cent or possibily 50 per cent and that the net worth tax be strengthened correspondingly.
B. Fluctuating Incomes.
A taxpayer whose income fluctuates violently from year to year is in danger of being treated unjustly under an income tax with steeply progressive rates. In the few years when he gets an unusually large income, he finds himself up in the high income brackets, where the tax rates are severe. Someone else, who gets the same total income over a period of years but gets it in regular amounts year by year, is never put up into those high brackets. The net result is that the taxpayer with the irregular, "lumpy" income pays more tax than the one with a regular income. An author whose royalties from some best sellers are concentrated in a few years of his life is an example, compared, for instance, with a newspaper editor whose income is evenly spaced over the years. Income from fishing is also apt to fluctuate widely from one year to another. There are variations in the run of fish, and large losses now and then due to storms. Forestry income may tend to be lumped into a few years. Gains and losses from the sale of real estate, or securities, or other capital assets are likely to be realized in large lump sums.
We recommend a special provision to lessen the impact of the income tax on such incomes, to make the result more like what it would be if the same amount were gained by the taxpayer in equal, regular amounts, over a period of years. The provision is more complicated than the alternative of simply including all such income in full, in the year when received. But here is an instance where the gain in equity under the tax is certainly worth the extra trouble. The number of taxpayers involved is small, their incomes will usually be considerable, and the taxpayers will be willing and able to make the extra computations that are required to lighten their tax burden, (or at least to request competent assistance in making the computations).
The details of the recommendation are described and discussed at length in an appendix to this report. Here, only an outline will be given. The income from royalties, or capital gains, or other specified types of fluctuating income actually received all in one year, is spread forward over future years. It is treated as if only a part of it were received in the one year, another equal part in the next year, and so on, over say, a five-year or possibly a ten-year period. This prevents the taxpayer from being thrown up into the very high tax-rate brackets in any one year. A tentative total tax on the entire amount is computed and paid the first year, and proper adjustment is made as needed in future years, not by tax refunds, but by reducing the tax otherwise due.
Where a heavy loss is incurred in one year, as may be the case with loss from the sale of a capital asset, a similar problem arises, and a similar, though not identical solution is recommended (details are given in the appendix).
Under these recommendations, capital gains are included 100 per cent in taxable income and capital losses are 100 per cent deductible. A modern progressive income tax cannot be made effective unless capital gains are taxed in full, and capital losses are deducted in full. The present law provides that only 50 per cent of a capital gain is to be included in taxable income. This is an unwise favoring of speculative types of investment, at the expense of investment of a kind that yields its fruits in the form of regular interest and dividends, or regular profits of an unincorporated business. It is sometimes claimed that capital gains are in some sense not income, and hence should not be taxed at all under an income tax. We cannot be impressed by this terminological argument. The important fact is that capital gains give the possessor an increase in economic power just as surely as does interest or dividends. Still more significant is the ease with which astute tax avoiders can, by altering the legal form in which they realize their profits, change other forms of income into capital gains. The fact is, and experience in the United States amply reveals, that many a well-to-do and sophisticated investor can dodge almost untouched through the high income brackets if capital gains are given exemption or a low tax rate.
Our recommendations for the personal income tax and the corporation income tax are predicated on full inclusion of capital gains and full deduction of capital losses. We should recommend much less tax relief for corporations, and a much more severe treatment under the individual income tax for distributions of all kinds by corporations, if capital gains and losses were not included in full. Several other restrictions would have to be recommended, and even then the net result would be a much less equitable tax system. The full inclusion of capital gains and capital losses is among the most emphatic of our recommendations.
An important part of our recommendations concerning capital gains and losses is that when a capital asset is given away, during life or at death, the gain or loss accrued on the property by that time must be taken into account in the income tax return of that year. This is essential to prevent indefinite postponement of income tax through several generations. It is no answer to say that the gain element in the property is hit by the gift tax or death tax. These taxes also strike property that has no capital gain element in it -- cash, for instance.
However, it is not fair to tax at full rates those capital gains that are not real gains, but merely increases in the money value of the property that result from the depreciation of the monetary unit. And these mere paper gains have been especially important in Japan in recent years. We recommend that with respect to depreciable business assets, gain realized in the future be subjected to the full income tax rates only to the extent that they are real gains over the figure set for revaluation. Chapter 7 contains our recommendations for revaluing business assets. However, it would be unnecessarily inequitable to relieve such taxpayers entirely of all tax on their paper gains, while other who realized paper gains under the present law were required to pay a tax, and many who invested in savings, deposits, bonds, and the like suffered a real loss for which no deduction can be allowed. To minimize this inequity, we recommend that a tax of 6 per cent be imposed on the paper profits as determined by the revaluation.
As to other assets, especially securities held by individuals, we recommend that a somewhat similar allowance be made, but in a different way , since these assets will not be undergoing revaluation. When the asset is disposed of, the gain should if possible be computed by reference to the value that was used for the asset in the capital levy of 1946, adjusted by a price index up to a 1949 value. Where this figure is not available, some approximation to it may be used. In either case, a slightly different method is recommended in the case of losses. The details of this plan, and the exceptions suggested, are given in the appendix below.
We also recommend that similar special treatment of mere paper gains, or paper losses, be applied in the future, if the price level should get out of control again and fluctuate by more than approximately 15 per cent per year. Indeed, if all taxpayers can be treated alike from the start of any such price level change, paper gains and losses can be eliminated from the tax base entirely without inequity. However, for any fluctuation less severe than this, we recommend no specific allowance for changes in price. As long as changes in price levels are only mild the inequities and ill effects resulting from taxing such paper profits are neglibible, and the difficulties and complications resulting from the use of a price index outweigh any possible benefits.
C. Foreign Nationals.
An important feature of any program for the rehabilitation of Japan is the establishment of an economy that will attract foreign capital. Along with foreign capital must come some foreign personnel for the management and operation of the business or industry provided by the foreign capital. One prerequisite for attracting prospective investors is a system of taxation which gives those investors an opportunity to obtain a reasonable rate of return on their investment after deduction of all taxes collected both at the source by the government in whose jurisdiction the investment is actually made and to a certain extent the taxes collected on such income in the country in which the investors are domiciled.
The foreign national's greatest objection to Japanese tax system today appears to be to the level of personal income tax rates. As indicated in other parts of this report, present rates are so high and out of line with inflated prices and incomes that proper enforcement is impossible as applied to foreign nationals. It is a known fact that the standard of living of certain foreign nationals is considerably higher than that of the average Japanese national and also that the standard of living of other foreign nationals is no higher and may be possibly even lower than the average Japanese national. Many types of foreign capital investment are made only reluctantly if at all, unless some foreign personnel is sent along to provide at least some of the management and control. It is probable that more foreign capital is potentially available from investors of those countries whose standard of living is higher than that of the average Japanese national than from investors of those countries whose standard of living is equal to or less than that of the average Japanese national. In another part of this report, it is recommended that the top rate of the personal income tax be 55 per cent and that this rate be applicable to net incomes in excess of 300 thousand yen: and that a new net worth tax be enacted to supplement the personal income tax with the object of preventing further concentration of wealth by Japanese nationals. No reason exists for applying the net worth tax to foreign nationals except to the extent that they accumulate personal holdings in Japan. It is also recommended that the top rate of the personal income tax be reduced to 50 per cent or 45 per cent when the net worth tax has proved to be a dependable source of revenue. If foreign nationals were assured that the top rate to which their net incomes earned in Japan was going to be subjected was 50 per cent, including the local inhabitant's tax, it is believed that such rates would attract the necessary foreign national personnel to manage the essential new foreign capital, or at least the tax rates would not be a deterrent force. For example, an American executive subject to an American income tax that averages, say, 33 1/3 per cent of his income, and who moves to Japan where the would be taxed at an average rate of, say, 50 per cent, would need only a 35 per cent increase in his salary to make up for the difference in tax. Similarly, the unincorporated foreign trader would not have to increase his profits greatly.
Certain suggestions have been submitted to this mission in an effort to alleviate the burden on foreign nationals. One was that a foreign national should be permitted to pay the same tax that he would pay if he was a resident in his own country. Not only does this present untold administrative complexities simply from the standpoint of the number of income tax systems that the Ministry of Finance would have to know and interpret, but also it would give to those foreign nationals of countries having a standard of living equal to or less than the average Japanese national, an unwarranted competitive advantage over the Japanese. Foreign nationals of countries where indirect taxes are used almost exclusively, would be entitled to carry on their business activities in Japan without the payment of any income taxes and also would not be subject to the indirect taxes in their won native country. Such a suggestion, therefore, has unsurmountable administrative complexities and violates every principle of equitable treatment of taxpayers.
Another suggestion was that a special deduction or cost-of-living allowance be authorized for foreign nationals. If a uniform cost of living allowance were granted to all foreign nationals, then those foreign nationals who have the same standard of living or slightly less than that of the average Japanese would receive preferential tax treatment compared with those foreign nationals whose standards were above that of the average Japanese, and also compared with the Japanese nationals themselves. If an effort were made to adjust the cost of living index for each class of foreign national depending upon the country of origin, the administrative task of trying to determine the amount that should be allowable would be too great. Consequently, for reasons based on administration and inequality of treatment of taxpayers similarly situated, this suggestion proves to be of no merit.
At the present time, income in non-yen currency now earned in Japan by foreign nationals is in practice exempt from Japanese taxes. This exemption was intended to be only temporary. In light of the above discussion, it is recommended that this exemption cease in its entirety as of January 1, 1950, and that the rates of the personal income tax as indicated above be applicable to foreign nationals. It is hoped that revenue needs will soon decline enough to allow the top income tax rate to be set at 50 or possibly, 45 per cent.
In order to attract foreign capital for reinvestment or for new investment in the Japanese economy, it may be desirable to make some special provision for somewhat lighter taxation on such investment and on its earnings than on investments made by the Japanese themselves. In part such discrimination may be justified as to some extent offsetting the obstacles placed in the way of international investment by the difficulties of foreign exchange and especially the burdens that are placed on such investment directly or indirectly by customs duties. But primarily the reason or such discrimination is the fact that the Japanese economy is in great need of additional capital, and that it may be difficult to secure all of the needed capital from domestic sources. Voluntary savings appear to be far too small to supply the need, and even if adequate capital could be secured by imposing severe restraints on consumption, the resulting level of consumption would probably be considered undesirably low and the controls or taxes needed to enforce this level of consumption would have undesirable effects of their own.
At the present time, corporations are withholding a tax of 20 per cent of dividends paid to all shareholders. Japanese nationals are able to credit this withheld tax against their individuals income tax liability, and in addition are allowed a 15 per cent credit against income tax as a partial offset to the 35 per cent tax on the corporate income. Moreover, it is proposed elsewhere in this report to abolish the 20 per cent withholding tax at source on dividends and to raise the 15 per cent credit against the income tax to 25 per cent. Non-resident aliens, however, are seriously discriminated against by this scheme, in that their own laws do not ordinarily provide for comparable credits for the corporate tax against the income taxes which they must pay to their own governments. Indeed in many cases there is no income tax, or only an unimportant one. It would appear that the corporate tax of 35 per cent alone would be an adequate rate at which to subject those earnings in Japan. It is recognized that at the present time there are prohibitions against aliensmaking investments in Japan, but a revision of the revenue system at this time should take into consideration that this restriction will be removed sometime in the future. It is therefore recommended that no withholding be applied to dividends paid to non-resident aliens who have filed with the corporation paying the dividend, a statement on a form approved by the Ministry of Finance, setting forth that he is the owner of number of shares of said corporation and the number of the certificate and that he is a non-resident alien. Mandatory penalties should be provided where false information is furnished.
Aliens may also desire to make their investments in the form of commercial loans or bonded indebtedness. At the present time, a 20 per cent withholding on all interest paid to foreign nationals and non-resident aliens is required. This 20 per cent withholding may be justified in so far as foreign nationals are concerned who are residents of Japan, but it may not be as to non-resident aliens if the attraction of foreign capital is so urgent. What this rate should be is something that the Japanese themselves should determine. It may very well be that after consideration of the urgent need of the economy for foreign capital, that they would be prepared to require a withholding rate as low as 10 per cent.
D. Interest on Bank Deposits and Other Loans.
Many proposals have been made to subject this or that form of income to a special flat rate of tax in lieu of including it in the income to be taxed at progressive rates. Some of these proposals have at least some color of reason in that application of the tax to such income has in practice been rather less equitable than it should be in theory. But in the proposal that bank interest should be taxed at the source at a flat rate in lieu of all other income taxes we find no merit whatever.
It has been urged that this flat rate taxation is necessary because the tax is widely evaded and that this is the only way to collect any substantial tax. But if this is true it is in large measure due to the policy of allowing depositors to spread their deposits anonymously in large numbers of accounts, for the purpose of concealing not only the interest income but also income from other sources. This policy has no justification whatever, and we recommend that no bank be permitted in the future to carry a deposit that it has reason to believe does not stand in the correct name of the depositor. Moreover, tax inspectors should be allowed to inspect the bank records, upon presentation of a suitable authorization, for the purpose of investigating the income of taxpayers. If these steps are taken, it is probable that the amount of interest that escapes its fair share of the tax will diminish.
Moreover, it is not necessary to have a final flat rate tax in order to collect a substantial amount of revenue at source. If a tax of 20 per cent or 25 per cent is withheld at the source, the liability of most taxpayers with respect to such interest income will be satisfied. Hence, even if the interest is not reported in the individual's tax return, the amount of evasion will be relatively small. If however, the omission of further tax on such income is legalized, then it will be completely beyond the reach of the assessor, and even large and conspicuous amounts of interest income could be received with a relatively light tax. Bank deposits would then become a haven of tax avoidance for the wealthy individual, and the principle of progressive income taxation could be completely vitiated.
The other claim put forth on behalf of this special concession to bank interest is that such a concession is necessary in order to encourage individuals to use banks as places to deposit funds. It is alleged that this will encourage saving and therefore help to increase Japan's stock of capital equipment. In reality, however, the concession would produce quite the opposite effect. The concession would have practically no effect on the small saver, since the flat tax rate would be almost the same as the withholding rate and the rate that he would have to pay on his own income. His tax on the interest would be the same whether or not the concession is made. The chief effect of the concession would be on those with larger incomes. But individuals with larger incomes have other means of investing their savings than through bank deposits, and indeed such other means of investment are far more likely to promote the installation of new capital than merely depositing money in banks. A bank deposit must be reloaned before it can serve to promote the installation of new capital. In a pinch, if there is a shortage of funds for bank loans, these can be supplied by rediscount at the bank of Japan, so that even if a rich taxpayer were driven by the tax to hoard his savings in bank notes rather than deposit them in a bank, this need not in itself cause any reduction at all in the growth of capital in Japan. Indeed, the full taxation of bank deposits would have the beneficial effect of driving the wealthy investor out of bank deposits and into types of investment, such as the purchase of stocks and other equities, which the banks cannot well undertake themselves. This would provide more funds of the kind that can actually be used for capital expansion.
If banks really want to attract additional deposits, it would seem that they could offer higher rates of interest. The present spread between the 10 per cent charged borrowers and the 4 per cent or so paid to depositors is too large, and would seem to indicate either excessive profits for the banks or great inefficiency in the handling of the banking operations. In few other industrialized nations does the margin absorbed by the expenses of bank operation come anywhere near this figure. If banks want to expand their role in the economy, they should bring the cost of their services down to a point more nearly in line with what they are wroth.
In short, it is recommended that interest of whatever kind be included in individual incomes in full for tax purposes. With the revision in the rates that is contemplated, the existing provision for an optional 60 per cent flat rate will become a dead letter, but it should be completely repealed in any case, as it has no place in a tax on the consolidated net income of individuals. As an administrative device, the 20 per cent withholding on interest payments may well be maintined, but, if so, this should be with the clear understanding that the individuals from whom this tax is withheld are to be able to credit this withheld tax against the tax as computed by them on their entire income. However, individuals who are taxable only at the 20 per cent rate applicable to the first 50,000 yen over the exemptions may be excused from reporting their interest income on which the tax has already been withheld. Of course, no credit for the withheld tax will be granted unless the interest is included in the taxable income.
E. Special Deductions.
Deduction for the physically Incapacitated.
Certain individuals are so physically handicapped that their cost of subsistence is considerably greater than for persons enjoying the full use of all their faculties. To the extent that this can be done without introducing undue administrative difficulties, it would e desirable to grant some extra allowance to such persons as a moderate concession to this extra cost of subsistence. Accordingly it is recommended that for blind persons an extra personal exemption of 12,000 yen be allowed. This deduction may be treated in withholding and similar tables as an extra dependent. This allowance might properly be made available either to the blind person himself or to the taxpayer claiming him as a dependent.
This exemption might also be extended by administrative regulation to other types of physical disability that can be clearly distinguished and that impose comparable burdens on the victim. In setting up such additional categories for this special exemption, care should be taken, especially at first, to avoid types of disability that involve many borderline cases, which are likely to be temporary, or which are fairly well taken care of through the deduction for extraordinary medical expenses. Indeed, it may be found best to stop at first with the blind, and make further extensions only after some experience has been gained with such a provision.
Deductions for Miscellaneous Losses.
There is in the present law a general provision permitting the tax authorities to abate the income tax of an individual if he has "badly lost his ability to pay because of calamities or other reasons". While the law directs that the relief to be granted in such cases be specified by regulation, the regulations appear to be equally vague. In general such a vague provision is undesirable, since on the one hand it gives opportunity for the exercise of favoritism, and on the other gives the taxpayer no definite basis for making a claim with any assurance of what the outcome will be. Indeed, the taxpayer may well feel that it is useless to press a claim for special consideration under such a provision, since all he will get will be a brush off. This is particularly likely to be true if any pressure is directly or indirectly being brought to bear on the tax office to increase its receipts.
The form of relief usually granted in the United States is to permit the deduction of certain individual losses, such as those from fire, theft, and the like. However, this has led to the practice of deducting a large number of petty items, which unduly encumbers the administration of the tax without producing any corresponding increase in equity. Accordingly, it is recommended that relief for taxpayer who have suffered losses be allowed by permitting the taxpayer to deduct such losses, but only to the extent that they exceed 10 per cent of his net income (as computed without the benefit of the loss deduction). This will give the taxpayer a definite claim and a definite abatement of tax that he can count on without having to petition the tax office for a special favor. At the same time the administration will not be bothered with claims for the deduction of petty amounts.
The above limitation on the deductibility of losses would apply only to personal losses. Losses incurred in connection with a trade or business would still be allowed to be deducted in full.
Medical Expenses.
Expensive illnesses also constitute an occasion in which the ability to pay of the taxpayer is seriously impaired, even though the medical expenses in such cases are not always considered an allowable deduction. Indeed, to allow the normal expenses of occasional medical attention as a deduction would be allowing a separate deduction for living expenses that are to be considered covered by the personal exemption, and would impose an undue burden on the administration of the tax.
But where these expenses are abnormally large, as for major operations, or long hospitalization, or care of such chronic diseases as infantile paralysis or tuberculosis, there is a substantial impairment of ability to pay, and such expenses may appropriately be allowed as a deduction. If the general limitation of the deduction of losses is applied, to the effect that such deductions will be allowed only to the extent that they exceed 10 per cent of income, the problem of barring the deduction of normal medical expenses will be largely met.
On the other hand it is necessary to place some limit on what may be deducted under the heading of medical expenses, lest wealthy taxpayers take undue advantage of this provision and attempt to deduct under this guise the expense of long stays at spas, vacation trips, and the like. Accordingly, a maximum limit on the amount of medical expenses that may be deducted in any one year is placed at 100,000 yen.
[# end of Chapter 5]