Chapter 14
COMPLIANCE, ENFORCEMENT, AND APPEAL UNDER THE INCOME TAXES

Because the income tax is the most important single tax in the Japanese system, and because its sudden, recent emergence as a mass tax has raised in a few years problems that in other countries have developed more gradually over decades, it is appropriate that our report contain recommendations concerning its administration. Even so, we do not venture to submit specific suggestions on the organization of the tax offices or the proper relation of local to regional and national offices. Rather, we have studied the ways in which relations between taxpayer and tax administrator can be improved. The analysis covers both personal and corporation income tax.

The Goal System

Under pressure of the need to bring in revenue to meet a nationwide total of estimated yield from the income tax for a given fiscal year, the income tax administrators have developed what is known as the goal system. Its essential characteristic is that an estimate of income tax revenue for the forthcoming fiscal year is made for each local area covered by each tax office. In the fiscal year 1948-49 the local-area estimates were, on the whole, imposed from above. For 1949-50 they have been, in general, made first within each local area office, and adjusted later by conferences with the central-office officials so that the total of local-area estimates approximates the global estimate that the Tokyo office made at the time the budget bill was passed last spring.

In either case, the essential evil of the system remains: there are brought into existence estimates of what the tax will produce in a local area. Existence of such a figure in the mind of a tax office chief tends to produce a distortion in the administration of the income tax. Unless the temptation is strongly resisted, meeting the estimate tends to become a principal objective to the head of the area office and his attention may be diverted from the avoidance of over-assessment or under-assessment. The temptation is particularly strong as the end of the fiscal year approaches. If collections are behind the estimate for the local area in question, there is temptation to assess fairly heavily those taxpayers who are not stubborn and who happen to have the cash on hand, and to press for immediate payment. Once the end of the fiscal year was passed, and it was again twelve months before another local-area estimate had to be justified, the pressure of the goal is off, and the tax office is tempted to relax and not push so hard to collect the full tax from taxpayers who had somehow or other avoided making payment. That these pressures and temptations on the tax officials should be avoided is beyond question.

Both central and local tax offices of the national government should, in our opinion, refrain from making estimates, even for internal use, of what the income tax is going to yield in any sub-national area. No such estimates are made in the United States, for the income tax, nor are we aware of such technique in other countries, though it doubtless exists here and there. It is the distinction between a global, national total of estimated revenue from the tax and an estimate for a sub-national area that is of the heart of the problem.

It may be said that the income tax will not work without a goal system; that local-area estimates are essential to evaluate the efficiency of each office, and indeed just to get the money in. This may or may not be so; only experience can tell. Unfortunately, experience has already made it clear that the income tax will not work with a goal system. If it will not work without it, the income tax should be repealed. But we are of the opinion that it will work, if other factors, noted in the appendix to this report, are used instead to evaluate the performance of the local offices. And the revenue will come in if, but only if, the Japanese workers, business men, and farmers accept the income tax as something that they do not want to see fail.

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Declaration of Estimated Tax

The self-assessed income taxpayer is supposed to estimate his income, and his tax, for the current year, and pay one-third of it upon the filing of a return by June 30, a third by October 31, and the balance, corrected to reflect the tax on the actual income for the year, by January 31.

In practice, taxpayers tend to underpay, and make it up with a large payment in January, especially under pressure of reassessment. We recommend that each taxpayer be required to enter on his preliminary declarations a figure for income equal at least to his income for the preceding year, as then finally determined, and pay the tax installment on this amount. He could then be guaranteed against reassessment on the first two installments. Some necessary exceptions to this rule are given in the appendix.

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Withholding

Our questioning of taxpayers during our field trips convinced us that the employee is fully aware of his national income tax burden, even when he files no return, but pays only through the withholding system. But this awareness is limited to those cases where the pay envelope, or an accompanying slip of paper, states clearly what the gross pay is and what each deductions from pay are for, and how much they are. We recommend that every employer be required, under severe penalty in case of failure, to submit such a statement with each wage or salary payment. Otherwise, the income tax on wages and salaries will degenerate into an impersonal tax on payrolls, which would be the beginning of a disintegration of the personal income tax system. A number of other specific suggestions for withholding technique are made in the appendix,including a method for withholding from farmers, discussed further in the section below on farmers.

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Returns and Payment of Tax

The more important changes that need to be made in the filing of income tax returns and payment of the tax are three:

a. The tax return form for the small taxpayer should be simplified, by having fewer different kinds of computation for him to make and by using simpler language. We have already recommended (Chapter 4, Section B) that the allowance for dependents be computed in the same way as the personal exemption, partly for simplicity's sake. Each return should have a tax table on it, which the taxpayer could use to determine his tax if he wished to avoid computation.

b. Income tax returns should be made confidential (at present they are open to inspection to anyone, on payment of a small fee), but there should be posted for public inspection at each tax office a list of taxpayers with incomes of more than 250,000 yen, showing the amount of net income reported by each.

c. Tax offices should increase their efforts to keep their records current as to payments received from taxpayers, to avoid continued re-billing of taxpayers who have in fact already paid their tax.

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Assessment and Collection of Farm Income

Although farmers are listed in the self-assessed group of income taxpayers, in practice there is little self-assessment. The farmer's net income is estimated on the basis of standards set by the tax offices for various types of land within the area covered by the office. The farmers are expected to enter in their tax return a net income that corresponds to these standards. Any one farmer enters, therefore, not his actual net income for the year, nor even an average over the years for his farm, but an average for farms of a similar type in that area. But the essence of the personal income tax is that it takes account of individual differences. Consequently, we recommend that action be initiated at once to move away from standards and averages in computing the farm taxpayer's net income. This recommendation becomes still more important in view of our recommendation that the inhabitant's tax be strengthened, with increased reliance on the net income element in that tax (Chapter 11).

The payment of his income tax by the farmer should be adjusted more closely than it now is to the seasonal pattern of his income. Also, he should be relieved from elaborate return-making duties at the time when he is busy with the crops. To achieve these ends, we recommend that, if more than 70 percent of a farmer's estimated net income is from staple food crops and tobacco, he should not be required to file a return of estimated income (declaration), and should have a tentative estimated income tax, as computed by the tax office, withheld from the payments made to him for these staple crops and tobacco. For other farmers, the filing and payment dates should be changed to July 31, November 30, and February 28 in two-crop areas, and to November 30 and February 28 in one-crop areas

Coupled with this withholding procedure there should be a method of estimating the net income of farmers that would be based on actual production data for each farmer, in place of the averages now used. These and other data are already available in various offices outside the tax administration, and they should be used to the fullest extent possible.

Details of the recommended withholding system are given in an appendix to this report.

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Reassessment

The small and medium size business man -- shopkeeper, manufacturer, wholesaler, and so on -- is the storm center of reassessment. In practically all of the tax offices that we have examined, the vast majority of the income tax returns filed by the non-farm group of self-assessed taxpayers have been deemed inadequate by the tax officials. The amount reported as net income is marked up by the official, often by 50 percent or more, and not infrequently by more than 100 percent. This has been done commonly, or at least fairly often, without any current investigation of the taxpayer's premises or books, and without any explanation to him of how the reassessed amount was reached. This is not to say that overassessment occurs frequently. On the contrary, our impression is that, even after reassessment the net income of most of these taxpayers has still been understated. But the hasty, arbitrary-appearing method itself is a barrier to obtaining that taxpayer compliance without which a recourse to some such method is almost inevitable. It will take time to break out of this vicious circle, but we are of the opinion that it can be done, provided the recent reforms in the structure of the Japanese tax administration and the detailed suggestion in the appendix to this report are adopted.

The reforms in the structure of the administration include the establishment, in 1949, of the Tax Administration Agency in the Ministry of Finance, with direct supervisory powers over the Regional Bureaus, and, through them, over the local national-tax offices.

Among the detailed recommendations, we emphasize the necessity of changing the present rules governing the access of tax officials to bank records, to allow them to obtain much more information that is now at their disposal. The practice of holding bank accounts in fictitious or dummy names should be forbidden. Any effect that these new rules might have in causing taxpayers to hold bank notes rather than bank deposits would be largely transitional; and in any event, the economic consequences flowing from such a hoarding of bank notes can readily be offset by appropriate action by the Bank of Japan, and can hardly be serious, quantitatively, in any case. In particular, the result is not likely to be an appreciable decrease in saving, that is to say, an increase in consumption spending.

Compulsory registration of all corporate securities is another important reform that is needed for tax enforcement and that will have no ill effects in other fields. Bearer securities should no longer be permitted.

The use of standards -- external indicia like number of employees, or internal relations like the assumed percentage of net income to gross receipts -- must be steadily lessened, but only as taxpayer compliance in filing on a "blue form" progresses. Such filing would be permitted only to taxpayers who were keeping books in accordance with regulations prescribed by the Ministry of Finance. These taxpayers would be guaranteed that they would not be reassessed without examination by the tax official of the taxpayer's accounts.

A good deal of reassessment and litigation can probably be avoided if the tax administration will publish its interpretations of the substantive provisions of the tax laws. This can properly be done, however, only as the skill and experience of the tax administrators grows.

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Right of Taxpayer to Protest the Reassessment

The income taxpayer has two chief complaints against the present method of allowing him to protest a reassessment: first, he must pay the tax before he is allowed to appeal to a higher administrative agency or to the courts; and second, his protest is commonly made to the same tax official who made the reassessment and who is, therefore, (as the taxpayer sees it) not likely to listen sympathetically and disinterestedly.

Where a tax system is well establishment and functioning properly in a stabilized economy, the first rule is far too strict. Taxpayers should be able to protect themselves from improper or arbitrary action of examining agents by having the right to appeal without payment of the proposed tax where the reassessment is considered illegal or improper. The Government is adequately protected because taxpayers are required to pay, if the tax is finally determined to be correct, an interest rate that is slightly higher than the normal commercial rate. Also, appeal usually entails extra personal expense. In the United States, these have generally operated as a sufficiently deterrent force to prevent frivolous appeals. But those factors are not now present in Japan; in time they should exist. Until they do, however, it is necessary to continue the present procedure, which require the payment of the tax before an appeal is allowed to a higher administrative agency or to the courts. But the tax office should have the power to postpone payment in cases of genuine hardship. General allowance of appeals by taxpayers without payment of tax should be kept constantly in mind, however, as a long-range objective of the Japanese system.

If the taxpayer and the official who reassessed his return cannot agree, after informal conference, he should be allowed to carry his case to a special Conference Group within the tax office or attached to a prefectural group of national tax offices. Further appeal to a Conference Group in the Regional Tax Office should be allowed in certain cases. At present there is, in principle, a right of appeal to the Regional office, but our general impression is that few taxpayers have thought it worthwhile to press their cases this far.

Dissatisfaction with the present system has given rise to a number of proposals for citizens' committees to settle disputes between the taxpayer and the official who made the reassessment. If there could be no expectation of improvement within the tax office, such committees would be useful. The problem is, however, that once such committees are set up, there is no longer much pressure for improvement of the protest mechanism within the tax offices. The committees would tend to perpetuate the very difficulties that brought them into existence. And no matter how carefully they were chosen, they could never do as good a job in this highly technical field of income taxation as could a well developed system of Conference Groups. Moreover, there is always the danger that the committees might get into the hands of persons who would try to use them for their own ends. We, therefore, recommend that citizens' committees be not introduced into the system of income tax administration.

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Litigation

An absence of tax cases in the courts may be a good or a bad sign. It may mean that the laws are so carefully drawn and so meticulously observed, and that taxpayer and tax administrator are so reasonable in settling their differences, that there is no need for courts. But it may instead mean that the game is being played without any rules, or without any effective umpire, so that there are no technical disputes to bring into the courts. At the present time there are only about 150 income tax refund suits by taxpayers in the courts of all of Japan. There are still fewer cases of prosecution for tax evasion. These facts reflect more the second of the two possibilities noted above. But it is a reflection of the past rather than the present. Under the reformation of the tax administration that was put under way in the winter of 1948-49, there is no doubt that the number of tax cases will soon increase substantially. Especially vigorous action has been taken in recent months against large tax evaders.

The judicial system and the tax administration are not at present adequately equipped to handle this prospective amount of highly technical litigation. The Attorney General's Office and the tax administrators need to work out in more detail the way in which they will cooperate in handling the defense against suits by taxpayers. Development of machinery for the prosecution of tax evaders is much further along; it involves cooperation between the inspectors of the Regional Bureaus and special tax procurators. Specialized judicial tribunals, non-existent in Japan, will need to be set up in the not too distant future. One possibility is the creation of an exclusive jurisdiction for civil tax cases in a tax panel of the Tokyo High Court, the members of the panel travelling on circuit to other parts of the country at scheduled times. Or there might be tax panels in each of the High Courts. In either case there should be appeal by certiorari to the Supreme Court. Still better would be the creation of a new inferior court devoted solely to hearing tax cases brought by the taxpayer, with appeal to a tax panel of the Tokyo High Court and final appeal by certiorari to the Supreme Court. Details of these suggestions are given in an appendix to this report.

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Penalties

The present system of penalties under the income tax needs drastic revision. There are no penalties where there should be some, and certain penalties are far too heavy. Specifically, we recommend:

1. That failure to file a return on time should be subject to a penalty, probably 10 percent of the tax for each month that failure persists, up to the end of the third month. The penalty should not apply if failure to file is due to reasonable cause, not willful neglect. But the possibility of prosecuting the taxpayer for a criminal offense should also be provided for, if failure to file a return is due to willful neglect. At the present time, there appears to be no penalty at all for failure to file a return on time.

2. That the present penalty of 25 percent of the tax, for any failure to pay the tax on time, no matter how slight the delay, be lowered, and made to vary with the length of the delay.

3. That the present interest charges of approximately 31 percent and 71 percent a year on delinquent taxes be reduced, to the equivalent of 12 percent a year up to the time the tax office demands payment, and 24 percent a year thereafter. Interest rates as high as the present ones are self-defeating. They tend to make the taxpayer hopelessly delinquent within a short time. This is probably one reason for the large amount of delinquent tax now outstanding.

These recommendations are not intended as an exhaustive list of needed changes. More changes will doubtless be found necessary. Some of the possibilities are discussed in the appendix, together with the related problems of extension of time for payment, civil penalty for fraud, penalty for failure to keep books and records, and refund procedures.

The present tax delinquency situation is especially serious, and much effort needs to be devoted during the remainder of the present calendar year to eliminating the delinquent accounts.

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Simplification

The degree of success in the administration of tax laws bears a rather direct relation to the degree of simplification of these laws, ordinances, forms, and other matters that confront taxpayers. This is particularly true when the base of the income tax structure has been broadened to include millions of taxpayers. Many substantial changes to the Internal Revenue Code have been recommended in this report that will go far toward simplifying the law. Ordinances should be constantly reviewed to determine whether they also can be further simplified. The filing requirements, the forms, the tax tables should all be examined with a critical and constructive eye toward more and more simplification. It is believed that outside experts in advertising and public relations would prove extremely helpful in devising material that would simplify the task of the taxpayer. Sampling techniques of various types should be used to determine the degree to which the objective has been attained. There should never be any relaxation of efforts in this direction, because this is a task that is never completed.

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Personnel

At the present time Japan does not have adequately trained personnel in sufficient numbers in administration, national, prefectural, or local. The details of personnel recruitment and training lie outside the field of our study, but we point out that the recommendations made throughout this report will be greatly impaired in their usefulness unless continued and rapid improvement in tax personnel is achieved. If we did not think such improvement would occur, we would recommend an entirely different sort of tax system. Some opinions on matters of detail, which we have formed in the course of our visits to tax offices and discussions with taxpayers, are given in the appendix. Special attention should be paid to the newly organized Training Institutes, and to improvements in office procedure.

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The Role of Accounting

The development of the Certified Public Accountant in Japan is essential to the long-term success of the tax program that we recommend. There are very few such accountants in Japan today, but the newly enacted law regarding the qualifications of C. P. A.'s gives promise that more will be developed soon, provided high examination standards are upheld. We suggest that the recent amendment, which would allow public accountants of 15-years standing to qualify by taking a panel examination, be replaced by a requirement that they take the Special Examination now afforded to those currently practicing in this field. We urge that the status of the Review Council selected by the Finance Minister be changed to that of an independent commission under the general jurisdiction of the Ministry of Finance. We also urge that the Securities Exchange Commission exercise strongly its substantial powers to bring about an improvement in the accounting methods of business firms over which it has a degree of control in financial matters. Standards of accounting prescribed by this and similar administrative agencies in other countries of the world have signally contributed to the present high standards of accounting and of the accounting profession of those countries. It is therefore believed appropriate to recommend that the Security Exchange Commission be allotted sufficient funds to permit it to add to its staff certified public accountants on a full time basis. Efforts of the Security Exchange Commission to open regional offices and have certified public accountants n those offices should be encouraged to the utmost. A well-staffed accounting division of the Security Exchange Commission can make a substantial and effective contribution toward the goal of better administration of the income tax laws through the establishment of reasonable standards of accounting.

The tax law should be amended to require that all corporations and individual business returns over a certain income amount be accompanied by a balance sheet, profit and loss statement, and certain other data which should be certified by a C. P. A. Also returns showing a loss which the taxpayer wishes to carry forward or back might be required to be certified by a C. P. A.

The unincorporated non-farm business firm should be encouraged to keep books, through the "blue form" device, described earlier in this report. The Ministry of Finance should publish samples of the kinds of books that it requires the taxpayer to keep, if he is to be allowed to file a blue form, and should distribute these samples widely. A taxpayer filing on a blue form would not be reassessed without examination of his books; and, unlike other unincorporated taxpayers, he would be allowed to deduct depreciation in computing net profit (see Chapter 6, Section B).

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The Trade Association

Under the pressure of a greatly increased work load and the limitation of an inadequate number of trained personnel, many tax offices have become dependent on the so-called trade associations to collect and even to assess the income tax on the small shopkeepers, tea-house owners, and others who make up the membership of the associations. The associations bargain with the tax offices over the total amount the members shall be taxed, and even undertake to allot the total among the membership in accordance with standards that vary from one association to another, if indeed there are true standards at all.

We have endeavored to consider this institution sympathetically, in view of the important role the association is said to play in Japanese commercial life. We must conclude, however, that there is only one acceptable answer, and that is, the associations must refrain completely from taking any part in the taxing process. No such system can meet even elementary tests of equity; and the importance we attach to equity has been explained in Chapter 1. Often, indeed the result may be boss-domination and favoritism.

We therefore recommend that the tax law be amended to prohibit the associations or their officials from negotiating collectively with tax offices, national, prefectural, or local, from allocating any tax amount among their members, from submitting information to the tax offices which ranks their members for tax purposes or results in tax allocations among their members, or from filing returns or paying taxes on behalf of their members.

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Scholarly Interest In Taxation

Taxation in Japan will become more effective as the study of taxation acquires more prestige. For, as increasing numbers of keen-minded persons turn to the study of taxation, they will raise more and more important and challenging intellectual problems in this field. This remark applies to those who practice law and accounting, and also to those who teach and carry on research in the universities and in the government research departments.

The single most helpful step that the government can take to stimulate such study is to compile and release, regularly, a large amount of statistical data gathered from the tax returns -- not only income tax, but all others; and this remark applies not only to the national government but also to the prefectural and municipal governments. To this end, we recommend that the governments select members of their tax research and administration staffs to serve on a continuing committee with other interested persons staffs to serve on a continuing committee with other interested persons in the universities and elsewhere, to advise the governments on the kind and extent of the tabulations they should publish. Perhaps the newly formed taxation group consisting of academic, business, and government representatives could be helpful in initiating the work of such a committee.

An appendix to this report discusses some miscellaneous matters that are not included in the present summary: representation of taxpayers by Tax Practitioners and others; the publication of tax laws, regulations, rulings, and judicial decisions; and the growth of unofficial published material on taxation. As interest in tax technique spreads, the willingness to accept a vaguely defined tax administered on a rough estimating or negotiating basis will fade, and a modern tax system will have matured in Japan.

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