Why Is Japan’s Consumption Tax So Low?

In April 2018, Angel Gurría, Secretary-General of the Organization for Economic Cooperation and Development, told Minister of Finance Aso Tarō, “Japan needs to raise its consumption tax rate in stages to around 19%, the average for OECD member nations.” Given the problems with public finances in Japan, why is Japan’s consumption tax rate less than the OECD average? In this report, I describe how the decision-making structure of Japanese politics has changed over time and unravel its process.

Income-Tax-Centered Policies

Before leaving a nation still exhibiting the scars of World War II, economist Carl Shoup(*1) described Japan’s tax system—long centered on indirect taxes—as “immature.”

Prior to World War II, tax policy in Japan centered on indirect revenue such as via the liquor tax. During the war years, the income tax was increased to raise war funds, becoming a central plank of the tax system. Since this made nominal income the unit of taxation, inflation bore down heavily on Japanese citizens after the war. Meanwhile, to curb inflation, the Allied occupation would not allow taxes to be lowered. This led the Ministry of Finance to introduce a turnover tax. This indirect levy on transactions at the stages of manufacture, wholesaling, and retailing invited fierce opposition from small and medium-sized enterprises, and it was withdrawn after a mere 18 months.

It was in this context that a mission led by Carl Shoup arrived in Japan to offer advice on taxation. The Shoup Mission recommended a fundamental overhaul that would place the income tax, a more modern form of taxation, at the center. The mission’s proposals were adopted nearly in full in the tax reforms of 1950. Shiozaki Jun,(*2) who was responsible for the turnover tax at the time and who later became director-general of the Tax Bureau, gradually came to recognize the superiority of an income tax that would contribute to the elimination of income differences. He has remarked that he learned the logic of democracy through the Shoup recommendations. They enabled income-tax-centered policies to take root at the Tax Bureau of the Ministry of Finance and established the direction for Japan’s postwar tax system.

Once the Allied occupation withdrew from Japan, the bureaucrats of the Tax Bureau gained authority over tax policy. The Tax Commission effectively controlled by the bureau became the highest decision-making body regarding the government’s reforms. While a value-added tax introduced by France in 1954 spread around the world, the Tax Bureau maintained its focus on income tax, and it adhered to an institutional philosophy of eliminating income differences through the adjustment of the progressive tax rate and of reducing the burden on citizens by lowering taxes. Even in the reforms of 1966, when a recession led to the issue of government bonds for the first time since World War II, the Ministry of Finance still chose to reduce income tax.

Adoption of Consumption Tax and the Age of Party-Led Tax Reform

A political realignment in 1955 gave rise to the dominance of a single party, and politicians representing special interests materialized in the Liberal Democratic Party. When the period of high economic growth ended, a politics of allocating benefits based on the natural increase of tax revenues became untenable, and such policies as tax exceptions, exemptions, and reductions gained importance. Around 1970, the LDP’s Research Commission on the Tax System began to mediate conflicts of interests between government ministries and industries and to influence the details of the tax system including exceptions and exemptions. A few members of the LDP leadership strengthened their political power to the point where the Prime Minister’s Office was simply sidestepped. In this manner, the LDP took leadership over tax policies from the Ministry of Finance. This change is epitomized by Yamanaka Sadanori,(*3) the reputed kingpin of the LDP’s tax commission, who is reported to have said that people like the prime minister who know nothing about taxes should just shut up.

Some of the criticisms that came to be heard were the unfairness of the income tax and the need for stable tax revenues in view of the regular issue of government bonds. In response, the Tax Bureau began to consider the use of indirect taxes. At that time these were a specific consumption tax assessed individually on such items as automobiles or liquor. The work of reforming the tax system ran into difficulties, however, when related business interests banded together and when politicians became involved, even when concerning a few items or a modest tax rate. As the bureaucrats of the Tax Bureau became tied up in responding to individual industries, they became more receptive to the idea of a general consumption tax that would assess a fixed rate on all products and services.

The Tax Bureau initially turned to the prime minister, who it sought to win over as opportunities arose. In this it succeeded, and the cabinet of Prime Minister Ōhira Masayoshi decided in January 1979 to aim for the introduction of a consumption tax in fiscal 1980. Prime Minister Nakasone Yasuhiro, strongly influenced by President Reagan’s tax reforms of 1985, developed an interest in fundamental tax reform, including the introduction of a general consumption tax. Both prime ministers, however, encountered strong opposition from voters, and both lost badly in elections: Prime Minister Ōhira in a House of Representatives election in 1979 and Prime Minister Nakasone in a House of Councillors by-election and in nationwide local elections in 1987. Consequently, the introduction of the consumption tax was abandoned.

Takeshita Noboru, who followed Nakasone as prime minister, viewed the introduction of a general consumption tax favorably. Yamanaka, who led the LDP’s tax commission and criticized Nakasone as ignorant about taxes, was open to such a tax. Yamanaka believed that Nakasone’s failure resulted from the opposition of small and medium-sized enterprises and the distribution industry. He held many hearings at the party tax commission attended by industry organizations, and he developed many tax exceptions for small and medium-sized enterprises, such as the temporary allowance of price cartels prohibited by the Antimonopoly Act. Gradually, business interests were pacified, and opposition weakened. On Christmas Eve of 1988, the Consumption Tax Act was finally passed. Even so, the LDP suffered a major loss in the House of Councillors election of the following year.

Prime Minister Takeshita Noboru in conversation with Yamanaka Sadanori (left), chair of the LDP’s Research Commission on the Tax System, on May 18, 1988, at the Prime Minister’s Office in Tokyo. The party tax commission adopted a tax reform plan that included the introduction of a 3% consumption tax in June. A related bill was passed in December and became law. (© Jiji)

The LDP’s tax commission remained powerful in subsequent years. In the first half of the 2000s, when Prime Minister Koizumi Jun’ichirō pushed for structural reforms, he left the discussion to the party tax commission and did not seek to assert leadership.

The Political History of the Consumption Tax

The Prime Minister’s Office Takes Control

“To ensure the success of Abenomics, I will postpone the increase of the consumption tax to 10% for 18 months and seek the will of the Japanese people,” stated Prime Minister Abe Shinzō in dissolving the House of Representatives in November 2014.

The dominance of a party institution in the formation of the government’s tax policies was a matter that repeatedly came into question. When the Democratic Party of Japan assumed political power in 2009, the party-level tax commission was abolished, and the development of policies returned to the Tax Commission of the Tax Bureau. While the DPJ administration was initially reluctant to raise the consumption tax rate, the sharp decline of tax revenues ensuing from a global financial crisis compelled the administration to change its policies.

Prime Minister Kan Naoto believed he could gain the understanding of voters if he made strengthening social security the reason for increasing the consumption tax and moved to do so. Yosano Kaoru, who was appointed Minister of State for Economic and Fiscal Policy in 2011, received the backing of the Ministry of Finance and put together a plan to raise the consumption tax in stages to 10% by fiscal 2015. With Prime Minister Kan providing his approval, tax reform proceeded under the leadership of the Prime Minister’s Office. Noda Yoshihiko, who followed Kan as prime minister, revived the party tax commission as a place to vent but continued to push for tax reform led by the Prime Minister’s Office.

The leaders of the LDP tax commission were supportive of these developments. The tax commission coordinated views within the LDP and accepted the DPJ proposal. This eventually led to a three-party agreement between the LDP, DPJ, and Kōmeitō to raise the consumption tax to 8% in April 2014 and to 10% in October 2015. A bill to increase the consumption tax was passed in August 2012 and became law.

The LDP returned to power the same year. The second Abe administration that was formed in December placed many bureaucrats from the Ministry of Economy, Trade, and Industry in positions in the Prime Minister’s Office. As he promoted Abenomics, Prime Minister Abe worried that a higher consumption tax would undermine the economy, and he did not show much interest in fulfilling the three-party agreement.

The increase of the consumption tax in April 2014 was finally approved by combining the increase with the reform of the corporate tax desired by the Ministry of Economy, Trade, and Industry. The Ministry of Finance negotiated with the Prime Minister’s Office and METI while the party tax commission was kept in the dark. The Ministry of Finance had forecast that GDP would still grow if the consumption tax was raised to 8%, a forecast it shared with Prime Minister Abe, but GDP actually recorded negative growth.

Becoming distrustful of the Ministry of Finance, Prime Minister Abe postponed the increase of the consumption tax scheduled for November 2014 and dissolved the House of Representatives. In this election, the ruling parties held on to nearly all their seats. Then, in June 2016, Abe announced that he would once more postpone the increase of the consumption tax by two and a half years.

These postponements of a higher consumption tax are said to have been led by the Prime Minister’s Office and METI bureaucrats. The Ministry of Finance and the party tax commission were left out of the decision-making process.(*4) While Abe did declare that he would raise the consumption tax as scheduled going into the general election of 2017, he also promised to use half of the revenue increase of more than ¥5 trillion from raising the consumption tax two percentage points for child support measures. Added revenues that were meant to pay back debt would be diverted toward policy expenditures. The restoration of sound public finances sought by the Ministry of Finance would be further delayed.

The Consumption Tax and the Future of Japanese Politics

The turnover tax’s failure and the Shoup recommendations delayed the introduction of a general consumption tax when tax policy was led by the bureaucracy. Once the Tax Bureau broke with income-centered policies, it came to believe it would be easier to raise the tax rate on a general consumption tax than on specific consumption taxes. However, political administrations eager to introduce a general consumption tax repeatedly lost elections. As a result, political circles came to be dominated by sentiment that considerable commitment was needed to take up the consumption tax. When special-interest politicians were at their peak, many of whom were elected from stable voting districts, they did at times reach decisions unpopular with voters. However, once the Prime Minister’s Office assumed leadership over tax policy, the prime minister as party leader had to make decisions with the entire party in mind.

That said, there is no denying that the Abe administration winning the general election of 2017 on a platform of raising the consumption tax, while modifying the use of added revenues, was a landmark event. Political winds may be shifting in Japan.

As the party tax commission lost influence within the LDP, the Kōmeitō, the coalition partner of the LDP, began to establish a strong presence. In raising the consumption tax to 10%, Prime Minister Abe decided to include a reduced tax rate for food, beverages, and newspaper subscriptions in consideration of the Kōmeitō. The Kōmeitō tends to view the consumption tax in relation to the low-income bracket, its support base. As long as the coalition government of the LDP and Kōmeitō continues, the trends within the Kōmeitō will deserve attention.

Whatever the case, changes in the center of gravity for consumption-tax decision making reflect changes in the center of gravity for Japanese politics as a whole. What was first led by bureaucrats in central government ministries and agencies moved to special-interest politicians and then to the Prime Minister’s Office. As long as this paradigm holds, the future of the consumption tax now lies in the hands of the Japanese leader.