Japan: Silly Self Destructive Behavior
May 24, 2008
Our tale continues:
May 18, 2008: Japan: Tax Hikes are No
May 11, 2008: Japan: Now What Are We Going To Do?
April 21, 2008: Japan -- WTF is Going On Here?!?
April 13, 2008: This Is So Not Like Japan
Prime minister Obuchi actually had some haphazard but significant growth-boosting tax cut policies. At this point, the government was flailing around for anything at all that might work, even (gasp! horror!) cutting taxes. Temporarily of course -- because, for some reason, it was always believed by the bureaucrats and politicians that taxes were going to be raised to the moon, just as soon as the economy pulled itself together. Property-related taxes were lowered somewhat, and a 20% "temporary" tax discount was implemented. Basically, you got to the last line on your income tax form, and reduced the figure by 20%.
Koizumi made some interesting bureaucratic reforms, mostly related to government spending (especially public works spending financed by the postal savings system). None of this had much growth effect. However, by then the BOJ was implementing its "quantitative easing" policy, which was having some effect. Also, the dollar itself was beginning to decline in value. This allowed monetary conditions to become reflationary in Japan, and eventually inflationary, but in a pleasant way. Koizumi happened to be in office at the time, and enjoyed the benefits. Also, he promised not to raise taxes while in office, and kept his promise. Not very suprisingly, people wanted him to stay in office as long as possible.
Shinzo Abe followed Koizumi's departure in September 2006. Abe made some interesting moves toward a lower corporate tax rate, which encouraged investors. This trend has apparently fizzled out, however. Indeed, the situation for corporations has gotten somewhat worse. Something like 40 deductions and exemptions are being phased out, including the deduction for corporate entertainment spending. I judge this to be a more substantial change than it may appear. Japan's corporate tax system worked for many years, despite high headline tax rates, because it had been punched full of holes in the form of deductions, exemptions, rapid depreciation, etc. (In the 1950s and 1960s, it was intellectually fashionable to have high tax rates, and the Japanese leaders seemed to think that they should not be too much of an exception in this regard.) One such exemption was corporate entertainment spending. Upper income tax rates are quite high in Japan, hitting as high as 88% in the late 1980s. In addition, payroll-type taxes apply to all income earned, so the effective rate was over 90%. Not surprisingly, high level corporate executives never had very high salaries. They were effectively paid in perks, such as company-paid housing, company-paid transport, large numbers of beautiful young women about the office, and bottomless expense account budgets which in turn supported the incredible profusion of restaurants and clubs for which Japan's large cities are known. Top income tax rates have fallen somewhat since then. The top rate is now 50%, but that is after payroll taxes which now consume about 24% of income. MOF especially seems to regard the "loopholes" that were created to allow the economy to function despite high official rates as a diminution of their duly-earned largesse. Today, Japan has the highest effective corporate tax rates in the developed world. The U.S. official rate is also about 40% (higher than just about everyone in Europe), but careful tax planning has reduced the effective rate to 17% for the top 275 companies, according to one study. So, now it's the US that has punched its tax code full of holes, as is practically inevitable in a democracy with headline rates that are too high.
You will remember from our quick history sketch last week that the opposition parties, primarily the DPJ, have only gained significant popularity when they have proposed tax cuts against the LDP's tax hikes. The opposition won their first Upper House majority victory in 1989 on a platform of eliminating the brand-new consumption tax. In 1993, the opposition managed their first Lower House victory on a platform of tax cuts. Since then, the opposition has mumbled and grumbled about mostly pointless "reforms," most of which are actually not much different from those of the reformist wing of the LDP such as Koizumi.
The DPJ won its second Upper House victory in July 2007, on the basis of its policy of -- tax cuts! (The DPJ's withdraw-from-Iraq policy also helped.) Helllloooo politicians? Is this so hard to figure out? In December 2007 (the traditional season for planning the next year's tax changes), the DPJ laid out its (still not very impressive) plans. This is how the Nikkei Weekly described it:
The opposition DPJ came up with its own fiscal 2008 tax reform guidelines on Dec. 26. The guidelines made by the DPJ's tax research commission focus on cuts and differ markedly from the position of the ruling coalition. . . .
Tax breaks for capital gains and dividends are set to expire at the end of 2008 and March 31, 2009, respectively. The DPJ proposes restoring the original 20% tax on stock capital gains, while keeping the lower 10% rate on dividends as a way to encourage more individuals to buy stocks.
The ruling coalition seeks to effectively extend the 10% rates through the end of 2010 for capital gains of up to 5 million yen and for 1 million yen in dividends. . . .
Under the opposition party's fiscal 2008 guidelines, the consumption tax would be kept at 5%, with all its revenue used for financing basic pensions. . . .
While the guidelines state that proposals for tax cuts and hikes are still being assessed, the overall emphasis on lowering the tax burden is evident.
The newspaper also reported that: "The coalition is well aware that if a tax reform bill specifies a time frame for raising the consumption tax, the opposition will vote it down." Those LDP activists who wanted to bring down the corporate tax rate were apparently stymied by the inability to push through a consumption tax hike, as if one required the other. They thought it would be unpopular to lower taxes for corporations while raising them for consumers -- and they're right. A better solution would be to lower both corporate and individual income taxes.
I like to think that I was at least a little responsible for the recent interest, subdued as it is, in reducing the corporate tax burden in Japan. I pitched the tax-cut/growth solution to a reporter from Nikkei Business (the country's largest business magazine) back in 2002 or so. He got the idea right away, and Nikkei Business was soon promoting a 5% reduction in corporate taxes on their front cover. Also around 2002, I sent a series of faxes to government, business and media leaders, which illustrated both a) Japan's very high corporate tax rates compared to those throughout the developed world, and b) the tendency, especially in Europe, to lower those tax rates still further. This seems to be the only tax cut idea which has made any impression on the leadership in Japan.
After a recent tussle involving road-related taxes, prime minister Fukuda's approval rating dropped to 21%. Road-related taxes (on gasoline for example) are actually quite substantial, and are directed into road-building activities. Both political parties have talked about making this revenue part of the general budget, which would allow further reduction of the massive road-building pork orgy that has continued for some decades. So, who's next once Fukuda gets broomed? Kaoru Yosano is mentioned as a candidate to succeed Fukuda, supposedly under the "Koizumi reform" banner. However, Yosano looks like a committed tax-hiker, while Koizumi never was. Not only does he buy into the popular "raise consumption taxes to double-digit European levels" meme, he also wants to raise income tax rates to make the tax system more "progressive." The "supply side" idea that lower tax rates can lead to an improved economy and improved government finances has a few fans among politicians, but Yosano isn't one of them. "The claim that growth will bring in enormous amounts of revenue and solidify the nation's finances is a grand illusion," he said in February.
To make a long story short, the LDP has trended toward higher taxes, which is an economic mistake and also very unpopular with voters. The other parts of the "Koizumi" bureaucratic reforms, such as reducing the size of the public works pork fiesta, have been hugely popular. The DPJ has made some rather weak movements in opposition to the tax hike trend. The DPJ thus became the best monkey wrench around to throw into the LDP's tax-hike machine, and voters did so in 2007's Upper House election. As a result, movement has stopped somewhat, which is frustrating to some but overall a good thing. Most of the other reforms are not all that pressing, so if the whole parade is brought to a halt there is no real harm done. Avoiding harm done is the goal today.
Rather than going on and on with the convoluted details of policymaking in Japan, which is at least as depressing as policymaking in the U.S. or any other country, it might be best to end here with some suggestions:
Lower corporate taxes: Japan's corporate tax rates are the highest in the developed world, and reducing the various loopholes and exemptions that allowed companies to function under this oppressive system isn't exactly helping. Just step up and cut the rate to 20%. Make entertainment deductible again. I've argued that reinvestment of corporate cashflow is one of the primary sources of capital in an economy, and abundant capital tends to lead to economic abundance as well. Japanese leaders, back in the high growth days of the 1950s and 1960s, used to understand this very well -- keep the obstacles to capital accumulation LOW LOW LOW.
Lower income taxes: The top rate is 50% as it is, and that does not count the payroll taxes, which are effectively 23.9%. So, the real effective rate is more like 62%. That might be OK, if it was applied to income of something like $50 million. A better solution is to just cut the top income tax rate to about 35% or so. There is an easy way to cut both the corporate and income tax rates, and that is to eliminate prefecture-level income taxation, and replace it with some of the income from the consumption tax.
Lower capital-related taxes: Sometimes countries can function reasonably well, despite high taxes in some areas, if they have lower taxes elsewhere. The U.S. has about the highest capital-related taxes (capgains, dividends, interest, inheritance) in the developed world, which is one reason the U.S. economy is a bit sickly despite having lower income and sales-related taxes. Japan has always had low capital-related taxes, which helped things along despite high income taxes. In the 1980s, the last time the Japanese economy really worked properly, capital gains taxes on equities were zero. Dividend taxes were very high (taxed as regular income) but taxes on interest income were zero, which is why Japanese corporations tended to be heavily debt-capitalized and mysteriously not very profitable (as they took advantage of all the aforementioned exemptions, deductions, and accelerated depreciation). Property-related taxes, in particular, were much lower than they are today. An easy solution is to eliminate taxes on capital gains of all sorts (including property), eliminate taxes on dividends (paid at the corporate level), make taxes on interest income at low levels of 15% or less. No taxes on interest income would also be just fine, and seemed to work well in the past. Inheritance taxes have headed down somewhat, but this could head lower as well.
No consumption tax hikes: I am not too much of a critic of the consumption tax, as it is a relatively efficient tax, generating large amounts of revenue without too much economic distortion -- if the rate is maintained at 5%. I might even be OK with a 10% consumption tax, if matched with huge tax decreases elsewhere such as a total elimination of corporate taxation and a reduction of top income tax rates to 20% or so.
No more payroll tax hikes: Payroll taxes are scheduled to rise to the moon to finance retirees. The pension and medical care systems common in developed countries today are likely unsustainable in their present form. By demographic fact, Japan's government will have to deal with these issues a bit before other governments. The simple solution, it seems to me, is to decide on a level of taxation that is appropriate for a healthy economy, and then use the revenues from that tax in the most effective possible way. For example, someone could say: "Today's payroll tax is already very onerous. Further increases will be self-defeating, as they would lead to economic deterioration that makes it even more difficult to fund a cushy welfare state." Then, they would use the income from the tax -- whatever it may be -- as a budget for welfare programs. This gets out of the "entitlement" system. Japanese people, in general, are rather more psychologically hardy than their entitlement-addicted American counterparts, and would be willing to accept such a change, it seems to me. Actually, even retirees would be better off with such a change, as the ultimate benefits that can be provided by a healthy economy are greater than those that can be provided by an unhealthy one. The total "tax burden" in Japan is around 40%, compared to about 20% in the high-growth days of the 1960s. That "tax burden" isn't going to go much higher without serious negative consequences. What are they thinking: "All of our problems would be solved if we could just get that up to 50%."??? The politicians of the 1960s had a specific goal of keeping this "tax burden" below 20%, and cut tax rates whenever the "tax burden" threatened to rise above that level. They ended up cutting taxes every year. The result was an explosion of tax revenue.
We have a winner!
Since the late 1980s, the trend has been toward higher and higher tax rates. Has this produced any improvement in revenue? Combined with disastrous monetary deflation, the combination has produced stagnant and falling tax revenue. In fact, in nominal terms, the government's revenue today is about the same as it was in the late 1980s! That was twenty years ago! And before the introduction of the consumption tax.
Chart showing (pink line) central government expenditures, (blue line) tax revenues, and (green bars) government bond issuance, in trillions of yen. The first year in the chart is 1983, and the last is 2008 (estimate).
So, you see, when I talk about the Magic Formula, this is serious stuff.
Reduce public works expenditure drastically: The FY2008 budget is for 83 trillion yen. Of this, tax revenues contribute 54 trillion and deficit financing 25 trillion. On the expenses side, 20 trillion goes to debt financing, and 7 trillion to public works. However, there is 16 trillion of "local allocation tax grants," which matches a roughly equivalent amount of public works spending (15 trillion) on the local level. Thus, the total public works spending financed by the central government is more in the realm of 22 trillion. See here.
Twenty two trillion yen is a lot. That is more than the total revenue of the personal income tax (16.4 trillion), or the corporate tax (16.5 trillion). Can you imagine -- the entirety of all corporate taxation is funding public works waste? What if, instead of being destroyed in waste, that capital was reinvested in the private sector? That might actually be good for the economy. The stock market would have a big party.
Japan's voters have shown a preference for tax cuts and spending cuts. Why not give it to them? Reagan did, and he was the last Republican president worth a damn. Thatcher did, and she was the last Tory leader worth a damn. Both were very popular. Sure beats getting incinerated by proposing another consumption tax hike. Japanese politicians -- helllooooo?
If you add Stable Money to Low Taxes, the result would be very, very good.
* * *
Buy or Rent?
The New York Times says that prices have fallen enough that "buying is conceivable again." Oh really?
Now, these generalized price/rent ratios tend to be rather off. Often they are single family houses vs. three-bedroom apartments or something like that. This results in a price/rent ratio that is higher than you'd find on the ground. You really have to look at it on a specific-property basis. However, let's just assume that these numbers are correct.
Is "buying conceivable again" in New York City or San Francisco? The New York price/rent ratio is 22.2. San Francisco is 26.1. That means the rental yield for New York City is 1/22.2 or 4.5%. The 30-year fixed-rate mortgage is 5.85%. That's the best possible rate. Let's just assume you qualify. Including amortization, it works out to 7.1% per year in mortgage payments alone.
Let's put it another way. Your rent is $3,000. Your mortgage payment is $4,733. Then, there's the downpayment, PMI perhaps, insurance, property taxes, maintenance and capital replacements, and all that other stuff that goes into owning a house. All together, it probably comes to $7,000 a month or so.
When you own a place, it's like "renting it to yourself." OK, you're a landlord. You pay yourself $3,000 in rent, and then you pay $7,000 in property costs. You just lost $4,000 in a month's time. Rinse and repeat for the next 30 years.
The simple fact is, most people who pay $3,000 a month in rent can't pay $7,000 to own the same residence. They can't pay $7,000 under any conditions, because if they could, they would already be paying $7,000 in rent.
Here's a simple rule: when the total costs of owning a property (mortgage, insurance, taxes, maintenance) are equal or less than your rent, then you can "consider" buying it. The fact of the matter is, properties will probably get a lot cheaper than that. But, if you bought on that basis, you would probably do OK.
In the meantime, keep renting, and with the extra $4,000 a month you're saving, start piling up a down payment. Because, you're going to need 20% down.
Here's a little rundown showing what I mean. Your rent is $3,000 and your total costs of ownership are $7,000 including a $4,733 mortgage payment on a fully-amortized 30yr mortgage at the best possible rate. The numbers are annualized. Rent is assumed to rise at 3% a year. Historically, rent has risen roughly in line with inflation. The mortgage payment stays fixed. Non-mortgage costs also rise at 3% per year. The money you save by renting instead of owning is put into a bank account paying 3% per year, called Total Savings.
Notice that the cash costs of renting are cheaper every year until year 31, when the mortgage is fully paid off. Then, renting costs more than owning. However, at that time you've accumulated $2 million in your 3% savings account, which you can use to pay the difference between renting and owning. Actually, your savings account is so large at that point that it keeps getting bigger even when you make withdrawals to pay the rent! At year 50, you're still renting, and you have $2.8 million in your bank account. The homeowner has a house, which at 10x annual rent, is worth about $1.5 million.
Now let's look at what happens when you follow my advice, and buy when your total cash costs of ownership are equal to your rent. This is the way it normally is, because how are you going to pay more than you're paying for rent? You can't, and normally your banker is aware of this.
In the first year, the costs of ownership and the costs of renting are the same. However, over time, rent rises at 3% a year while your mortgage payment stays the same. Thus, there is a little savings from owning, which gets bigger each year. The total savings from owning is expressed in the final column as a negative number, which is the negative savings from renting. In Year 30, if you had taken the money you saved from owning instead of renting, and put it in the bank at 3%, you'd have a bank account worth $490,000, plus you would own your house free and clear. Then, after that, you aren't paying the mortgage anymore, so the cash costs of ownership are much lower than renting, and your accumulated savings really starts to rocket. At the end of fifty years, you own a house worth $1.5 million PLUS you have $2.7 million in the bank. Can you see why buying a house has worked out for so many people if they buy at the right price?