Consumption tax was first introduced in Japan in 1989. The rate was successively raised to 10 per cent in 2019, accounting for 35 per cent of the government budget — both national and local. The consumption tax has remained significant and stable over business cycles but has been criticised by the public for many years, who note that it is not fair compared to the progressive income tax and puts a heavy burden on lower income households.
Still, the virtue of the consumption tax is its horizontal equity. One can hide their sources of income, but no one can escape the consumption tax burden. Equity becomes more critical in the context of Japan’s ageing society, where the income tax base from the working population is shrinking. In contrast, the consumption tax is broader, covering the increasing number of retired people who live on accumulated assets.
The government had initially compromised by making a generous exemption for small- and medium-sized enterprises (SMEs) with annual sales of less than 30 million yen. The ceiling was lowered to 10 million yen in 2004, though it remained high by international standards. In the value-added tax system, each firm is obliged to pay consumption tax for goods and services purchased from other firms after deducting the consumption tax paid by others.
The current scheme is unfair because tax-exempted SMEs still receive consumption tax from consumers or other firms that purchase goods and services through business transactions. To keep procedures simple, tax-exempted SMEs are also not required to keep invoices for consumption taxes and can record them through their own bookkeeping methods.
The traditional scheme is no longer sustainable, since multiple consumption tax rates were introduced for the first time in 2019 — 8 per cent on foods and beverages and 10 per cent on other categories.
The current reform is not intended to increase taxes as advocated, but to remove protection measures for SMEs. SMEs will have to choose to withdraw from non-exempt status by applying for a unique number from the tax authorities, in order to receive certificates to be attached to consumption tax invoices.
Alternatively, SMEs can stay in the traditional exempt status, though not as comfortably as before. It is unlikely that SMEs will continue to be paid the 10 per cent consumption tax from purchasing firms as they will no longer be able to deduct the consumption tax paid to the exempted firms without a certificate.
During the six year transitional period before the invoice system is fully implemented, tax authorities will accept 80 per cent of the consumption tax to exempt firms without the required certification in the first three years and 50 per cent in the following three years. The Japan Fair Trade Commission also warns of unfair business practices by firms who may refuse to pay the consumption tax to SMEs, despite official considerations being made to reduce the burden during the transitional period.
Qualified invoicing issuer rules need to be introduced to remove protections for SMEs, which had been implemented to counter strong objections to the consumption tax when it was first established. The reform makes the consumption tax system more transparent by clearly indicating the values of sales and expenses. As a result, it also better reflects the actual profits for small firms and makes relative improvements to corporate income tax collection, reducing the large gap in taxable incomes between SME owners and wage earners.
In Japanese politics, SMEs in both urban and rural areas are significant supporters of the ruling Liberal Democratic Party and its various policy measures for employment protection. The traditional practice of long-term employment protection also provides a good excuse for protecting SMEs, as a necessary step to prevent unemployment. But those policies negatively incentivise SMEs to stay below the thresholds for protection.
Japan’s tax reform is unpopular among those with a vested interest in the current tax scheme, but it is a necessary step to improve the performance and fairness of Japan’s tax system.
Naohiro Yashiro is a specially appointed professor of the Global Business Department at Showa Women’s University.