Anne O. Krueger

Takatoshi Ito

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: The Political Economy of Tax Reform, NBER-EASE Volume
1
Volume Author/Editor: Takatoshi Ito and Anne O. Krueger, editors
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-38667-8
Volume URL: http://www.nber.org/books/ito_92-2
Conference Date: June 14-16, 1990
Publication Date: January 1992
Chapter Title: Introduction to "The Political Economy of Tax Reform, NBER-EASE
Volume 1"
Chapter Author: Takatoshi Ito, Anne O. Krueger
Chapter URL: http://www.nber.org/chapters/c8510
Chapter pages in book: (p. 1 - 6)Introduction 
Takatoshi Ito and Anne 0.  Krueger 
The rapid emergence of  the East Asian region as an important geopolitical- 
economic entity has been one of the most visible and striking changes in the 
international economy. In that new role East Asia raises a number of issues of 
economic interdependence that call for considerable economic analysis and 
increased trans-Pacific understanding. 
For the world economy as a whole, there were two major themes of  the 
1980s. A first identifiable trend was growing interdependence among coun- 
tries, as communications and transportation continued to become quicker and 
cheaper. The growth in the volume of  world trade continues to outpace the 
growth in world output,  as exports and imports account for an increasing 
share of most countries’ GNPs. At the same time domestic firms are increas- 
ingly sensitive to events in the world as a whole: changes of  1 or 2 percentage 
points in costs, which before would have been buffered by  transport costs of 
20 or 30  percent of  factory price,  instead have been  reflected quickly and 
entirely through shifts in competitive position. 
The second trend, evident in most industrialized countries, was heightened 
sensitivity to the implications for economic efficiency, living standards, and 
growth of  incentives confronting individual producers. This was reflected in 
concerns with, inter aha, deregulation, removal of trade barriers, and changes 
in tax structure, as there was increasing recognition of the importance of  the 
effects of these on productivity and “international competitiveness.” 
All of  these concerns were reflected in the economic policy debates in East 
Asia and in the United States. Increased interdependence means that each in- 
dividual’s and each firm’s competitive position is affected by all of the circum- 
stances. When competitors are perceived to be producers in other countries, 
Takatoshi  Ito  is professor of  economics at Hitotsubashi University. Anne 0.  Krueger is  Arts 
and  Sciences Professor of  Economics at  Duke  University. Both are  research associates of the 
National Bureau of Economic Research. 
1 2  Takatoshi Ito and Anne 0.  Krueger 
concern focuses not only on what domestic economic policies are, but on how 
they position the individual relative to those foreign competitors. 
Because East Asia has been so successful in economic terms, attention has 
turned to that region of the world perhaps more than to any other. It seemed 
natural, therefore, to focus the first NBER-East  Asia Seminar on Economics 
on one such problem of interdependence and to investigate how the different 
countries addressed it: tax reform. 
Because of heightened concerns with incentive effects on the functioning of 
markets and for other reasons, all of the major countries of East Asia and the 
United States considered and undertook major tax reform programs during the 
1980s. Analysis of these programs is interesting in its own right. In addition, 
it sheds light on the ways in which interdependence interacts with domestic 
economic and political concerns in affecting issues as politically vital as tax 
reform. One of  the interesting findings to emerge from the conference was 
that,  in  all  countries,  international considerations had  become  secondary 
when domestic political interests were focused on issues of tax structure and 
reform. 
Part I contains two background papers. The first, by  Assaf Razin and Ef- 
raim Sadka, provides a theoretical basis for considering some of the important 
issues of  interdependence in tax policy. Razin and Sadka consider linkages 
between systems of  taxation and domestic capital formation in open econo- 
mies. They note that a great deal of  attention has been paid to the ways in 
which exchange rate management and monetary policy are affected by  inte- 
gration of  capital markets across countries, but that much less attention has 
been given to the effects of alternative tax structures in the presence of capital 
mobility. Investors may decide to invest abroad because of differences in tax 
structure (or in the enforcement of  taxation of foreign source income) when 
the economic rate of return is higher on domestic investment if the tax struc- 
ture  is  inappropriate. Razin  and  Sadka show how  these considerations are 
likely to affect not only tax structures but also governmental fiscal policies, as 
countries’ capital markets become increasingly integrated. 
In the second background paper, Vito Tanzi and Parthasarathi Shome pro- 
vide a survey of  taxation  structures in eight East Asian economies, Hong 
Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and 
Thailand, paying attention to similarities and differences among countries as 
well as to tax reforms. On the basis of their analysis, they conclude that dis- 
tortions in tax structure become important impediments to growth once mac- 
roeconomic stability has been  achieved; it is probably preferable to have a 
distortionary tax  that closes the fiscal deficit than to let the deficit persist. 
Interestingly, countries with macroeconomic instability included those with 
high and low levels of taxation: fiscal deficits were not necessarily associated 
with low levels of taxation. Once macroeconomic stability is achieved, Tanzi 
and Shome conclude that undertaking tax reforms that substitute other reve- 
nue sources (such as the value-added tax) for highly distortionary taxes (such 3  Introduction 
as customs duties and high rates of  income taxation) is worthwhile and can 
contribute significantly to growth. 
Part I1 contains four papers, on Japan, the United States, Korea, and Tai- 
wan. Each paper is designed to provide an analysis of the political-economic 
interactions that underlay the tax reforms undertaken in that country. Authors 
were requested to focus on both the economic considerations pertinent to the 
reforms in their countries, and the political factors that affected the outcome. 
An  interesting observation made at the conference is that domestic political 
considerations were such an important element that international issues hardly 
surfaced in any of  the four countries when decisions were being made. Of 
equal interest to conference participants was the extent to which the “politi- 
cal” considerations and behavior that apparently determined outcomes were 
similar in all four countries. 
The Japanese tax reform, analyzed by  Masaaki Homma, represents a ten- 
year struggle to introduce a value-added tax. The first attempt was made by 
Prime Minister Masayoshi Ohira in 1979. The effort was abandoned when the 
LDP was defeated in the next general election because of the tax reform issue. 
Opposition to  reform arose both  from distributors who believed  that  they 
would be forced to absorb the value-added tax and from consumers who be- 
lieved that distributors would pass it on to them (see also the discussion in 
Yukio Noguchi’s paper on the bases for opposition to the reform). The next 
attempt at introducing a value-added tax, then called a sales tax, was made by 
the Nakasone government in 1986 and also failed, again with serious political 
consequences. The third attempt, this time called a consumption tax, was in- 
troduced by the Takeshita government and won approval in 1988. However, 
the LDP was defeated in the next election. In  his paper, Homma traces the 
history of the tax reform effort and analyzes the differences between the three 
reform proposals. 
The American tax reform, analyzed by Charles McLure, had a very differ- 
ent history. It was believed to be politically impossible to remove a large num- 
ber of very inefficient exceptions, complications, and special treatments that 
had been introduced into the American tax code over a long time. In the early 
1980s, however, a group of technocrats was encouraged to start developing a 
tax reform package that would not change overall tax revenue but would sim- 
plify the tax structure. The technocrats were enabled to formulate their pro- 
posals without public scrutiny; once the proposals were public, the political 
appeal of  simplification turned tax reform from political suicide to political 
necessity. The ensuing simplification of the tax structure and reduction of the 
high marginal rate of income tax constituted in fact a very significant tax re- 
form. 
In contrast to the Japanese and American tax reforms, which were aimed at 
major changes in the structure of  taxation that would greatly reduce distor- 
tions emanating from the tax  structure, Taiwan’s  tax reform represented  a 
much  smaller effort.  The government introduced  a business  tax  in  1986, 4  Takatoshi Ito and Anne 0.  Krueger 
which was presented as improving economic efficiency and social equity of 
the tax system.  In fact, however,  Chuan Lin considers the  1986 reform an 
important building block for the future, as Taiwan continues to have high in- 
come tax rates applied to a small base  and high commodity taxes on a few 
items. The Taiwan reforms to date would thus appear to be much more partial 
than those of Japan and the United States. 
Among  the  four countries,  Korean tax reform  has progressed  least.  Al- 
though there have been a large number of changes in the tax code and in tax 
administration during the period of Korea’s rapid growth, Taewon Kwack and 
Kye-Sik  Lee show that the tax system remains highly distortionary. In part, 
the problem is one of tax administration and compliance, as the absence of a 
“real-name system” in Korea prevents the identification of holdings and thus 
the tracing of assets and income.  However, many of the tax changes to date 
have focused on the government’s  efforts to contain real  estate speculation 
through increasing taxes on holdings of land and real estate. Until the time of 
writing, these taxes had not had their intended  effect. Kwack and Lee con- 
clude that more fundamental reform of the tax system, to make it less distor- 
tionary, is a task that still remains for the Korean government. 
The tax reforms in the four countries (as in the eight surveyed by Tanzi and 
Shome) thus ranged from far-reaching attempts at simplification and unifica- 
tion of rates to more partial efforts to remedy particular problems. Taiwan and 
Korea are at earlier stages of their development than are Japan and the United 
States. Perhaps for that reason, they have still further to go in reforming the 
tax system. Interestingly, in light of the conference focus on the implications 
of  tax reform for interdependence,  it is significant  that in none of the four 
countries did issues of  interdependence have any political weight in the con- 
sideration of tax reform possibilities.  Even in the United States and Japan, 
domestic political concerns seem to have entirely dominated consideration of 
the issue. 
The final part of the volume contains papers on individual aspects of the 
linkages between tax structure, economic efficiency, growth, and interdepen- 
dence. Tatsuo Hatta  and Hideki  Nishioka  evaluate  the efficiency effects of 
changing  the  effective  marginal  capital  income  tax  rate  by  simulating the 
Nakasone-Takeshita reform. They estimate that the efficiency effect of elimi- 
nating the maruyu  (exemption of taxation  for interest income) was between 
-  0.2  percent and 0.9 percent of consumption wealth; in addition, the maruyu 
had constituted a major avenue for tax evasion. Tax reform therefore was eco- 
nomically efficient and closed an effective tax loophole. However, taxation of 
other sources of capital income was not reformed. If the marginal capital in- 
come tax rate had been reduced to the average, Hatta and Nishioka estimate 
that there could have been an efficiency gain of 0.77 and 1.69 percent of con- 
sumption wealth without any loss in tax revenue. 
Irene Trela and John Whalley analyze the linkages among the Korean tax 
structure, Korea’s outward orientation, and its rate of economic growth. They 5  Introduction 
show how the tax structure was modified over time to support Korea’s growth 
strategy, shifting away from taxation of exportables and toward other sources 
of  taxation as the growth orientation changed. They also develop a general 
equilibrium model with which to estimate the contribution of the tax structure 
to Korea’s growth rate.  Recognizing that tax structure is only one of  many 
contributors to growth, they nonetheless note that the model does capture the 
resource reallocation effects of shifting from import substitution to export pro- 
motion,  and conclude that  less than  10 percent  of growth,  or  1 percentage 
point of the growth rate, was contributed by the tax structure. 
Yukio Noguchi considers the impact on the Japanese need for savings, the 
aging population structure, and the tax reform. He notes that, despite the po- 
litical discussion, a major issue that went virtually unnoticed was the need to 
finance future social security expenditures as the Japanese population  ages. 
Noguchi  traces  the  implications of the aging population  for social security 
expenditures  in  the  coming  decades.  He shows that  tax  comparisons with 
other countries  currently  indicate that Japanese taxes are low,  but  that this 
finding is questionable when the younger age structure of the current Japanese 
population  is taken  into account.  In the  coming decades,  the  demographic 
structure of  Japan relative to other industrialized countries will change mark- 
edly. It is this phenomenon  that made a reform of  the Japanese tax  system 
essential: in years to come the number of working people relative to the num- 
ber of  pensioners will decline so much that raising adequate revenue through 
an income tax would require extremely high marginal rates. Noguchi notes 
that there are also macroeconomic implications of the changing demographic 
structure,  especially  on the likely level of national  savings and the current 
account balance, but he does not focus on those in the present paper. 
Thomas Barthold and Takatoshi Ito describe and contrast the gift and estate 
tax systems of the United States and Japan, and calculate the magnitudes of 
intergenerational  transfers  induced by  the two  systems.  Among the  several 
differences between the two systems, the chief are that (1) the American tax is 
based on the estate, while the Japanese tax is based on the size of the bequest 
to each individual; (2) land and real estate is valued at very low rates in Japa- 
nese bequests relative to its true value, whereas there is no such bias in Amer- 
ican taxation; and (3) spouses are entitled to receive an estate tax-free in the 
United States, whereas only half of the relatively large estate in Japan may be 
given to a spouse tax-free. Barthold and Ito show that three-quarters of Japa- 
nese taxable bequests consist of real estate, whereas only one-quarter of the 
value of American taxable bequests consists of real estate. 
The implications of tax policy for foreign investment  are important in all 
countries, but are often neglected. In his paper, Kun-Young Yun reviews the 
taxation of foreign capital in Korea and examines whether the tax system dis- 
torted resource allocation.  He calculated the effective tax rate for investment 
financed  with foreign  capital and concluded  that the overall  tax burden on 
foreign investors appeared to be reasonable.  Despite this, he regards the tax 6  Takatoshi Ito and Anne 0.  Krueger 
treatments provided  in the Foreign  Capital  Inducement Law as being “ex- 
tremely generous .” 
For Taiwan, Ching-huei Chang and Peter W.  H. Cheng consider the same 
issue. In Taiwan, tax rates for foreign investors have been about two-thirds of 
those confronting domestic owners, as the authorities have sought to encour- 
age foreign investment.  Chang and Cheng obtained  data covering both Tai- 
wanese and foreign-owned firms and attempted to estimate the impact of these 
special tax incentives on rates of return. They found that, for all manufactur- 
ing industries, tax incentives appeared to have no effect on firms’ net worth, 
with the exception of  the electronics industry. They conclude that further work 
needs to be  done before  their findings can be translated  into policy  terms, 
although they  note that, as the Taiwanese economy grows, the case against 
distorting treatment of capital from different sources grows stronger. 
Three conclusions emerge from these studies. First, there is a striking sim- 
ilarity in the tension between political considerations and good economics in 
the formation of tax policy in all the countries covered. The political economy 
of  tax reform  is not well understood,  and there  is much in common across 
countries. Second, consideration of tax policy in the individual countries has 
thus far proceeded with little attention to the implications of interdependence 
for its formulation and administration. There is clearly a lag between the fact 
of increased interdependence and recognition of it in ways that result in mod- 
ified policy discussions. Third, although the studies contained in this volume 
shed considerable light on the structures of taxation and their economic effects 
in the countries concerned, a great deal of work remains to be done to under- 
stand the effects of alternative tax structures on income distribution, resource 
allocation, and economic growth. We hope that the results reported here will 
stimulate further work on these issues. 

The Political Economy of Tax Reform, NBER-EASE Volume 1

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