The Last Life Boat.

• Author: NARAYANAN, KRISHNAMURTHY
• Position: Tax reform in Japan - Brief Article

Having tried everything else, it's time Japanese strategists call for a tax holiday on new investment profits.

Considerable debate has been devoted to what Japan should do to dispel its current economic malaise and resume growth. Few policymakers, though, ever consider the most obvious and potentially effective solution: an aggressive variant of the classic Investment Tax Credit to prompt an investment boom.

There are four main culprits behind Japan's economic problems. First, despite zero nominal interest rates, real borrowing costs for smaller and weaker companies are still too high, thanks to the banking system's post-bubble loan problems. Second, Japan's aging population and repeated ineffective fiscal remedies have caused the government's finances to deteriorate significantly. Third, Japan's business framework overwhelmingly reflects a post-war focus on manufacturing exports, something that can no longer drive growth. Fourth, even cash-rich companies are unwilling to invest locally because poor economic performance during the last several years has unleashed significant deflationary forces.

Japan's short-term priority should be to generate a reasonable level of growth to boost employment and consumer confidence. The government should declare a tax holiday for profits from all new investment (in excess of normal depreciation) undertaken by the corporate sector during the next three years, the duration of which could be ten years from the investment's initiation.

Notice that this proposal is for a tax exemption on future profits on new investment that might not have been undertaken otherwise. Thus, the credit's effect on Japan's current and future deficit should be minimal. Second, the beneficiaries of this measure should be the stronger private sector companies that have the least default risk. Many of these firms are among the world's most admired and are more efficient at capital allocation than Japanese government. Further, the tax break would not be effective unless the new investment generates positive returns. In a zero-rate environment, this would be truly "efficient." Finally, the measure is consistent with reducing Japan's investment-savings imbalance and maintaining a strong yen. Accordingly, Japan's trading partners should welcome it.

The superiority of this proposed policy change becomes more apparent when compared to the most frequently suggested alternatives.

The first is the classic fiscal stimulus in which deep and...