Are Hikes in Compensation Eaten Up by Taxes?

The Myth of the Missing Millionaires, Part 4

Source: https://www.oecd.org/en/publications/2024/04/taxing-wages-2024_f869da31.html Note: See text for explanation

In a LinkedIn discussion about the supposed dearth of millionaires in Japan, one expatriate contributor blamed the entire situation on taxes, declaring, “I love getting a 4% salary increase and then having 90% of it get eaten by taxes.” I have no idea whether he really believed this story, even though no one has ever experienced anything close. The reality is that, for almost all Japanese earners, taxes are lower in Japan than in other OECD countries.

Consider the case of a married couple with one earner and two children. Suppose they have a gross salary equal to two and a half times the average wage. That’s ¥13.5 million ($142,000 PPP), enough to put them in the top 6% of Japanese adults. Let’s suppose it’s all labor income (investment income is taxed at a lower rate). (PPP stands for Purchasing Power Parity. It is the exchange rate at which X number of yen or euros buys the same amount of goods and services as $1. These days, the PPP exchange rate for Japan is ¥95/$.)

In Japan, your tax burden at this income level is 36%. In the typical OECD country, it’s 41%. Japan has the 25^th lowest rate among 31 OECD countries (see chart at the top). This includes all taxes on labor income: local and national income taxes, as well as taxes for old age pensions and healthcare.

Now, let’s see how much the tax man takes as you move from an average salary to true affluence.

Suppose you earn ¥5.4 million ($57,000 PPP), the average income of a married full-time worker with two children. Your total tax bill will be 22% in Japan but 25% in the typical OECD country.

Now, suppose your salary multiplies fivefold to ¥27 million ($284,000 PPP). That’s enough to put you in the top 2.5% of Japanese adults. Your tax bill will rise from 22% to 38% in Japan, but even more in the median OECD country: from 25% to 42%. Japan’s tax rate is the 19^th lowest.

In Japan, your post-tax income will have multiplied fourfold: from $44,300 to $176,000. Yes, that’s not as much as the fivefold hike in pre-tax income, but it’s far from the government taking away 90% of the hike, or even 70% as someone else asserted. Moreover, after paying those taxes, you’ll have $176,000 left over in Japan but only $164,000 in the OECD (see chart below).

Source: oe.cd/taxation-labour-capital from paper https://dx.doi.org/10.1787/04f8d936-en

Let’s take a closer look at how taxes in Japan rise as your income improves. For the lowest earners, taxes are substantially offset by cash benefits. This includes the flat 12.5% tax on social insurance (healthcare and old age pensions). Consequently, for those earning only half the average wage—not far from the poverty level—the net tax rate on labor income is just 6%. While I don’t have exact figures, I suspect this is entirely a portion of the flat tax on social insurance tax. For those earning average wages, net taxes take 14% of labor income. Finally, at 2.5 times the average, net taxes take 28%. Even though the tax rate rises, so does the post-tax income, and by a substantial amount (see chart below).

Source: OECD staffers graciously sent me this data via email.

It’s true that Japan has increased its income taxes on those earning 2.5 times the average salary; however, taxes in Japan still remain a bit lower than in the rest of the OECD (see chart below).

Source: OECD, which graciously sent me this data via email

Japan’s Top Tax Rate Is The Highest, But Few People Pay It

If all this is true, why, then, do many people complain about high taxes in Japan? One reason is that Japan’s top marginal income tax rate is the highest in the OECD: 56%. This consists of 45% at the national level and a flat 11% across prefectures and localities, regardless of the level of labor income.

In reality, virtually no one in Japan faces that rate, or anything close to it. The top rate kicks in when people’s taxable labor income reaches ¥40 million ($420,000 PPP). That’s almost eight times the average taxable wage. However, given all the deductions, it takes something like ¥50 million ($525,000 PPP) in gross salary to reach net taxable income of ¥40 million. Only 0.7% of Japanese adults earn that much or more. The 56% rate applies only to the portion of income exceeding ¥40 million. The first ¥40 million of taxable income is taxed at an average rate of 33%, and, given additional deductions, the amount exceeding ¥40 million is also charged at a rate less than 56%.

While other countries also have a high marginal tax rate, for most, that rate kicks in at a lower income level. Moreover, deductions vary from country to country. For those earning 20 times the average ($114 million PPP in Japan), just 7,500 taxpayers, the tax rate would be 51%, but only if it were all labor income. Admittedly, that would be higher than the OECD median tax rate: 46%. But very few in Japan pay that because the majority of their income stems from investments that are taxed at a flat rate of 20%. Let’s look at this next.

20% Tax on Capital Gains and Dividends

As income rises in Japan, all sorts of benefits kick in that make the effective tax rate much lower than the nominal statutory rate.

For one thing, social insurance taxes are capped. The 9.15% old age pension premium is only applied to labor income below ¥7.8 million ($82,000 PPP). Healthcare premiums—at 5%—are only charged on salaries below Y22.4 million ($235,000 PPP).

Secondly, all of the calculations I’ve discussed so far apply to someone whose income consists entirely of wages. By contrast, income stemming from stock market dividends, bank interest, or capital gains from stocks and real estate is taxed at a flat rate of only 20% (15% national and 5% local). The intent behind this tax break is to incentivize people to save and/or invest so as to increase business investment. The result can be a very sharp reduction in the tax bill, depending on how big a portion of one’s income comes from these sources. Meanwhile, owners of small and medium-sized businesses are charged 15% on the first ¥8 million ($84,000 PPP) of income and a flat 23% on all income exceeding that amount.

Japan’s 20% tax on dividends is the 21^st lowest in the OECD. The median is 26% (see chart below).

Note: Estonia and Latvia have no tax on dividends

The size of the tax reduction depends on the proportion of your income derived from these investment sources. The OECD calculated the difference in taxes between someone in Japan receiving 100% of their income from wages and someone receiving only half from salaries and the other half from dividends.

First, let’s consider someone earning three times the average income (¥16.2 million or $170,000), as shown in the chart above. Japan’s effective tax rate on the entire amount is 32% if it comes entirely from a salary, but just 23% if half of it comes from investments. Someone earning 20 times the average—¥108 million ($1.14 million PPP)—pays 51% if it all comes from wages but just 33% if half comes from dividends.

In other words, someone with income of $1 million per year, and half of that from dividends, pays more or less the same rate as someone earning only $170,000 if all of the latter’s income comes from a salary.

Across the OECD, those with higher incomes get an increasing share of their income from these low-taxed investment assets. In Japan, people earning ¥20 million ($210,000 PPP) per year—about 3.5% of adults—get 25% of their income from investments and/or ownership of a business. As income rises to ¥74 million ($788,000 PPP)—the top 210,000—they receive at least half of their income from investments, the same share as in the OECD’s example above. And those earning ¥115 million ($1.2 million PPP)—just 3,000 adults—get more than 70% of their income from investments and the like.

Consequently, in practice, Japan’s effective tax rate on all income peaks when someone reaches a gross income of ¥100 million ($1.05 million PPP) per year and then goes down. Only 10,000 adults in Japan take in that much per year. And they pay a lower tax rate than the rest of Japan’s 108 million adults. This is known as the “¥100 million wall” (see chart below).

Note: This refers only to national taxes, not local and prefectural taxes, nor social insurance premiums

Prime Minister Fumio Kishida talked for a few days about remedying the ¥100 million wall in the name of fairness. However, the stock market threw a brief temper tantrum, and Kishida quickly backed down. Shigeru Ishiba also discussed it when he was running to be head of the Liberal Democratic Party (LDP), but, once selected, he, too, dropped the idea.

Do Japanese Millionaires Need Such High Tax Breaks On Investment?

Only as incomes approach $1 million per year (PPP) do Japanese taxes surpass the typical OECD country, assuming people in both areas have half their income from wages and half from investment assets (see chart below).

Is Japan better off by giving such large tax breaks to people with an income of a million dollars a year or more? I don’t think so. As I’ve detailed many times, companies on the stock market rake in far more cash than they need to finance business investments. As a result, they don’t need to issue new equity to hike investment; on the contrary, they’re buying back shares en masse. So why should multimillionaires be given lavish incentives to invest in the market? I’d raise the tax rate on dividends and capital gains for Japan’s top few percent.

On the other hand, I’d make any necessary changes to ensure that the new NISA accounts are effective in luring the middle class to invest in these new tax-free stock market accounts. The purpose is for the bottom 90% to share some of the enormous profits that big corporations earn by suppressing wages. For one thing, this would boost consumer spending power. Secondly, if the middle class were invested in high-dividend investment trusts, it might help introduce more market discipline into the corporate world.

Conclusion

Here’s my conclusion from these four posts:

1) Japan does not suffer from a dearth of millionaires; the rise and fall in millionaires results from asset prices in the three lost decades

2) Japanese are not afraid to invest, but, due to taxes and other reasons, invest more in real estate than stocks

3) Low salaries for the highly-skilled not only make it harder for people to accumulate wealth, but also leave Japan starved of key occupations

4) The notion that Japan’s taxes block wealth-building is another myth

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