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Supply-side tax reforms would spur business investment in high-tech industries that create jobs.

By Nicholas Benes　　Jan. 27, 2010 10:25 am ET

Tokyo

The warning Tuesday from Standard & Poor’s that it may cut Japan’s government credit rating is just the latest sign of growing unease about the country’s economic health. S&P noted in particular that a downgrade could come if “measures to boost medium-term growth are not forthcoming.”

Unfortunately, Tokyo doesn’t yet have an economic plan that will do that kind of boosting. The Democratic Party of Japan administration, in office for only a few months, has released the outline of a 10-year growth strategy, and the next fiscal year’s budget may include additional stimulus measures. But the DPJ’s approach to spurring growth is depressingly similar to the preceding Liberal Democratic Party’s methods.

Prime Minister Yukio Hatoyama and his DPJ government need to tackle the many hurdles that stand in the way of the businesses that can generate growth and a larger tax base: the businesses investing for the future. Instead of favoring certain industries like manufacturing exporters, green technology or health care, Tokyo should craft policies that will help a wide range of businesses. For just one example of how to do it, look at an arcane aspect of tax law that has a huge impact on investment flows in every industry: the tax-loss carry-forward period allowed for companies to recoup tax benefits on operating losses.

Tax-loss carry-forwards allow a company to deduct operating losses accrued in the early years of large investment from profits in future years. Imagine, for instance, a small biotech or pharmaceutical company developing a new drug. It may lose money during the years when it is carrying out expensive research and development, but will earn significant profits once the drug is launched. Tax-loss carry-forwards reward that investment by allowing the company to apply its R&D-induced loss to the first years of its profitability—subtracting the amount of the earlier loss from the subsequent profit so as to reduce taxable profits.

This doesn’t mean companies get off tax-free. They still pay payroll tax, and the employees they hire pay income taxes. They will pay corporate tax on all of their profits. The carry-forward just ensures equal tax treatment for companies that are not large and diversified and therefore lack other current profit sources that can “absorb” the loss immediately. Often such firms are venture businesses, growth firms or foreign companies—the type of companies that struggle the most in Japan today.

The time horizon matters. Emerging high-tech fields like biotechnology, pharmaceuticals or Internet businesses might take years of investment to turn their first profit. In industries ranging from insurance to retailing, it can take many years of huge investment and marketing expenses to build enough scale to turn profitable. Being in a low-growth developed economy lengthens the time before companies can expect to reap returns on their investments. The United States and Canada allow companies to carry forward operating losses for up to 20 years, while Britain, Ireland and Germany apply no cap at all or a very gradual phase-out.

Japan, however, allows companies to carry forward tax losses for only seven years. This made sense 40 or more years ago when Japan’s economic “miracle” was in full swing. In a fast-growth, low-cost developing economy, investments can start generating profits relatively quickly. Economies like China or Thailand are thriving despite tax-loss carry-forward periods as short as five years. But Japan’s old approach no longer works for many of the new industries and companies that it most needs.

While various Tokyo stimulus plans have purported to work toward business-friendly taxation, these have generally missed the point. Narrowly focused tax deductions and tax credits for selected industries either result in misallocation of resources (if policy makers favor an industry in which the country doesn’t have a natural competitive advantage), or just aren’t very effective. Special tax benefits mean little to a growth company, new entrant or any other firm that is still in the red, because the company is not paying any tax in that year, and may not for many more years.

Japanese businesses and foreign investors need genuine supply-side tax reforms that are applied across the board. Policy makers should also consider options such as making taxation of mergers and acquisitions less burdensome and more predictable. This would encourage badly needed consolidation and a more vibrant market for corporate control. Increasing the consumption tax rate from the present 5% would also have a beneficial supply-side impact, by stimulating price competition and accelerating the closure of marginal competitors that never pay corporate profit tax at all. Tax policies that were adequate for the Japan of the 1960s no longer work as well in the Japan of 2010.

The Ministry of Finance is dead-set against extending the tax-loss carry-forward period, or most other supply-side tax reforms. Bureaucrats and politicians alike worry too much about possible short-term revenue losses and not enough about the increased revenues that would come from a stronger economy. Only political leadership from Mr. Hatoyama and his cabinet will change this. For a government eager to distinguish itself from its predecessors, tax reforms that are truly stimulative and also expand the future tax base would be the perfect place to start.

Mr. Benes is president of JTP Corporation, which provides mergers and acquisitions advisory services in Japan.