Japanese tax and benefit system for working parents: marginal tax rates

Imagine a government giving subsidies to single parents that actually raise tax rates on overtime work. This is the case of a Japanese single parent who earns the approximate equivalent of US$39,981 and faces a marginal tax rate of 57%. With just a small raise of $599, she would face a marginal tax rate of 359%. A Japanese parent who benefits from a government program worth $5,123 could lose 100% of that benefit if they earn above the income threshold.

This is why the marginal tax wedge is relevant to understanding how workers might benefit (or not) from a wage increase once taxes kick in.

While the tax and benefit system may be successful in keeping low-income working households out of poverty and encouraging labor market participation, high marginal tax rates like the one seen in this Japanese working parent act as barriers to upward mobility, discouraging parents from advancing in their careers. Very often, these high rates are hidden in complex tax structures. However, a recently published study by the Archbridge Institute and the Tax Foundation highlights the underlying policies that drive the spikes in marginal tax rates that workers face in a number of countries.

When moving up the income ladder, a Japanese worker with children can face tax spikes of over 250% at two different levels due to child-raising allowance and child-raising allowance.

Japanese single parent with two children faces marginal tax rates (MTR) of over 250%
Japanese single parent with two children Average labor cost: 5,937,440 JPY (59,899 USD)
Total labor cost ¥4,571,829 ¥10,170,746
Net profit before increase ¥3,562,284 ¥6,778,705
Increase amount ¥59,374 ¥54,665
Amount of tax reduction/additional benefits due to the increase ¥213,227 ¥140,751
% of increase gobbled up by MTR 359.12% 257.48%
Net profit after increase ¥3,408,432 ¥6,692,619
Source: OECD, “Taxing Wages – Tax Wedge Decomposition”, https://stats.oecd.org/Index.aspx?DataSetCode=TXWDECOMP; OECD, “Taxing Wages – Comparative Tables”, https://stats.oecd.org/Index.aspx?DataSetCode=AWCOMP; and Tax Foundation calculations.

In 2021, the first peak in the marginal tax rate occurred at 77% of the average wage and around 88% of the median wage. If the employer of this Japanese worker increased his compensation by only 59,374 JPY, the worker suffered a net loss and saw his earnings reduced by 153,853 JPY. This Japanese relative faced a marginal tax wedge of 359% for a 1% increase in gross earnings on top of gross annual salary of JPY 3,963,097. Indeed, the parental education allowance, which is a benefit available to single parents, disappears from the income ceiling.

Moving up the earnings ladder, this worker faced a marginal tax wedge of 257% for a 1% increase in his gross earnings on top of the gross annual salary of JPY 8,904,101. This Japanese single parent faced a net loss and saw his income reduced by 86,086 JPY. This is due to child allowances being halved from 240,000 JPY to 120,000 JPY when the ceiling of 6,980,000 JPY is reached.

Child-raising allowance and child allowance generate marginal tax rate peaks of more than 250% when they reach the income ceiling. A gradual disappearance of these advantages would eliminate these tax peaks.

Additionally, a single-earner Japanese couple with two children faced marginal tax rates of over 100% at five different points due to child allowance, but also due to the local fixed standard tax. and spouse’s allowance.

As they move up the income scale, a single-earner Japanese couple with two children faces five MTR spikes of more than 100%
Single-income Japanese married couple with two children Average labor cost: 5,937,440 JPY (59,899 USD)
Total labor cost ¥3,087,469 ¥10,170,746 ¥12,302,681 ¥12,849,331 ¥13,395,981
Net profit before increase ¥2,496,730 ¥6,889,301 ¥8,091,945 ¥8,381,282 ¥8,663,965
Increase amount ¥59,374 ¥54,665 ¥54,665 ¥54,665 ¥54,665
Amount of tax reduction/additional benefits due to the increase ¥79,334 ¥140,751 ¥57,116 ¥63,772 ¥63,772
% of increase consumed by MTR 133.62% 257.48% 104.48% 116.66% 116.66%
Net profit after increase ¥2,476,770 ¥6,803,215 ¥8,089,493 ¥8,372,176 ¥8,654,858
Source: OECD, “Taxing Wages – Tax Wedge Decomposition”, https://stats.oecd.org/Index.aspx?DataSetCode=TXWDECOMP; OECD, “Taxing Wages – Comparative Tables”, https://stats.oecd.org/Index.aspx?DataSetCode=AWCOMP; and Tax Foundation calculations.

For this couple, the first peak in the marginal tax rate occurred at 52% of the average wage and around 60% of the median wage. If the employer of this Japanese worker increased his compensation by only 59,374 JPY, the worker suffered a net loss and saw his earnings reduced by 19,960 JPY. This Japanese couple faced a marginal tax wedge of 134% for a 1% increase in gross income on top of gross annual salary of JPY 2,676,377. Indeed, at this level of income, in addition to the local fixed standard tax of 5,000 JPY, a local income tax of 10% is due.

The second spike in marginal tax rates this Japanese couple faced was due to caps on child allowances, such as a single parent with two children.

Moving up the earnings ladder, this worker faced a marginal tax wedge of 104% for a 1% increase in his gross earnings on top of the gross annual salary of JPY 10,911,384. This Japanese couple with two children faced a net loss and saw their income reduced by 2,451 JPY.

This Japanese couple with two children faced two additional marginal tax wedges of 117% for a 1% increase in their gross income on top of gross annual salary of JPY 11,426,072 and JPY 11,940,760. These last three increases in the marginal tax wedge generated by the increase in income taxes are due to the gradual loss of the spouse’s allowance from one third of its initial amount until it is completely abolished. Therefore, a gradual reduction in the spouse’s allowance would significantly reduce these three peaks in marginal tax rates.

The tax and benefit system in Japan is extremely complex with many thresholds. In addition, the existence of different tax advantages and thresholds for single parents and single-earner couples generates a series of marginal tax rates that could keep some workers in Australia just below the income threshold that triggers the tax rate spikes. Removing these barriers through a more consistent tax and benefit system will allow workers to access higher wages without facing these barriers.

In addition, the different levels of income tax and the design of local income tax create a poverty trap for single-earner couples. In order to eliminate this poverty trap, the fixed standard local tax must be eliminated and regional and local income tax rates and thresholds must be aligned.

Two lessons from Finland

Japan could follow Finland’s example where central and local income taxes work together. In Finland, local income tax and central income tax are adjusted and well coordinated and do not generate peaks in marginal tax rates as described in Japan. Finland also offers a fixed family allowance independent of taxable income which prevents the formation of peaks in marginal tax rates such as those observed in Japan. Nevertheless, marginal tax rates above 50%, as seen in Finland, could discourage employment and labor supply. Even if marginal rates do not rise in a way that traps people in poverty, high marginal rates still have a direct impact on workers.

Finland. Marginal tax wedge for single parent with two children as percentage of labor cost by labor cost level in EUR

The loss of benefits that single parents and single-earner couples, especially in Japan, face when they accept overtime work may deter them from advancing in their careers, showing that the system of tax and benefit system is ineffective in promoting upward parental mobility. Japan’s tax and benefit system comes with trade-offs that policymakers should keep in mind when considering tax policy reform. In Japan, even parents close to the poverty line are affected by peaks in marginal tax rates. Therefore, redesigning some of these policies to generate a smoother variation in marginal tax rates across different income levels and household types would likely increase labor supply and encourage upward parental mobility. Japanese.

To note: This is part of a five-part blog series that sheds light on the findings of a recently published study by Archbridge Institute and Tax Foundation and explores the underlying policies that drive the spikes in marginal tax rates at which workers are submitted in a number of countries.

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