By Tetsushi Kajimoto and Shinichi Saoshiro
TOKYO (Reuters) - For corporate Japan, burdened by one of the industrialized world's steepest tax rates, a tax cut at the center of Prime Minister Shinzo Abe's latest growth strategy will end up giving with one hand - and taking back with the other.
While the headline tax rate will fall, Tokyo, under pressure to shore up its finances with a public debt twice its annual GDP, is seeking to offset the tax cut by scaling back exemptions and deductions favoring small and loss-making companies.
That regime - in which fewer than a third of firms shoulder the entire corporate tax burden - has been seen as essentially subsidizing inefficiency and punishing profitability.
"Corporate tax cuts and broadening the tax base would make Japan's taxation fairer and more stable, even though it would impose a burden on unprofitable companies that are not paying corporate tax, many of which are small and unlisted," said Hiroshi Watanabe, senior economist at SMBC Nikko Securities.
"If the government continues to levy high tax on profitable firms, that would drive more firms out of Japan."
The changes, part of the latest instalment of Abe's "Third Arrow" of growth-promoting structural reforms, will mean short-term pain for the 70 percent of Japanese firms that pay no corporate tax, especially among the small firms that employ seven out of 10 Japanese workers.
In other developed economies such as the United States and Britain, by contrast, more than half of firms pay corporate tax.
But in the longer term, the changes are expected to nurture more profitable firms, while it is hoped the lower tax rates will encourage foreign direct investment and capital spending to spur growth under the reflationary policies dubbed "Abenomics".
A number of foreign companies with Japan-listed units, including Oracle Corp
CARRYING FORWARD LOSSES
Abe's cabinet approved on June 24 the plan to cut Japan's corporate tax rate - among the highest in the world at above 35 percent - to less than 30 percent over several years.
Decisions on how to offset revenue losses and other details were deferred, but a government tax panel has issued proposals that included expanding taxation to companies with less capital, meaning that even loss-making firms will have to pay local corporate tax.
The panel also proposed changes to deferral provisions, which let companies carry forward losses to offset future taxes.
Those generous carry-forward provisions resulted, for example, in Toyota Motor Corp <7203.T> - one of Japan's most profitable manufacturers and its most valuable by market capitalization - paying no corporate tax for the five tax years from the onset of the global financial crisis in 2008.
The Ministry of Finance estimates that each percentage point of tax cuts would reduce government revenue by about 470 billion yen ($4.6 billion) a year. Cutting the tax rate below 30 percent would cost some 2.8 trillion yen in terms of lost revenue.
Nomura Securities estimates that a 6 percentage point cut in corporate tax could boost GDP by around 0.3 percent over time, although the effect would be smaller if revenue losses were financed by alternative sources.
"The immediate impact of the tax cut may be small. But in the long run, lower corporate tax rates would encourage foreign direct investment and boost cash flow at profitable firms and encourage them to raise capital spending and wages," said Minor Nogimori, economist at Nomura Securities.
Among the 34-member OECD economies - whose average rate is around 25 percent - Japan's corporate tax rate ranks second after the United States. In Britain, Germany and Canada, the rate is below 30 percent.
In Asia, China and South Korea impose a corporate tax around 25 percent and Singapore at 17 percent.
Some observers believe the effort to encourage foreign direct investment is coming just as Japanese small and medium size enterprises (SMEs) are looking attractive to foreign buyers.
"Many foreign companies want to buy mid-cap Japanese firms. We are at the crest of a good wave of interest, possibly the first and last," said Takashi Mitachi, Co-Chairman Japan at Boston Consulting Group.
"The 2011 Fukushima disaster was an unfortunate event, but the resulting supply chain disruption also showed the world that there are many lucrative SMEs in Japan that boast large global shares."
He added, however, that a tax cut would not be effective unless coupled with eased visa restrictions and steps to encourage entrepreneurship.
Broadening the tax base would be crucial for Abe to keep his aim of balancing the primary budget - excluding new bond sales and debt servicing - in fiscal 2020/21 to fix the public finances. Japan's public debt is twice the size of its $5 trillion economy, by far the highest in the industrialized world.
Analysts say the government should also find ways to spread out the corporate tax burden, which they say could help streamline businesses and sharpen competitiveness.
"If the corporate tax is imposed on loss-making firms, that would bring about a realignment of businesses and it could also encourage them to make better use of their capital to raise profits," Nogimori at Nomura Securities said. ($1 = 101.3700 Japanese Yen)
(Editing by Alex Richardson)