Japan is the country with by far the highest government debt to GDP ratio in the world. As this ratio is equal to around 250% one can ask what can be done to diminish it. One obvious and simple answer is increasing tax rates in order to generate higher government revenues. However, as an Japanese economist shows, this answer is not so straightforward as one has to take into account the “Laffer curve” effects of raising tax rates.

Using a neoclassical model described by Trabandt and Uhlig in their famous paper the author finds that the Laffer curves for labor and capital taxes in Japan have single peaks and that in case of the labor tax its rate is smaller than the peak. The capital tax rate is close to the peak or even greater than it. This would suggest that in order to maximize tax revenue the Japanese government should increase the labor tax rate and lower the capital tax rate. In case of the consumption tax rate there is no “Laffer curve” effect as the revenues from this tax are increasing monotonically with respect to the tax rate. However increasing the consumption tax rate influences the peaks of the Laffer curves for labor and capital tax by diminishing them. This in turn aggravates the problem of a too high capital tax rate. Therefore the author suggests that the optimal solution for the Japanese government is to increase the tax rate for consumption and lower it for capital.

The paper, which can be found here, shows in a nice way how the model described by Trabandt and Uhlig can be used for tax policy analyses and recommendations. It also shows that a straightforward solution (raising all tax rates in order to generate more tax revenues) isn't, as often the case, an optimal one.