Japan Inc. is getting its groove back. An overlooked policy change could be a driver.
In recent months, Japanese companies have been posting a wave of positive data. Machinery orders — a key indicator of companies’ capital spending in the future — rose 12.6 percent on the year in August to the highest level in a decade, data Wednesday showed, much faster than forecast. Several analysts had expected orders to fall.
Meanwhile, corporate investment shot up last quarter to the fastest pace in over a decade as profits climbed 18 percent. Firms are planning to spend even more and business confidence is rising, according to the Bank of Japan’s Tankan survey.
All of the good news comes as manufacturing activity slows worldwide and the U.S.-China trade war delays investment. On Tuesday, the International Monetary Fund cut its outlook for the global economy. Japan must be doing something right.
Has Japan Inc. had a sudden change of heart, after years of pressure to loosen the purse strings and trim its heaps of cash? Or are corporations finally taking advantage of their next-to-nothing cost of capital?
Neither. A much more likely reason for the remarkable numbers from Japan’s industrial sector is Prime Minister Shinzo Abe’s tax-reform package that quietly kicked in this year. Unlike President Donald Trump’s straight-out tax cut, this is a credit or incentive.
Here’s how it works: Companies’ effective tax rate can drop to as low as 20 percent from 29.74 percent if they hike wages, train employees and boost “high quality” domestic investment in the “Internet of Things,” IT and automation. The policy also provides a special depreciation allowance for investing in related assets and facilities, with a minimum outlay of 50 million yen ($385,000). Meanwhile, a fixed-asset tax on new equipment will be waived.
It isn’t all carrots: Big firms can’t get the research-and-development credit if they don’t reinvest their profits. And the incentives are only available for three years, which explains the rush.
The relief comes at a time when governments globally have been slashing corporate taxes. Though the effective rate has ticked down over the last decade, Japanese companies have long endured one of the highest burdens in the world. Part of this is because Japan’s corporate-tax system is complicated and differs by a company’s size, income and location. That’s created distortions in investment and financial decisions.
Now Japan Inc. is reinvesting the cash it hopes to rake in — the primary basis of the tax breaks. That’s unlike peers in the U.S., which have shoveled their savings toward paying down debt, raising wages and bonuses, and ramping up stock buybacks. This likely explains the surge in capital spending, as corporations upgrade outdated equipment and attempt to take advantage of the reform while it lasts.
For one of Japan’s largest machinery companies, Keyence Corp., the effective tax rate has dropped around 6 percentage points over the last three years, while total research-and-development expenditure rose 16 percent last year (though it’s still low as a portion of sales). Operating profit per employee has risen, too.
At Fanuc Corp., the company that makes machines for almost every big factory floor, R&D as a portion of sales has risen to almost 7 percent and its effective tax rate is already close to 26 percent. Like other machinery companies, its returns on invested capital have climbed sharply over the last year.
There are even nascent signs of an uptick in labor productivity. An index for sectors including electrical parts and devices rose 7.8 percent and one for machinery rose around 5 percent in July on the year.
The Topix’s machinery index, meanwhile, is trading at 17 times its one-year forward price-earnings multiple — a 6 percent discount to its five-year average. Returns on equity are at a 13 percent premium.
If Abe’s tax breaks are in fact starting to work, investors should hope that companies ride the policy as long as possible. They should also keep an eye on those firms simply happy to grow their piles of cash.