Japanese companies’ profits are severely understated

Japan’s stock market could see a sharp rise if the government cuts the depreciation allowances for companies in tax legislation, according to Andrew Smithers, economist and author of The Road to Recovery.

Earlier this week, Japan’s government announced plans to cut corporation tax to below 30% in several stages, starting next year.

The measure is part of Prime Minister Shinzo Abe’s plan to revive the Japanese economy, which includes the quantitative easing measures taken by the Bank of Japan.

Smithers said the government will have to make up for the loss in revenue caused by the cut in corporation tax by reducing allowances. In some cases, the generous depreciation allowances incentivise Japanese companies to publish lower profit figures, he argued.

“The published profits of Japanese companies, which include depreciation charges at the same rate as those allowed for tax purposes, greatly understate the true level of profits, unlike the situation in the US, where published profits overstate ‘true’ profits,” Smithers said in a recent note.

If the depreciation allowances were to be cut, companies’ reported earnings would increase, which would likely lead to “a sharp rise in the stock market,” he added.

Rising profits would also lead to an increase in wages and would allow corporate savings to decline, further boosting the economy, according to Smithers.

Economists at Bank of America Merrill Lynch recently calculated that Japan’s future economic growth will depend on the rate of participation of the country’s women to the workforce – something that will in turn depend on rising salaries.

Japan will also benefit from continued depreciation of its currency, as quantitative easing is set to continue, Smithers said.

He noted that economic growth – at 6.7% in the first quarter – was boosted by a rise in domestic consumption ahead of an increase in sales tax on April 1, a performance that is unlikely to be repeated in the second quarter.

“To offset this, the economy needs a boost from external demand through rising exports,” Smithers added.

Japan’s public debt is more than twice the size of its economy, so the country needs “a steady decline” in its fiscal deficit.

A fall in the corporate sector’s cash surplus, coupled with an increase in the current account surplus due to a weaker yen, would work towards achieving the cut in the fiscal gap, according to Smithers.