June 23 (Bloomberg) -- Japan's government may signal it will consider cutting corporate taxes in an effort to encourage more foreign investment into an economy expected to grow at the slowest pace in five years this year.

The government will review corporate taxes to help cut business costs, according to a draft of its economic and fiscal policy released last week. The final 2008 policy will probably be submitted to Prime Minister Yasuo Fukuda's Cabinet this month.

``The government recognizes the need to cut corporate tax to help improve Japan's competitiveness,'' said Mamoru Yamazaki, chief Japan economist at RBS Securities in Tokyo. ``It will be tough to get public support because a company tax cut would reduce revenue and require increasing sales or income tax.''

Fukuda's first economic policy statement as prime minister comes as foreign investors urge Japan allow more foreign investment. European Union Trade Commissioner Peter Mandelson said in April that Japan is the developed world's ``most closed'' market and needs to allow more investment from abroad.

The draft said the government will maintain its goal of balancing the budget by 2011, so that it can start reducing the public debt, which the Organization for Economic Cooperation and Development estimates stands at 182 percent of gross domestic product. To achieve this, the government needs to cut spending or find a way to increase revenue to fund social welfare costs.

Heizo Takenaka, economy minister under former Prime Minister Junichiro Koizumi, said in May that the government should lower corporate taxes by 10 to 15 percentage points to revitalize growth.

Tax Rate

Japan's effective corporate tax rate, which includes national and regional corporate taxes, is 40.7 percent, compared with 29.8 percent in Germany, 28 percent in the U.K., and 25 percent in China, according to the Finance Ministry.

A 5 percentage-point cut in Japan's corporate taxes would increase foreign direct investment by 12.7 percent in a year and add about 3.8 trillion yen to the economy over six years, according to Dai-Ichi Life Research Institute.

``Keeping the tax at this high level may prompt Japanese companies to go abroad while also making foreign companies stay away from Japan,'' said Toshihiro Nagahama, chief economist at Dai-Ichi Life in Tokyo.

The government will review the tax burden of companies and examine ways to broaden the tax base, the draft said. Only a third of companies pay corporate taxes in Japan, according to the OECD.

Broader Base

``There is considerable scope of base broadening,'' the OECD wrote in its April report on Japan. It said the drop in revenue from lower company tax would be limited by positive effects from increased investment and a larger corporate sector.

Foreign direct investment in Japan was about 3 percent of gross domestic product at the end of 2007, according to the Cabinet Office. The figure compared with 44.6 percent in England, 13.5 percent in the U.S. and 8.8 percent in South Korea.

Any policy concerning changes to taxation needs the approval of the ruling Liberal Democratic Party's tax panel. Members of the ruling LDP may block a tax cut, concerned it would be unpopular with voters after last July's Upper House election loss.

The government will also have to deal with opposition parties' objections to lowering corporate taxes because they control the upper chamber, said Naoki Minegishi, an economist at Shinkin Central Bank Research Institute in Tokyo.

``Even within the LDP, some legislators are advocating that the government try to boost economic growth first to boost tax revenue,'' Minegishi said on Bloomberg Television.

Lower Tax Revenue

Japan's tax revenue probably fell short of the government's 52.6 trillion yen ($488 billion) estimate last fiscal year as lower corporate profits reduced receipts, the Finance Ministry said this month.

``It's difficult to cut corporate taxes politically and economically when tax revenue is declining,'' said Susumu Kato, chief economist at Calyon Securities in Tokyo. ``It will lead to criticism that the tax burden is unfair if the government cuts corporate taxes and raises the sales tax instead.''

The government will also study ways of encouraging companies to bring home profit earned abroad and review rules restricting foreign investment on the grounds of national security, according to the draft of the policy.

South Korea's government said this month that it will cut corporate taxes and expand tax breaks for companies investing in research and development to spur economic growth. The U.K. and Germany also cut corporate taxes this year.

``People need to understand that if corporate taxes aren't cut, Japan will sink,'' said Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo. ``Japan should cut the taxes to the lower end of the 30 percent level.''

To contact the reporter on this story: Keiko Ujikane in Tokyo at kujikane@bloomberg.net

Last Updated: June 23, 2008 02:29 EDT