The Last Life Boat.

NARAYANAN, KRISHNAMURTHY

Having tried everything else, it's time Japanese strategists call for a tax holiday on new investment profits.

Considerable debate has been devoted to what Japan should do to dispel its current economic malaise and resume growth. Few policymakers, though, ever consider the most obvious and potentially effective solution: an aggressive variant of the classic Investment Tax Credit to prompt an investment boom.

There are four main culprits behind Japan's economic problems. First, despite zero nominal interest rates, real borrowing costs for smaller and weaker companies are still too high, thanks to the banking system's post-bubble loan problems. Second, Japan's aging population and repeated ineffective fiscal remedies have caused the government's finances to deteriorate significantly. Third, Japan's business framework overwhelmingly reflects a post-war focus on manufacturing exports, something that can no longer drive growth. Fourth, even cash-rich companies are unwilling to invest locally because poor economic performance during the last several years has unleashed significant deflationary forces.

Japan's short-term priority should be to generate a reasonable level of growth to boost employment and consumer confidence. The government should declare a tax holiday for profits from all new investment (in excess of normal depreciation) undertaken by the corporate sector during the next three years, the duration of which could be ten years from the investment's initiation.

Notice that this proposal is for a tax exemption on future profits on new investment that might not have been undertaken otherwise. Thus, the credit's effect on Japan's current and future deficit should be minimal. Second, the beneficiaries of this measure should be the stronger private sector companies that have the least default risk. Many of these firms are among the world's most admired and are more efficient at capital allocation than Japanese government. Further, the tax break would not be effective unless the new investment generates positive returns. In a zero-rate environment, this would be truly "efficient." Finally, the measure is consistent with reducing Japan's investment-savings imbalance and maintaining a strong yen. Accordingly, Japan's trading partners should welcome it.

The superiority of this proposed policy change becomes more apparent when compared to the most frequently suggested alternatives.

The first is the classic fiscal stimulus in which deep and lasting government tax-cuts or direct outlays are used to stimulate growth. This policy could be a short-term stabilizer, but it is not viable in the long run absent self-sustaining growth. Repeated government expenditures have caused deterioration in Japan's public finances and big distortions in domestic capital allocation.

Next, economist Paul Krugman and others have suggested that the Bank of Japan (BOJ) should print money, possibly by direct purchases of government bonds, to raise expectations of future inflation, thus driving real interest rates lower. With real interest rates low to negative, consumption and investment could be increased. The depreciation of the yen that might result could also serve to increase exports. Thus, virtually all effects would combine to create growth.

The Bank of Japan has been reluctant to pursue this solution, and with good reason. This is probably one of the most risky stimulative solutions because for it to work, the BOJ has to walk a tightrope. It has to be perceived as being sufficiently "irresponsible" to trigger inflationary expectations, but it cannot be so reckless as to permit a complete, destabilizing collapse in the yen. History is certainly not on the BOJ's side: Unfettered money creation is a recipe for capital flight and potential currency disaster.

The final alternative, supported most vocally by the investment community, is something akin to large-scale, U.S.-style restructuring that improves efficiency in the allocation and use of capital. While this may be essential in the long run, it is unlikely to deliver the short-term goal of stabilizing government finances and generating growth. This proposal amounts to requiring a sick person to run a marathon -- it is arduous even when well, and its benefits are questionable; but its near-term consequences are likely fatal.

One could argue that such proposed tax changes may be difficult to administer in the context of Japan's tax system. However, after its string of ineffective fiscal remedies, the additional bureaucracy necessary to manage this policy might be the best expenditure Japan's government could undertake today.

Krishnamurthy Narayanan is Chief Investment Officer at Trident Investment Management, LLC.