Playing Japan, if you annex all those occupied Chinese cities the happiness actually increases slightly, although it does bump the clip levels to get great people and the next SP level (which is way far away anyway). Now why would the happiness increase? You would think it would go down, unless all the existing buildings are not being recognized in that strange-puppet state. Those cities are indeed puppets, and not in a state of revolt as when just conquered, yet not producing anything. So I think you could set them to annexed and I guess the player would need to set them all to build courthouses.
I agree it is somewhat of a cake walk for Japan into China, although a very nice test of tactical combined arms to do it efficiently without losing any pieces. Plus, once I took Wuxi China capitulated and gave me all cities except Chongqing plus a bunch of other goodies. That's not historical at all ... but I doubt there is any way to set the AI to fight on at all costs. Obviously, the military AI leaves a lot t be desired, which makes scenario building difficult.
One other little detail on playing Japan ... why does South Africa appear as the only initially known CS and it's in a state of war? Given its distance wouldn't it be better to leave that one out and have the only initial contacts be Russia and China?