Japan's economic challenges

Japan's recent expansion is now under threat and more reforms are needed, but how?
Economics Department
Until 2002, Japan was mired in a prolonged period of stagnation–the “lost decade”–which saw its per capita income drop from the fifth highest in the OECD area in 1992 to only 19th in 2002. The miracle economy that mesmerised the world in the 1980s looked decidedly weak. Now, thanks to exports and business investment, Japan has achieved the longest expansion in its post-war history.
However, Japan’s expansion is now threatened by the turbulence in international financial markets that has reduced the prospects for growth across the entire OECD area. The impact on Japanese exports will be compounded by the trade-weighted appreciation of the yen by about 10% since mid-February. Some OECD countries are responding to the slower growth outlook with monetary and/or fiscal policy stimulus. However, there is much less scope in Japan for such a response.On the monetary side, the short-term interest rate is already close to zero at 0.5%, while the large budget deficit and high level of public debt rule out fiscal stimulus as an option. Indeed, Japan’s public debt has reached 170% of GDP, the highest ratio ever recorded in the OECD area.The government’s priority should be to balance its budget to stabilise and eventually reduce the debt ratio. As a first step, Japan should focus on achieving its target of a primary budget surplus for central and local governments combined by fiscal year 2011. There has been progress; the general government budget deficit has fallen from 8% of GDP in 2002 to less than 4% in 2007, thanks to buoyant tax revenues and cuts in expenditure, mostly in public investment.Clearly, balancing the budget will be difficult in the context of rapid population ageing, which tends to boost public expenditures on pensions and healthcare. Therefore, if Japan is to meet its fiscal objectives, the government will need to raise additional revenue. And the best way to do that is via a comprehensive tax reform package, the 2008 OECD Economic Survey of Japan recommends. In addition to boosting revenue, tax reform should be designed so as to help support economic growth, cope with widening income inequality and improve the complicated local tax system.Raising the consumption tax should be part of tax reform. Experience in OECD countries shows that indirect taxes have a less negative impact on growth than taxes on income. In fact, the consumption tax rate should really be the primary source of additional revenue. At 5%, Japan’s rate is the lowest among OECD countries that have a value-added tax, and thus could be raised. Personal and corporate income tax bases could be broadened by reducing deductions and tax expenditures. Indeed, less than half of wage income is taxed, while only one-third of firms pay corporate taxes.Japan’s corporate tax rate is the highest in the OECD area at 40%, and reducing it would help broaden the tax base. There has been a downward trend in the corporate tax rate in the OECD area in recent years, reducing the average to around 30%. A cut in Japan’s rate would likely give a boost to growth by attracting more international flows of capital to Japan and providing an incentive for firms to invest more. Other changes in the tax system to promote growth include removing features that distort the allocation of investment and discourage the full-time employment of second earners (usually women) in households.As for rising income inequality, this could be addressed though the tax system by the introduction of an Earned Income Tax Credit, an approach used in many OECD countries to provide support to low-income households while strengthening incentives to work.Although a well-designed tax reform could have a positive effect on Japan’s growth potential, the key for long-term growth is to increase labour productivity. The potential growth rate in Japan is estimated to be around 1.5%, the lowest in the OECD area, reflecting a large negative contribution from a declining working-age population. As the drag on economic growth from population ageing increases in the years to come, sustaining rising living standards will depend on accelerating labour productivity growth.Labour productivity per hour worked in Japan is 30% below the US level, so there is certainly room for faster growth. Manufacturing productivity is growing by around 4% a year, suggesting that reforms should focus on services, where productivity growth decelerated from 3.5% a year in the period 1976 to 1989 to only 0.9% between 1999 and 2004. click here for larger graphA comprehensive strategy is needed to promote competition by accelerating regulatory reform, strengthening the enforcement of competition policy by the Japan Fair Trade Commission and increasing international openness to trade and inward foreign direct investment. In addition, Japan’s special zone initiative, which allows local areas to act as a testing ground for reforms that can be later introduced at the national level, should be revitalised with a more nationwide focus. It is also essential to unlock potential in key service industries, such as the retail sector, energy, transport and business services.Another way to boost income levels is to raise labour force participation, which would help counter the impact of a declining working-age population. If the participation rate for each age cohort by gender remains at its 2005 level, the labour force would decline by one-fifth by 2030, based on the government’s population forecast. In contrast, if female participation rates were to rise to the current level of men by 2030, the decline in the labour force would be limited to around 6%.Increasing female participation requires a number of reforms. First, it is important to reduce labour market dualism between regular workers and non-regular workers, who are subject to precarious employment, lower wages and less coverage by social insurance systems; women account for two-thirds of non-regular workers. Second, regulatory reforms to increase the availability of childcare are needed. Third, improving work-life balance and encouraging more family-friendly work practices would raise participation while having a positive effect on the fertility rate.As the 2008 OECD Economic Survey of Japan argues, Japan must move ahead with reforms despite the difficult situation in the world economy. By acting on the many recommendations in the report, the strong recent economic performance could be sustained, helping Japan to face challenges like ageing and globalisation from a position of renewed strength.Reference
OECD (2008), OECD Economic Surveys: Japan, Paris.
See www.oecd.org/japan and www.oecdbookshop.org, ISBN 9789264043060©OECD Observer No 267 May-June 2008

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