The Path to Higher Growth: Does Revamping Japan's Dual Labor Market Matter?

Giovanni GANELLI

This presentation is based on a working paper that I wrote with my colleague Chie Aoyagi and does not necessarily reflect IMF's views. A dramatic increase in the size of the dual labor market, especially over the last two decades, has been observed in Japan. While some workers belong to the Japanese lifetime employment system, others are non-regular workers, who, in comparison, have a lower level of employment protection, career prospects, access to training, benefits, and so on. A number of microeconomic and cross-country studies have shown that an excessive reliance on non-regular workers can reduce productivity. In this regard, two channels elucidated by studies—training and effort—will be discussed later. This background, which could lead to a negative impact on growth, should be considered in light of the three arrows of Abenomics. How can this duality be reduced?

As for the methodological approach, we used cross-country regressions for a panel of Organisation for Economic Co-operation and Development (OECD) countries, and a proxy of labor market duality as the dependent variable. The attempt was to try to explain variations in this dependent variable which measures labor market duality. The main result was that the key to reducing duality is to reduce the degree of difference between regular and non-regular workers in terms of employment protection.

The main policy implication to draw from this paper is that a new form of contract should be considered. In the new framework, there should be slightly more employment protection for non-regular workers and slightly less for regular workers.

Concerning the trend in the Japanese dual labor market, the share of non-regular workers in the number of total employed has been rising dramatically. It now stands at 35% compared to around 20% before the burst of the economic bubble in the early 1990s. In other words, more than one-third of workers are non-regular, and slightly less than two-thirds are part of the so-called lifetime employment system.

In Japan, regular workers are defined not so much on legal grounds but more so in terms of their relationship with their employer. A regular worker is one who works full-time, is hired directly by the company, and also has an open-ended contract. Workers who fail to meet one or more of these conditions are classified as non-regular workers, which comprise various categories. The largest such category is part-time workers, of which the majority are female workers. 70% of non-regular workers in Japan are women. The share of non-regular employment tends to increase for female employees especially from around the age of 30. However, the share of non-regular workers among non-married females is stable. There could be complementarity between reforming the dual labor market and increasing female labor participation.

There are some difficulties in looking at the size of the Japanese labor market in an international context. There is no international consensus of the definition of non-regular work. The share of temporary workers is an imperfect proxy of non-regular workers because although all temporary workers are non-regular, not all non-regular workers are necessarily in temporary employment. In comparison, the size of the market duality in Japan is already higher than that of the OECD average, but this is somewhat of an underestimation. The definition of temporary work in Japan only includes contracts of up to one year. In European countries, on the other hand, and, in fact, in the Eurostat definition of temporary work, it includes contracts of any length. A comparison using a more consistent definition would then find Japan to have an even higher level of duality compared to other OECD countries.

As for the costs and benefits of labor market duality, first, reliance on non-regular work is not all bad. Benefits include the possibility of satisfying demand for non-regular work by certain workers, because of the attractiveness of options such as flexible working hours and other work arrangements. This can bring new voluntary non-regular workers into the labor force. Another advantage is that it can contribute to keeping overall unemployment low. Even after the Lehman Brothers collapse, unemployment remained remarkably low in Japan, marking 5% at the height of the global crisis compared to the OECD average of 8%. As for costs, considering training, the first of the two previously mentioned channels, there is evidence that in countries with duality, companies tend to train non-regular workers less than regular workers. Micro-evidence based on Japanese-firm data has confirmed this. As for the effort channel, according to survey data, a large percentage of non-regular workers are involuntary—they would prefer to be regular workers. It is conceivable that working involuntarily as a non-regular worker could reduce productivity. Firm-level studies confirm this.

In the context of Japan, there could be an additional, political-economic channel, which is that if growth is perceived to be shared unfairly within the society, support for other necessary structural reforms, such as deregulation in some sectors or trade liberalization, could be reduced, which again could lower growth.

Given the level of duality in Japan, the costs are likely to dominate, contributing to reducing growth. This is corroborated by looking at various sectors in Japan and their respective levels of share of non-regular workers and productivity. Sectors with a high share of non-regular employment, such as accommodation, wholesale and retail trade, and services, to some extent, tend to have a low level of productivity. Other studies have come to similar conclusions, including a highly detailed one that showed that the productivity slowdown in manufacturing in Spain was linked to excessive reliance on non-regular workers.

Given this background, what are the determinants of duality? In the panel data estimation, which was carried out on 17 countries and used annual data from 1995-2010 or less depending on availability, we used the share of temporary workers as the proxy of labor market duality (dependent variable). Explanatory variables included measurement of the Employment Protection for Regular (EPR) workers and measurement of the Employment Protection for Temporary (EPT) workers, and the OECD indexes of employment protection. Standard macro control variables such as employment and inflation levels were also used. Micro studies on Japan presented clues that foreign direct investment (FDI) outflows, female participation, and the share of employment in services could affect duality, thus these were included as explanatory variables as well. Spending on training was also thought to be a policy variable that could affect the level of duality.

The main findings were that increasing employment protection of regular workers tends to increase duality while increasing employment protection for non-regular workers including temporary workers tends to have the opposite effect. This is quite robust to various specifications and estimation techniques. As for policy implications, the main one should be to reduce the difference in the degree of employment protection between the two categories.

Scenarios were also built applying the results to Japan. For example, if the level of protection for regular workers was reduced from Japan's present level to that of Denmark or the United Kingdom, the first round effect of the reform could reduce the share of non-regular workers from the current 35% to around 30% or even less. A virtuous cycle could also be put in motion that would further reduce the duality. For example, a reform is implemented and manages to reduce duality to some extent, which, as productivity increases, stimulates growth. This growth in turn will reduce unemployment and help the country exit from deflation. Econometric results show that lower unemployment and higher inflation would further reduce duality, and the reduced duality would feed back to increase productivity, and so on. Our estimations might actually underestimate the impact of reforms because they do not take into account such second round effects.

From this analysis, our "first best" policy recommendation for a new framework which could reduce the degree of difference in employment protection between the two categories of workers, which has also been considered in the European context, is to offer a single open-ended contract to all new hires. Our policy suggestions for new contracts would apply only to new hires. Employment protection at the beginning of the tenure with the firm would be less, but protection would increase as they gain more seniority, reducing the marginal cost of converting non-regular workers to regular workers and finding an intermediate level of protection between the present protection afforded to non-regular workers and that to regular workers. No country has yet implemented this system, so how it would work in practice is still to be seen, and such a system would be difficult to implement in the short term (for example, it would require introducing a formal system of severance pay, which currently does not exist in Japan), but some simulations, including for Spain, have shown that it could be effective in reducing duality.

Another recommendation, which might be easier to implement in Japan, would be to encourage a wider use of the gentei-seishain (limited regular) type of contract which puts limitations on the content of the job while also reducing employment protection compared to regular workers and increasing it compared to non-regular workers. Our recommendation is to clarify the legal framework for gentei-seishain contracts in order to encourage a wider use of such contracts. This is also an official IMF recommendation since it was included in the last Article IV Report. Companies are reluctant to use this type of contract, thus a more clear legal framework could increase their use and help reduce duality.

Contract reform in Japan would require complementary reforms to facilitate its political and social acceptance. The complementary reforms themselves would also be beneficial and would help Japan to exit deflation. This would include a shift towards the "flexicurity" model, policies to encourage wage growth, and some changes in "soft institutions."

A shift towards "flexicurity" means that as contract reform results in less employment protection for regular workers, the model would change from the present lifetime employment system, which protects the job, to a system that focuses more on protecting the worker—giving them employment opportunities throughout their life. This brings about the need for a support system to help workers change jobs, support them during periods of temporary unemployment, and strengthen job matching and employment training programs. There appears to be room in Japan for an increase in unemployment benefits while reducing protection for regular workers, which will assist in the move towards flexicurity.

Looking at OECD data, real wage growth in Japan has been lagging productivity growth for 20 years. Higher wage growth would be important not only to exit deflation but also to encourage acceptance of reduced employment protection. We are in a crucial phase of Abenomics now that requires more private-led growth, therefore there might be a role for policies to encourage wage growth at this particular juncture.

As far as policies to realize increased wages in Japan, to exit deflation and complement the labor market reforms, the government is, to some extent, using measures such as moral suasion (the government requesting profit-making companies to increase wages) and tax incentives, though the latter have not been used much because many Japanese companies are not posting profits. Other possible policies include a framework of social concertation, which could be used to advocate for wage growth. Such framework would have the advantage of having an easy exit strategy: if wage growth picks up, the same framework could be used to advocate wage moderation. Another possible policy is a substantial minimum wage increase, since Japan's minimum wage is lower than that of other advanced countries. Some research has shown that increases in the minimum wage tend to increase average wages. Minimum wage hike policies can, however, have a negative effect on unemployment, particularly for certain categories of workers such as part-time non-regular workers, so such an increase would have to be calibrated carefully.

The final complementary reform, changing "soft institutions," means that if labor contracts are to be reformed to reduce employment protection for regular workers, some negative aspects of regular work should also be reformed, for example, regarding long working hours or lack of access to leave or job relocation. Some of this could be affected by policies, and others by voluntary changes in personnel and human resources practices. According to research presented a few months ago at a seminar at the University of Tokyo on the science of Japanese personnel management, in which Professor Tsuru participated in the panel discussion, one reason for Japan's long working hours is that relatively junior regular workers tend to signal their commitment to the company by working long hours. Researchers at that seminar discussed the need to find other ways to signal such commitment. Another reason for long working hours is that it is cheaper for Japanese companies to ask their existing workers to work overtime, rather than hiring additional workers, because overtime does not count toward bonuses.

To summarize, many studies have shown that there are substantial costs to labor market duality. In the case of labor market duality in Japan, the costs (loss of productivity, loss of growth) are likely to outweigh the benefits. Our empirical analysis suggests that one way to reduce duality and increase growth is to reduce the degree of difference in employment protection between regular and non-regular workers. Ways to implement this in practice include introducing a single open-ended contract and a wider use of gentei-seishain contracts. There must also be complementary reforms to facilitate acceptance of the changes in labor contracts including a shift towards flexicurity, policies to increase wages, and changes in "soft institutions." Revamping the labor market is important and should be part of a package of structural reforms in the three arrows of Abenomics.

Q1: If reducing the difference in protection means an increase in labor costs, this may encourage many companies to invest in foreign countries instead of Japan. It would be counterproductive to higher growth and the employment situation. What is your take?

Giovanni GANELLI
Equality in employment protection and flexibility in labor management are important. Reducing duality will increase productivity and will offset the wage increase burden on companies. Professor Kyoji Fukao of Hitotsubashi University presented a study showing that non-regular workers are 75% less productive than regular workers, but are paid proportionately more in terms of their output. If such workers become regular workers, not only will their wages increase, but also their productivity.

Q2: The measures you have mentioned for reducing duality in the labor market might be quite difficult among different parties. Are there examples in developed countries where duality was successfully reduced?

Giovanni GANELLI
Discussions have taken place in advanced countries, for example, Portugal and Italy, but it is still too early and the situations of these countries are different from that of Japan. Our first recommendation, a single open-ended contract, has not yet been implemented in any country, even though the European Commission is urging countries to go in that direction. Portugal decided that, rather than introducing contract reform, it would reduce the difference in severance pay between regular and non-regular workers. Italy, which is somewhat closer to Japan's situation in that there is no legal obligation to pay severance pay, has tried to encourage out-of-court settlements. Austria has managed to keep unemployment and duality low through measures such as portable notional accounts for workers to receive a set amount of severance pay. As far as changes in "soft institutions," there is the case of the Netherlands. As mentioned in one of Professor Tsuru's papers, workers in the Netherlands can choose between being part-time and full-time, and they can switch between them, so part-time work is no longer considered non-regular employment. This contributed to the country increasing its female labor participation.

TSURU Kotaro
As a supplementary explanation to severance payments and the singular contract, severance payments are monetary compensation for dismissal judged as unfair by the courts. There was heated debate in the Diet in the spring as to whether Japan should introduce compensation for dismissed workers. To introduce a singular contract, Japan needs to introduce a severance payment system, which is standard in other countries. We need a policy discussion on this matter.

Q3: Another problem is the declining working population. It must be strengthened by female participation and older workers. What impact would these measures you mentioned have on the improvement of the working population growth and on equalization concerning female and older workers?

Giovanni GANELLI
Structural reforms implemented as a package could increase potential growth including by counteracting the economic impact of the aging population. As far as female participation is concerned, increasing the availability of daycare centers and kindergartens will be important. My understanding is that the government has already budgeted for this. Deregulation of certain sectors could increase productivity and stimulate potential growth, and reforms of the financial system to facilitate a more market-based allocation of credit could help. The main idea is to increase the efficiency of the system, also through trade negotiations and participation in the Trans-Pacific Partnership (TPP), and increase the labor supply, partly by stimulating the level of participation of females. An increase in the pension age would also increase labor participation by older people. Another part of the package would be to slightly relax immigration requirements for certain areas where labor shortages are observed and where it is difficult for workers to immigrate, for example, in nursing or construction work. Reducing duality will contribute by increasing productivity.

Q4: Your regression results on employment protection are quite reasonable, but I am interested in the results for inflation and union density. The negative coefficient of inflation means that the first arrow of Abenomics is also good for the labor market, but the negative coefficient of union density suggests that increasing union density is also good for the labor market, or to reduce the duality of the labor market. What is the role of unions in tackling this issue?

Giovanni GANELLI
Some of the variables are policy variables. Others are institutional variables. The level of unionization is not a policy variable, so there is no recommendation on that. It is a free choice of Japanese workers to be members of unions or not. In order to control the effect of changes in policy variables, such as the level of employment protection, it is necessary to control for institutional variables, and this explains why the latter are also included in the regression. The negative coefficient of inflation could possibly result from people on the supply side being more motivated to look for regular jobs which have better pay if inflation rises. Then, there is the previously mentioned virtuous cycle.

Q5: In Japan, the labor union or groups of regular workers are very close to management. If the government attempts to introduce a policy to enhance protection for non-regular workers, the labor union or regular workers' groups would strongly oppose it, and executives would also be reluctant. What is your opinion of this unique Japanese situation?

Giovanni GANELLI
Our advice and recommendations are based on economic arguments and on what we believe is the best technical advice. This does not mean that we are blind to political economy problems. Reducing the difference in the degree of protection will reduce duality and be beneficial for the economy. Of course, there can be resistance; many arguments have been made about these recommendations. They should be introduced in the form of a package to increase acceptance and reduce resistance. Some of the negative aspects of regular work would also be reduced, and wages could also go up. To clarify, this would be applied to new hires, and not to existing workers. There would be many legal challenges and obstacles otherwise.

TSURU Kotaro
I agree that reducing the difference in the degree of employment protection between regular and non-regular workers would be key. However, how should that be accomplished? This year's new OECD data shows that the average employment protection index is 2.04, and, for Japan, it is 1.62. Japan is lower than the OECD average and 26th among the 34 OECD countries. As such, it is very difficult to say that Japan is very strict. Also, looking at the employee protection index for temporary workers, labor is very low, comparable to English-speaking countries. From this year, the Japanese government has introduced exit regulations for temporary workers. Contract workers with over five years of renewals have the option to be converted to permanent workers. It would be somewhat difficult to lower the level of protection for regular workers. I also mentioned and recommended lowering the differential of employment protection between the two categories, but how to do so is still a very important question.

Giovanni GANELLI
Yes, if you look only at the level of protection of regular workers in isolation, Japan doesn't particularly stand out. However, it's important to look at the differential. What is being recommended is not a massive increase or reduction in employment protection. An intermediate idea like the gentei-seishain could be a good way to go about introducing this. With the gentei-seishain contracts, protection is not decreased very much, and non-regular workers also gain more access to training. One objection I have heard is that some people are worried that gentei-seishain might just become one more category of non-regular work; but if this new category manages to successfully replace other non-regular contracts, then it will receive more positive reactions. Many European countries have a stronger level of protection, but there are differences. Portugal and Spain have very high duality. Also, for example, in Germany, it is very easy, compared to Japan, to make the transition from non-regular to regular work. According to the micro studies, the probability of transitioning to regular work in Japan is less than 10%, while in Germany, it is as high as 45%. Thus, looking at matters other than the level of protection is necessary.

Q6: Many Japanese companies have been forced to hire more non-regular workers due to harsh competition with low-wage countries like China, Korea, and those in Southeast Asia. In this situation, Japan's management cannot enhance its profitability or productivity. Management seems to be the main problem, particularly in the manufacturing sectors. What do you think about this?

Giovanni GANELLI
While it is true that companies have been paying a premium—some non-regular workers are paid more than their marginal productivity—in order to have flexibility, if these types of reforms are introduced, not only would wages increase but also would productivity. It is a matter of maintaining flexibility in labor management and increasing productivity.

TSURU Kotaro
As for limited-type regular workers, this issue is being discussed in a study group of the Ministry of Health, Labour and Welfare. I am a member of the Council for Regulatory Reform, and we will make a proposal to this study group to enhance the share of regular workers. It will be important for the job to be described well in the contract and for there to be exchange between limited-type and unlimited-type regular workers within the same company. We should introduce guidelines to support or increase such types of exchange. Balanced treatment between the two types of workers is also essential. Enhancing the use of limited-type regular workers in Japan is important.