Special Zones for Structural Reform Contribute to Productivity Growth

MIYAGAWA Tsutomu Faculty Fellow, RIETI

Expansionary fiscal measures are coming under the spotlight as people begin to whisper about the limitations of monetary policy tools such as quantitative easing and negative interest rates. Overseas pundits are also calling for the use of fiscal policy to overcome secular stagnation accompanying a downward trend in the capitalization rate. Against this backdrop, the development of social infrastructure has become a policy issue in the United States as well as in advanced European countries.

In Japan, economists and other experts have had little discussion on the economic effects resulting from the utilization of fiscal policy, partly because of the persistent government fiscal deficit since the burst of the economic bubble. Thus, in this article, I would like to discuss the economic effects of fiscal policy based on findings from my research conducted jointly with Toyo University Professor Kazuyasu Kawasaki and Kazuma Edamura, a researcher at the National Institute of Science and Technology.

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To begin with, let us share the fact that the second Cabinet of Prime Minister Shinzo Abe, since its launch, has been implementing expansionary fiscal measures that are more aggressive than those observed in past recovery periods.

Japan has experienced three economic recovery periods since the turn of the century. Its fixed capital formation in the public sector decreased by 6.2% per year in the first half of the 2000s when the country was undergoing the first of the recovery periods. It also remained roughly flat in the second recovery period, the one subsequent to the global financial crisis. In contrast, fixed capital formation in the public sector at a pace of 1.6% per annum* has been growing under the second Abe Cabinet, which calls for "flexible fiscal policy" as one of its key policy measures. The figure exceeds the rate of economic growth from the October-December quarter of 2012 through the July-September quarter of 2016 (1.3% per annum), indicating that fixed capital formation has been a key driver of the recovery.

Setting aside the fiscal theory of the price level (FTPL), an advanced theory advocated by Princeton University Professor Christopher Sims and which has been attracting significant attention lately, fiscal policy affects the economy in two ways.

One way is by creating demand. Government spending translates into an increase in revenue for the private sector, leading to greater income for workers and hence rising consumption. The idea is in line with the classical theory of Keynesian economics.

The other one is through the productivity-enhancing effects of social infrastructure on the supply side, in which government spending leads to enhancement in the productivity of private-sector companies by improving social infrastructure. In other words, government-developed infrastructure, such as ports, roads, and water supply and sewerage systems, enable private-sector companies to build more efficient production systems and thus achieve higher productivity.

As aforementioned, fiscal policy clearly has direct demand-side effects with an increase in public capital formation contributing to growth in gross domestic product (GDP) to some extent. The question is whether it has supply-side effects.

If the government intends to reduce the primary deficit by promoting economic growth and hence increasing tax revenue, it should be anticipating significant productivity-enhancing effects in developing social infrastructure. In this sense, social infrastructure development targeted by the second arrow of Abenomics must be consistent with the growth strategy or the third arrow. One of the targets of the growth strategy is to shift resources from low- to high-productivity sectors.

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In verifying the productivity-enhancing effects of social infrastructure, we used to examine the extent to which social infrastructure contributes to the enhancement of productivity in each region of Japan. The underlying assumption here is that each region is an economy consisting of one industry and the development of social infrastructure in the region contributes to enhancement in the productivity of the industry.

In reality, however, each region has various industries. Accordingly, enhancement in the overall productivity in each region is composed of two components: an increase in industry-specific productivity and a rise in the region's overall productivity resulting from a shift of labor and capital from low- to high-productivity sectors. Previously, we were unable to distinguish these two components due to a lack of sufficient data by region and industry. However, the Regional-Level Japan Industrial Productivity Database (R-JIP), a new database developed by RIETI, has made it possible to examine the effects of social infrastructure on productivity enhancement associated with a shift of labor and capital from low- to high-productivity sectors.

From the 1980s through the first half of the 1990s, improvement in social infrastructure had the effect of inducing a labor shift to high-productivity sectors. On the other hand, we could not find any clear effect of inducing a capital shift to areas with a higher rate of return, partly because the capitalization rate declined in all areas.

Meanwhile, with respect to improved social infrastructure in the latter half of the 1990 onward, it is difficult to confirm whether the development of social infrastructure prompted a shift of labor and capital to high-productivity sectors or areas with a higher capitalization rate, and thereby helping improve productivity in each specific region or the entire economy.

Furthermore, the latter half of the 1990s also saw the escalation of fiscal deficits, which prompted the government to suppress investment in social infrastructure investment in the 2000s. Introduced then against that backdrop was a program of special zones for structural reform (SZSRs). Initiated by the government of then Prime Minister Junichiro Koizumi, the program aims to revitalize the Japanese economy in general and local economies in particular by removing regulatory barriers to economic activities within SZSRs. More than 1,000 areas have been designated as SZSRs from 2003 to date.

The special zone for advanced medical industries in Kobe, designated in 2003, is one of the early examples. The city of Kobe proposed a set of measures to promote the agglomeration of life science research organizations and medical and healthcare businesses in Port Island and Kobe University. Those include the fast track processing of applications for entry and residence permits, applicable to foreign researchers and their families, as well as programs designed to encourage foreign companies to set up branches in the SZSR-designated areas. We can define the case of Kobe as an attempt to improve productivity via the reallocation of resources across industries in the region, in that the city is trying to induce the agglomeration of innovative industries by creating an SZSR.

Some of the areas designated as SZSRs are not necessarily intended to promote a shift in industrial structure. However, the number of SZSRs can be seen as an indicator of willingness for deregulation as a means to revitalize local economies. In fact, when we look at percentage changes in productivity attributable to a cross-sectoral labor shift, calculated for each region using data from the R-JIP database, and the cumulative number of SZSRs in the region, we can see that productivity has been on the rise in the Chubu and Chugoku regions where the number of SZSRs per municipality exceed 0.7 (Figure).

Figure: Productivity Growth and the Number of SZSRs per Municipality (2003-2009)
Figure: Productivity Growth and the Number of SZSRs per Municipality (2003-2009)

As aforementioned, SZSRs vary in their nature, and thus require a more detailed examination. However, our analysis of the data collected to date shows that regulatory reform utilizing SZSRs is more desirable and consistent with the government's goal of achieving higher productivity than the conventional approach focused on social infrastructure development. Given the current fiscal situation and tardy progress in bringing the primary balance into surplus, the government should be pursuing bolder regulatory reform through SZSRs.

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This, however, is not to deny the necessity of developing all types of social infrastructure. For instance, the government must renew aging infrastructure that is essential to people's daily lives.

Furthermore, from the viewpoint of improving productivity, the government should be pursuing the development of new types of social infrastructure such as the utilization of big data held by the government, rather than the development of physical infrastructure including roads and dams. Indeed, such new types of social infrastructure is what European policymakers have in mind in proceeding with their fiscal spending programs. Of course, the development of new types of social infrastructure must be combined with appropriate regulatory measures including those designed to ensure information protection.

If we were to consider only demand-side effects, it would be enough to look at fiscal spending solely from the quantitative viewpoint. However, if we also consider supply-side effects, the future course of the Japanese economy will change significantly depending on whether invested capital contribute to economic growth. Policy debate on expansionary fiscal measures must be more cautious and thorough, including coordination with the government's growth strategy.

* As of February 2017.

>> Original text in Japanese

* Translated by RIETI.

February 9, 2017 Nihon Keizai Shimbun

March 24, 2017