Political Stability and Corporate Behavior: The economic effects of the end to the divided Diet

Vice Chairman & Vice President, RIETI

Political stability and economic growth

In the House of Councillors election on July 21, the ruling coalition of the Liberal Democratic Party (LDP) and New Komeito won 76 seats, securing the majority in the upper chamber of the Diet. This put an end to the divided Diet for the first time in the three years since the previous House of Councillors election in 2010. In addition to a positive appreciation of "Abenomics," a set of economic policies of the government of Prime Minister Shinzo Abe, expectations calling for political stability are believed to be reflected in the outcome of the latest election. What is particularly important is that the ruling coalition's dominance in both chambers will likely continue for the next three years.

When the two chambers of the parliament are controlled by different parties or when the opposition controls the legislature under the presidential system, decision making on important policies is bound to be stalled or postponed, whether it is in Japan, the United States, or any European country. As I wrote in my previous article for this column, a series of empirical studies have shown that political instability and frequent change of government have a negative impact on the national economy. (Note 1) According to these studies, the economic impact of political stability is quantitatively massive, far exceeding those of major growth policies such as trade liberalization and corporate income tax cuts. Thus, there is a good possibility that the outcome of the House of Councillors election per se will serve as a significant driver of economic expansion and growth.

However, many hurdles remain to be cleared. In addition to ensuring the successful implementation of the "three arrows" of Abenomics (bold monetary easing, flexible fiscal spending, and a growth strategy), the government is faced with difficult policy decisions on a range of issues involving conflicts of interest among the people. In particular, it must lay out a clear path toward fiscal sustainability which includes a final decision regarding whether or not to go ahead with the planned consumption tax hike, reform the social security system, and clarify its stance on the negotiation of the Trans-Pacific Partnership (TPP) and other economic partnership agreements (EPAs). Will the end to the divided Diet dispel the uncertainty over the future course of government economic policies and regulations? The answer to this question is a key determinant of the success or failure of the government's efforts to motivate companies to take positive actions.

Policy uncertainty and corporate behavior

Various research attempts have been made to examine the economic impact of uncertainty (e.g., Bloom (2009), Carrière-Swallow and Céspedes (2013)). In particular, it has been found that, in addition to the macroeconomic environment, policy uncertainty has a substantial negative impact on the real economy such as the gross domestic product (GDP), equipment investment, and employment (Baker et al. (2013)).

Uncertainty about future economic policy and regulations prompts households to increase precautionary savings and affects their behavior in terms of participation in the labor force, investment in education, decisions about pregnancy, and so forth. For instance, it has been often pointed out that anxiety about the future of the social security system may discourage consumption. Also, the degree of certainty about the future course of economic policy has a significant influence on corporate management decisions with respect to medium- to long-term investment in equipment, research and development, business expansion overseas, human capital, and so forth. For instance, a country's corporate taxation and monetary policy (i.e., interest rates) affect the cost of capital, a key element in determining the profitability of investment. Labor market regulations—such as those for employment protection, agency workers, and workers hired on fixed-term contracts—affect the cost of employment. The social security system, which involves costs to companies in the form of employers' contributions, has a similar impact. Meanwhile, the government's policy for the TPP and other trade issues results in changes in the costs of international trade and direct investment, thereby affecting corporate decisions regarding business expansion in the global market. Since such investment is irreversible in nature and involves substantial adjustment costs, a wait-and-see strategy could be a rational choice for companies if the future course of policy is uncertain. Therefore, greater uncertainty about the future has a detrimental effect on investment and employment.

In other words, even where the government has chosen the right policy, it would not lead to actual long-term business investment if corporate managers believe that it may be changed in a year or two. In order to bring a positive impact on the real economy, it is important to ensure that political stability leads to the sustainability of individual government policies and regulations without being limited to the stability of the political power per se.

Problematic types of policy uncertainty from the viewpoint of businesses

However, most studies conducted to date have primarily analyzed the impact of macroeconomic uncertainty, and research delving into individual government policies and regulations has been scarce. Thus, we conducted an original survey of publicly listed Japanese companies to find out the specific policies over which they feel uncertainty, the impacts they believe such uncertainty has on their management decisions, the types of management decisions that are strongly affected by uncertainty, and so forth. In what follows, I would like to outline the key points of our findings. (Note 2)

First, we asked respondents to indicate the degree of uncertainty they feel about the future course of various types of government policies and regulations—such as tax policy, social security system, labor market regulations, corporate law and regulations, and international trade policy—by selecting from the following three options: "high degree of uncertainty," "moderate degree of uncertainty," and "no significant degree of uncertainty." (Note 3) The results show that international trade policy poses the greatest uncertainty to Japanese companies, followed sequentially by the social security system, environmental regulations, tax policy, and labor market regulations (see Table 1).

Table 1: Economic policy and regulatory uncertainty and impact on business management (%)Highslide JS[ Click to enlarge ]

Second, we asked to what extent their management decisions are affected by such uncertainty. For each type of government policy and regulation, respondents were asked to select from the following three options: "significantly affected," "somewhat affected," and "hardly affected." As a result, we found that uncertainty about tax policy has the greatest impact on corporate management decisions with nearly half of the respondents indicating that their management decisions are "significantly affected" by it. International trade policy and environmental regulations followed with the ratio of those "significantly affected" by their uncertainty at around 30%, and subsequently labor market regulations, corporate law and regulations, and social security system at around 20%. Meanwhile, a comparison between manufacturers and non-manufacturers shows that the percentage of those significantly affected by uncertainty about international trade policy and environmental regulations is substantially higher in the former whereas the percentage of those significantly affected by uncertainty about land use and zoning restrictions as well as consumer protection law and regulations is conspicuously higher in the latter.

Uncertainty could affect corporate behavior in a broad range of activities including equipment investment, innovation, mergers and acquisitions, and the hiring of new employees. Thus, we asked what type of management decisions are significantly affected by policy uncertainty. Cited by roughly two-thirds of the respondents, equipment investment is found to be most affected by uncertainty, followed by decisions regarding entry into or withdrawal from overseas markets cited by nearly half of the respondents, and then decisions on the hiring of permanent full-time employees and those on organizational restructuring (see Table 2). These findings suggest that the predictability of government economic policies and regulations is a critical factor in making long-term investment decisions.

Table 2: Management decisions significantly affected by policy uncertainty (%)Table 2: Management decisions significantly affected by policy uncertainty (%)

The government has pledged to push forward tax incentives to encourage private-sector investment in equipment. Our findings reflect the expectations pinned on such supportive tax policies in activating forward-looking business investment and boosting the growth potential of the Japanese economy. At the same time, they also suggest that improving the predictability of cross-industry policies and regulations—i.e., international trade policy, social security system, labor market regulations—would significantly help revitalize the economy.

This article has focused on the impact on corporate behavior. However, a greater predictability of the future would have just as much positive impact on household behavior. Japan is being faced with an array of policy issues that definitely require difficult political decisions amid conflicting interests, including inter alia fiscal consolidation and social security reform. Against this difficult backdrop, it is hoped earnestly that greater political stability will lead to the improved performance of the Japanese economy, putting an end to the prolonged stagnation.

July 22, 2013
  1. ^ "Seiji no Antei to Dai-shinsai-go no Keizai Seicho [Political Stabilization and Post-Quake Economic Growth]," RIETI Column dated April 6, 2011 (in Japanese)
  2. ^ See Morikawa (2013) for more details.
  3. ^ The survey asked about the following nine types of government policies and regulations: 1) tax policy, 2) social security system, 3) business licensing system, 4) labor market regulations, 5) environmental regulations, 6) land use and zoning restrictions, 7) consumer protection law and regulations, 8) corporate law/regulations and corporate governance, and 9) international trade policy.
  • Baker, Scott R., Nicholas Bloom, and Steven J. Davis (2013), "Measuring Economic Policy Uncertainty," unpublished manuscript.
  • Bloom, Nicholas (2009), "The Impact of Uncertainty Shocks," Econometrica, Vol. 77, No. 3, pp. 623-685.
  • Carrière-Swallow, Yan and Luis Felipe Céspedes (2013), "The Impact of Uncertainty Shocks in Emerging Economies," Journal of International Economics, Vol. 90, No. 2, pp. 316-325.
  • Morikawa, Masayuki (2013), "Policy Uncertainty and Business," RIETI Discussion Paper, 13-J-043. (in Japanese)

July 22, 2013

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