OECD Economic Survey of Japan 2015: Structural reforms to boost growth

I came to Japan twice during the preparation of the Organisation for Economic Co-operation and Development (OECD) Economic Survey of Japan 2015.

We asked what would be most useful for policymakers to help Japan improve. Instead of picking an academic topic, we tried to focus on issues that will actually help Japan over the next couple of years.

After sending a draft out to all 34 countries, we had a meeting about Japan on March 2, 2015 in Paris with all of the OECD countries. We then went over the survey in detail with Japanese ministries.

I'd like to go through some of the key points, starting with four main observations or challenges facing Japan: 1) sluggish economic growth, which reflects various structural problems; 2) government debt; 3) persistent deflation; and 4) income inequality and social cohesion.

First, growth in Japan has been falling for the last 25 years. In economics, we talk about potential. In 1990, at the peak of the bubble, Japan had 3% potential. Labor shifted from a positive to a negative contribution by the late 1990s, reflecting the fact that the working age population, ages 15 to 64, had begun to decline around 1996, and that working hours had been trending downward, causing labor inputs to become a negative drag on Japan's potential. Labor productivity has also been declining. We estimate current potential to be around 0.7%. Japan has had 0.9% average growth for the past 25 years, and of course the very ambitious target for the third arrow is 2%.

This period of sluggish growth has reduced Japan's per-capita income compared to the top-17 and the top-half of OECD. Labor inputs in Japan are still high because of long working hours, especially compared to European countries. In Paris, working hours are down to 1,500 hours a year. In Japan, it's still about 1,900 hours, not counting the enormous amount of unpaid overtime. Productivity is surprisingly low. Research and development (R&D) only constitutes 3.5% of Japan's gross domestic product (GDP), while Japan always scores the highest in the OECD on the Programme for International Student Assessment (PISA) test and its share of university graduates is always near the top. Despite these advantages, which should increase productivity, Japanese productivity is nevertheless about 25% below that of the leading OECD countries. This suggests attempting to improve Japan's performance through a growth strategy.

The second problem linked to low growth is government debt. In 1990, the debt was 60% of GDP. But with slow growth holding down the GDP, and with government spending rising with fiscal packages and the aging population, debt has risen to about 226% of GDP.

Deflation has been persistent since the late 1990s. The GDP deflator has come down by 18%, meaning that debt has been going up while nominal GDP has been stagnant or falling, further increasing the debt ratio. Deflation is also a hindrance to growth because it creates a cycle of falling wages and falling prices that acts against economic growth.

The final issue is the question of social cohesion and poverty. We've seen poverty and inequality rising in all OECD countries almost without exception during the past 30 years, and it seems to have risen again especially since the 2008 crisis.

We have been supporting the three-arrow strategy of Abenomics as a way of stopping deflation and boosting Japan's growth potential.

Increasing Japan's output growth is the first challenge. Japan faces four key obstacles: 1) The rapid aging of the population is the first problem. Japan is already the oldest society in the world, and it's continuing to age very rapidly. 2) The corporate sector has many weaknesses. 3) Japan lacks economic dynamism. 4) Japan is not well integrated into the world economy.

On the first point, comparing the elderly population to the working age population, in 2012, Japan was the oldest country in the OECD, and in 2050, it will remain so. This reflects the fact that the birth rate is well below replacement. Increased life expectancy is also increasing the number of elderly. This will remain a serious problem for Japan. The ratio of those in their working age to the elderly today is 2.5, and it will be 1.3 by 2050. 1.3 workers supporting one elderly person implies a heavy burden on the working population.

With regard to the corporate sector and its problems, Japan has high R&D, of which 75% is done by the business sector--very applied and practical. Business R&D in Japan is the third highest in the world after Israel and Sweden, but in terms of productivity growth, Japan is close to zero. This high investment in R&D does not seem to be used productively.

Another weakness is that the productivity gap is widening between manufacturing and non-manufacturing industries. This is typical in some countries because manufacturers have to compete in world trade so they are constantly trying to stay ahead of their competitor countries. Services and non-manufacturing tend to be less tradable so there is less severe competition. Japan is an extreme case in which the productivity in services is far below that in manufacturing. This is a problem for manufacturing because about 40% of value added in the manufacturing sector is from services. Low productivity services are depressing manufacturing productivity as well.

Another problem is that Japanese companies have low profitability. Return on equity is far below that in Europe and the United States, both in manufacturing and non-manufacturing. The corporate sector is holding large hoards of cash. During deflation, this was very easy to understand, but now there is an economy with some inflation, and we would like to see the corporate sector pay more in wages to workers, pay more dividends to shareholders, and invest in R&D or finance startup ventures. We want to see this cash used productively to raise Japanese growth.

The problems in the corporate sector are reflected in Japan's falling share of world trade. In 1993, it was almost 10%, and now it has fallen to less than 4%. This partly reflects China's rise, but it also reflects problems in Japan. Looking at high-tech exports by the 34 OECD countries, Japan's share was 22% back in 1990; it's now half of that, at 11%. Korea went from only 4% up to 11%.

Trade is another symptom. To try to maintain Japan's market share, companies have been reducing export prices to compete with China and the Association of Southeast Asian Nations (ASEAN) countries with lower labor costs.

The third issue is dynamism--the birth and death rate of companies. The share of startups is only about 5% in Japan, while it is 20%-25% in some countries. We find in the OECD that it's the new startups that create most of the jobs and much of the innovation. All of these old companies mean stagnation. Looking at all of the companies presents the same picture. We don't see many small and medium-sized enterprises (SME) in Japan which grow to become large companies. This is due partly to what we call the "Peter Pan syndrome." If you are a successful SME, why grow? Remain an SME and keep receiving government benefits. We need more dynamism. Part of the reason for the lack of startups is the small role of venture capital. Japan has venture capital at 0.02% of GDP, below the OECD mean and far below some of the leading countries.

The fourth issue is lack of international integration. Japan has a very small amount of inward foreign direct investment (FDI), the lowest in the OECD at less than 4%. Obstacles exist that discourage increase.

In terms of R&D, the international links in Japan are not working well. Japan is excluded from international R&D. As for trade, Japan has joined 50 economic partnership agreements (EPA), but they cover only 20% of Japanese exports. Agriculture is a stumbling block due to Japan's high level of agricultural protection.

We have a range of recommendations for boosting economic growth. The first step is to try to make better use of Japan's population by increasing labor force participation, particularly by women. If the female participation rate stays at where it is now, the labor force will fall by 20% by 2040. Instead, if it were to increase and reach parity with men, the labor force would remain roughly the same between 2015 and 2035. This is not just a question of getting more part-time irregular female employees into the workforce. High-quality regular employment is important. The gap between those types of employment is huge. Educated women in Japan have a low rate of participation. In every other country in the OECD, except for Korea which has the same problem, women with university degrees participate to a greater extent because they have higher opportunity costs, have advanced degrees, and can earn more.

In terms of the corporate sector, Japan is below the OECD average but is not as deregulated as some other countries. Japan wants to be the most innovative and creative economy in the OECD, meaning even greater deregulation. Japan's barriers to trade and investment are relatively high.

Business enterprises account for 75.5% of R&D spending, with 98.9% inside firms, only 0.5% in universities, and 0.6% at government research institutes. Very little interaction takes place between government research institutions, businesses, and universities. We need to have greater interaction, meaning greater labor mobility. Foreign sources of R&D only account for 0.5%.

Another problem is the lack of dynamism. In Japan, SMEs are treated as a backward sector needing special support for companies that are not viable. SME policy needs to change to make them more innovative. The death rate of firms in Japan is 5% per year. To create more companies, we have to change the vision of entrepreneurship. Japan has the lowest positive rating in relation to parents who want their children to pursue entrepreneurship. Japanese parents equate entrepreneurship with instability and unemployment. They push their children in the direction of stable employment, and schools are not providing entrepreneurial skills. Japan has the smallest proportion of people who believe that schools should teach people the skills to start a new company. We need to teach entrepreneurship even in elementary school.

Finally, for international integration, the key is to reform agriculture. The average age of farmers is 68.5 and 56% are over age 70, meaning that many of the current farmers are going to be leaving their farms in the coming years. Consolidating farmland into larger farms, like that in other countries, will increase efficiency and productivity.

We need to strengthen competition and corporate governance (to push companies toward greater efficiency and investment, etc.) and increase integration with the world economy to make agriculture competitive.

The second topic is reducing government debt, a key issue for the OECD. Japan has the highest level in the OECD at 226%. The average is a little less than 100%, and it also has been on a downward trend in the OECD area. Japan's number is alarming. The impact has been limited by low interest rates. Net government interest payments as a share of GDP are less than 1% because, thanks to the Bank of Japan, the 10-year bond yield is about 35 basis points, and the effective borrowing rate is down below 1%. This will not last forever. Quantitative easing will end once the 2% target is reached. We have to try to reduce the government deficit.

Public debt service (interest payments and debt redemption) was the largest item in the February 2015 central government budget--larger than healthcare and pensions. The education budget declined in 2015. Japan should not spend less on science and education, both of which are needed to promote economic growth.

We have done some econometric simulations to show what will happen under various scenarios and forecast the future. If Japan does not take further steps to raise taxes or cut spending, assuming nominal growth of around 2.8%, we see the debt ratio rising to more than 400%.

In another scenario, there is 7% of GDP in consolidation. That would be equivalent to raising the consumption tax rate from 8% to 22%, the European average. It is a low-growth scenario of 1.5% nominal growth. This means the first and third arrows have failed. Inflation stays at half a point and growth stays at 1%. In this scenario, debt stays around where it is today.

To reduce the ratio, we have a third scenario where we have 7% consolidation and the first and third arrows work, with 2% inflation and 2% real growth. In that scenario, debt would gradually fall to around 100% by 2040. This shows why Abenomics is so important. We can't just raise taxes or cut spending. We need inflation at the 2% target, and we need to have real growth to bring debt back to a reasonable level.

The reason spending has been rising is because of social expenditures, which have risen from 12% to 24% since 1990. It is very hard to squeeze pension outlays and health spending. We see room to cut healthcare spending by making it more efficient.

The average hospital stay in Japan is 31.2 days compared to eight days in the OECD, reflecting the fact that a lot of long-term care is taking place in hospitals, where it is very expensive. Looking at acute care, the average stay is 13.4 days vs. 4.8 days. Even taking out long-term care, Japan still has very long hospital stays. We need to take the long-term care out of hospitals and put it in home-based care or in specialized institutions.

Another problem is the number of doctor visits: 13 times per year, twice the OECD average. Doctors have a tendency, being paid for every visit, to generate business by requiring multiple visits.

Pharmaceutical consumption is also very high in Japan (third-highest in the OECD), and generic drugs are underused (28% of the market in Japan vs. 84% in the United States). Raising the share of generics to 84% in Japan while lowering the price by 10% could cut spending on pharmaceuticals by half. Pharmaceutical spending explains half the rise in healthcare spending, so there is a great opportunity here to cut spending.

We need to raise the pension eligibility age. Japanese people have a life expectancy of 85 years and retire at age 60. We would suggest, as in Scandinavian countries, that the eligibility age be raised beyond 65 possibly even to 70. That would help the pension system as well.

More revenue is needed. Japan's consumption tax rate is very low. Even with the hike to 10%, it would still be the third lowest in the OECD; the OECD average is 19%. We also need to bring more money into the tax system by reducing the wage exemption.

Deflation has slowed quite dramatically from about 1.5% in early 2014 down to 0.2% in the latest month. This does not mean that quantitative and qualitative monetary easing is a failure; it reflects, first of all, weak growth in 2014 because of the tax hike and the falling oil prices.

Next is cohesion. Every country is having technology-related problems to some extent, but, in Japan, labor market dualism is also a problem. Regular workers acquire seniority, and their wages go up every year. Irregular workers start at a low wage which never rises. This creates a huge wage gap. To address inequality, we need to find a way to break down this dualism.

In irregular worker, single-worker families, the poverty rate goes up to 35%. Dualism is also creating a poverty problem in Japan. The tax and transfer system has a weak impact on equality. Also, the basic livelihood protection program provides generous benefits (70% of average wages), but it is concentrated among 1.7% of the population. The relative poverty rate is 60%, but less than 2% of the people actually get these benefits. We would hope that the benefit would be reduced and given more broadly to try to reduce poverty.

Q1. What are the odds that Japan will implement another tax hike? Also, is corporate tax evasion a problem in Japan as well?

Randall S. JONES
The plan was to raise the consumption tax rate in October 2015, but the economy contracted sharply last year (about 6.5% in the quarter after the tax hike and another 1.9% in the third quarter). The second tax hike was delayed until April 2017. Prime Minister Shinzo Abe has promised to go ahead with the tax hike in 2017 no matter what. The first tax hike was conditional and based on economic conditions. Abenomics wants to create an environment that can support this second hike. The hike is needed, especially for the deficit target. It's normal for there to be a certain decline when an economy has a tax hike. In 2014, people spent as much as they could, and once the tax hike went into effect, consumption dropped dramatically. It is still below where it was in 2013. We would rather see a 1% hike every year so people don't distort their consumption spending and distort the economic cycle.

On the corporate tax, basically one-third of companies pay corporate tax. It's not a question of evasion, but the SMEs are usually able to arrange things so that they don't pay tax. They can make their salaries as a business expense to show a loss. We want to increase the number of firms paying corporate income tax, which will require revising the treatment of SMEs.

Q2. What do you think about the bold monetary policy?

Randall S. JONES
Deflation started in Japan in the late 1990s. Quantitative easing was maintained for five years, at which point the Bank of Japan claimed victory with deflation at 0.1%. They stopped quantitative easing, raised interest rates a few months later, and deflation returned. This has been the cycle.

What we found positive about quantitative and qualitative easing is that, first of all, it didn't just focus on short-term bonds; it went out to 30 or 40 years, lowering the yield curve all the way out, which helps investment. Second, it promised to continue until the inflation target was reached, so premature withdrawal of monetary stimulus is not supposed to be a risk. A very clear inflation target was imposed for the first time. It also changed inflation expectations, which was crucial to breaking deflation in Japan.

A central bank can control many things, but not oil prices. The oil price shock has caused inflation to fall around the world. Japan is a huge energy importer. With the nuclear power plants closed, Japan is importing huge amounts of oil and natural gas. This is feeding into the consumer price index (CPI) and applying downward pressure.

If oil prices don't decline further, inflation will start rising in the second half of this year. An oil price rebound (Japan expects a rise to around $70) would apply pressure on inflation. We expect inflation to trend upward from the second half of this year.

It's a policy that looks risky, but for us, what is the choice? Continued deflation means a debt ratio that keeps rising. There are not many alternatives to end deflation once and for all. We support the first arrow quite strongly.

Q3. What things particular to Japan are making this a challenge to move forward?

Randall S. JONES
Tremendous changes have happened in Japan. Many sectors have seen major deregulation over the last couple of decades. When we ask for changes, we might get frustrated that they aren't happening or won't happen, but looking back, a lot of changes have occurred. A second aspect is that institutions such as the Ministry of Economy, Trade and Industry (METI) have realized the importance of structural reform. I think the landscape has changed to be more in favor of reform.

At the same time, Japan is a bit different from other countries in two respects. One is a very intense commitment to egalitarianism. For example, in healthcare, in Japan there's something called a drug lag. There might be a new drug available in the United States or Europe, but, in Japan, it might not be available under the national health insurance for five years. If you are a Japanese person with a disease and want that drug, and you take something outside the package, you lose your entire health insurance. For an American, that sounds bizarre. It's your choice to spend your own money on a drug. But in Japan, the rationale is that if one person gets it, everyone should have it, so wait five years until we do all of the testing so then everyone can have it. Irregular workers and a whole range of issues make reform difficult. The other thing is that Prime Minister Abe may not be as powerful as the leaders in other countries. These things make rapid change more difficult in Japan than in other countries.

Q4. We know we should do many of the things you have recommended, but the real question is how to implement this policy. What is the fundamental issue?

Randall S. JONES
The role of the OECD is what you might call external pressure. OECD governments use us as the bad news people. For me, the key thing first of all would be changing what the government cannot change: things such as the work-life balance. It goes beyond the government to change society--work-life balance, the role of women, internationalization, the spirit of entrepreneurialism, etc. The falling population and rising debt will force these changes. Japan is in a challenging situation, and looking at history, it has the ability to change its policy. We need a restoration or a new approach.

Alvaro PEREIRA, Director, Country Studies Branch at the Economics Department, OECD
This is an unprecedented debt situation. We need to raise awareness on this. Japan can do this.

Q5. We would like to hear how Japan will be able to carry on reducing government debt without falling back into recession again.

Randall S. JONES
If the growth potential is 0.6% and debt is reduced, it's very easy for it to turn negative. If the growth potential is 2%, then government debt can be reduced and still grow at 1%, for example. The key third arrow is the most important thing. To me, 2% is very ambitious. It all hinges on confidence. As soon as investors think it's unsustainable, Japanese money will leave Japan and go to the United States or Europe. A plan would instill confidence.

Q6. You mentioned that to achieve 2% real GDP growth is very ambitious. How much could the potential growth rate be enhanced by conducting all of these recommendations?

Randall S. JONES
How do we put a number on corporate governance? If we could encourage firms to maximize profits and use their cash, there could be a huge response. But if corporate governance is superficial, you won't have any impact. We started doing it for Italy and France, so our goal is to do a similar exercise for Japan as well. I think it's time to try that.