Assessing Japan's Growth Strategy: Breaking apart "bedrock"-like regulations with the establishment of special economic zones

HATTA Tatsuo
Faculty Fellow, RIETI

Prime Minister Shinzo Abe has called regulatory reform the "top-priority item" for his government's growth strategy. Under the strategy, the "Basic Policies for Economic and Fiscal Management and Reform," approved by the Cabinet on June 14, 2013, Abe has pledged to revitalize the Japanese economy by increasing its metabolism so as to accelerate the channeling of resources to the potential growth areas. This pledge defined his concept of the growth strategy.

When a country forges its growth strategy, there are usually two approaches. One is to provide subsidies to the particular industries discretionarily chosen by the government to promote their growth. The other is to reform regulations to boost the metabolism of the economy. Prime Minister Abe has adopted the second approach. The decision is extremely significant for Japan's economy.

However, the market's reaction to this growth strategy was lukewarm. This is because the Abe government did not present specific reasons as to why regulatory reform is the "top-priority item" for the strategy, and because the government failed to present an operational strategy to introduce regulatory reform that will overcome objections.

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Then, why should regulatory reform be the "top-priority item" for the growth strategy?

Growth in one industry is always accompanied by a decline in some other industry. In any industry, if new players step in with new ideas, the existing players will have to exit. In other words, old industries are set to be replaced by new industries.

Let's take an example. Until Japan opened its ports to the world at the end of the Tokugawa shogunate, Japan had been fully self-contained in the consumption and production of cotton. But just 10 years later, cotton was no longer produced in Japan, with its consumption fully dependent on imports. Similarly, the coal mining industry, which had been supplying most of the coal consumption in Japan after the end of World War II, was practically demolished in the early 1960s as Japan liberalized its crude oil imports. But this switch to oil led to a new era marked by rapid economic growth.

When economic growth has advanced to a certain stage, matured industries often seek to stop the growth of new industries in a bid to protect their vested interests. Thus, industries with vested interests present various plausible reasons for the enactment of legislation that aims at blocking the entry of newcomers. Such industries often employ the influence of politicians to arrange things to their advantage. Regulations to block new market entrants are the most significant impediments of economic growth. Abolishing such regulations, therefore, is the "top-priority item" of Abe's growth strategy.

The regulatory barriers blocking newcomers in Japan are often compared to bedrock, and are commonly called "bedrock-like regulations." The following are some specific examples showing how strongly Japanese society is bound by a web of bedrock-like regulations.

The first is related to the agricultural sector. As is widely known, in Japan, joint-stock companies are prohibited from owning farming land. The social cost of this barrier is enormous because private businesses can be the main players in the competition for technological innovation and for obtaining client information.

Barriers also exist in the medical services sector. Among them is a rule limiting the number of beds that can be placed in hospitals in urban areas. This rule is believed to have resulted in protecting the vested interests of existing hospitals, and entities eyeing the medical business, even with innovative ideas, are blocked from entering the market. As a result, hospital beds run short in urban areas, leading to patients being passed around by a number of emergency rooms without finding any willing to accept them.

Hair stylists also highlight the barriers to entry in Japan. Until 1998, becoming a hair stylist only required attending a beauticians' school for one year. However, they are now required to attend for two years. My proposal is to shorten the students' required attendance to less than one year so that they can start working at hair salons as early as possible. This could open the door to become hair stylists for people who cannot afford to attend school. However, the beauty school industry, exercising its influence to protect its vested interests, is an impediment to the proposal. This situation in Japan is in sharp contrast with that in Britain, where no national license is required for the job.

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Just as bedrock is formed by magma, bedrock-like regulations themselves are formed from some "magma-like institutions".

The first of the magma-like institutions is the employment system of the national public servants. In Japan, career bureaucrats who have lost the promotion race to their colleagues are customarily forced to retire well ahead of the mandatory retirement age. Therefore, bureaucrats, in making administrative decisions, tend to give consideration to post-retirement jobs, not only for themselves but also for their colleagues. This attitude is naturally conducive to the toughening of regulations in the interest of industries and businesses that want to maintain their vested rights.

If the current employment system for national public servants is reformed so as to give them employment guarantees until the mandatory retirement age, their motivation to protect the interests of only their ministries and agencies will decline significantly. What is necessary is not to hurl accusations against bureaucrats for their sectionalism but to institutionalize a system in which defending sectional interests is not necessary.

The second of the magma-like institutions is Japan's rigid employment system in the private sector, which has significantly reduced the mobility of the labor market. Seniority-based salaries and lifetime employment are two major characteristics of Japan's unique post-war employment system, which pays youths less than the value of their productivity and elderly workers higher than the value of their productivity.

Under this system, young people lack the incentive to change companies before they reach the age at which their salary exceeds the value of their productivity. Meanwhile, elderly workers also have no incentive to change companies, since no other company would offer the same amount of wages they are receiving. Therefore, the traditional employment system gives strong incentives to workers at all ages to remain with their first company, thereby freezing the labor market in Japan.

Japanese companies thus face high hurdles in reducing the size of employment. This has created a strong company-wide incentive to block the entry of competitive newcomers.

The employment system combining lifetime employment and seniority-based salary is the product of rapid economic growth. When the employment size of most of the companies were increasing and the wage rate rising, employers were in effect borrowing investment funds from the younger workers by paying them less than their contributions while workers were able to expect higher-than-market rate of returns from the de-facto savings at the company. The system is no longer sustainable in companies where the number of elderly workers surpasses that of young workers, and the wage rate is not expected to rise. With such a system collapsing, the number of workers employed on a fixed-term contract basis has been increasing rapidly relative to the number of workers employed on a lifetime contract basis.

In spite of this trend, however, the mobility of the workers equipped with human capital remains at low levels in Japan. This is because the employment law discourages employers from investing in human capital on fixed-term employees. Under Japan's current employment law, employers must offer lifetime employment to fixed-term contract workers if they want to keep them beyond the initial five years. This system gives strong incentives to companies to terminate contracts with fixed-term workers before the beginning of their sixth year of their service, and not to invest in human capital on them.

If the fixed-term employment contract can be renewed repeatedly without limitation, companies will restore their incentives to invest heavily in manpower development for fixed-term workers. As a result, the wages of some fixed-term workers will rise sharply. The current employment law, which strongly motivates companies to end employment contracts with fixed-term workers within a few years, keeps the wages of those workers at unduly low levels. This is the main reason why the mobility of skilled fixed-term workers has been curbed in Japan despite the increase in the relative increase of fixed-term workers.

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Destroying any "bedrock," will take time and energy, even for a powerful government. Whether or not the Abe government's growth strategy will end in success, therefore, depends on how much it is willing to pay in "political costs" in order to remove the bedrock-like regulatory barriers and the magma-like institutions that are blocking newcomers. The Abe government should adopt the following three operational strategies to eliminate such regulations.

First, in the short run, the government should focus on implementing a few selected regulatory reforms that can quickly stimulate domestic demand.

The political cost of regulatory reform entailing "painful" side-effects is significantly lowered if the economy is growing. Thus, the government should keep taking pump-priming measures while reform is underway. Fortunately, the government can keep the economy afloat without additional fiscal spending if appropriate deregulation is implemented.

To begin with, substantially relaxing regulations imposed on the floor area ratio of condominium buildings located in urban areas would be effective in stimulating the economy. In addition, regulatory reform would promote construction of long-distance underground gas pipelines. Under the current relevant law, the building of pipelines covering areas served by a number of gas companies is not regarded as a public-interest project, making pipeline construction under streets and highways effectively impossible.

Second, competition should be promoted only if it is accompanied by measures to strengthen redistribution from high-income earners to low-income earners. A substantial raise in the inheritance tax, for example, is a possible option of such measures. Incidentally, if the inheritance tax is raised, elderly people will likely spend more while they are alive, thus contributing to economic growth.

Under the current welfare system, as soon as people manage to come out of welfare, the co-payment for medical services accorded under the national health insurance scheme jumps from zero to 30% of the total amount received by the hospital. This system surely encourages people with chronic illnesses to remain as welfare recipients. Therefore, it needs to be rectified so that they can continue to receive free medical service for a certain period even after going off of welfare.

Third, it is necessary to utilize the special economic zones advocated by the government as a national strategy. The use of such zones could be a first step towards a nationwide effort to break the "bedrock." The Ministry of Education, Culture, Sports, Science and Technology has already begun to study the possibility of public schools being placed under private management if they are operated in one of these zones. Also, research at the relevant government department has begun into a proposed relaxation of regulations imposed on the floor area ratio of condominium buildings located in urban areas. On the employment of fixed-term contract workers, the Ministry of Health, Labour and Welfare is studying a proposal for enabling repeat renewals of contracts for fixed-term academic researchers.

While people were intoxicated with the success experienced in the post-war growth period, numerous regulations were introduced in various parts of Japan by parties that wanted their vested interests protected and maintained. These regulations have been hampering the flow of economic resources to promising industries, eventually stopping their growth. The Abe government's growth strategy is an attempt to break free of these regulations. In order to bring the latest strategies to successful implementation, it is vitally important to fully utilize the strategic know-how that has been accumulated by the ruling and opposition parties based on their past experiences of failure.

>> Original text in Japanese

* Translated by RIETI.

June 19, 2013 Nihon Keizai Shimbun

August 5, 2013