Japan's Wage System: Seniority-based wage profile growing flatter

Faculty Fellow, RIETI

The question of whether wages can be increased is of growing interest in political and economic circles. The repeated demands of the Shinzo Abe administration combined with an outlook for continued economic recovery has caused even the business community to make positive remarks on the possibility of wage increases.

As for how those wage increases will be brought about, however, the reality is that the Japanese business community is repeating some very cautious statements over whether it is better to go so far as to raise the base pay (hereinafter referred to as base-raising, i.e., changing the very pay scale that determines monthly base pay) or to increase wages by paying bonuses or other lump sums. I will discuss whether we can expect base-raising with Japan's so-called seniority-based wages.

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The Bank of Japan's stated aim of a 2% annual inflation rate is cited as grounds for the necessity of wage increases. If the Bank of Japan were to achieve this target and the consumer price index (CPI) rose by 2%, the real value of wages would decline unless those wages rose correspondingly. However, a 2% increase in the CPI is not grounds for immediately raising wages by 2%.

When lowering the nominal value of wages for any reason is difficult, inflation is supposed to be an important route for stimulating the economy. In this view, when inflation occurs, the real value of wages falls, encouraging businesses to hire workers actively, which solves unemployment. This mechanism does not work if the nominal value of wages rises in step with inflation. This mechanism is not that important right now, since Japan's current unemployment rate is not very high, but at least this need to be understood as a classical theory.

In addition, it is not necessarily true that businesses will be able to pay better wages if the CPI rises. The reason why is that the price index for the value produced by domestic businesses is the gross domestic product (GDP) deflator, not the CPI. For example, if prices of imports like crude oil and natural gas rise, the CPI, or the index of prices directly paid by typical consumers, also rises. It does not mean that domestic businesses are able to pay better wages. On the other hand, when the prices of export goods made by Japanese companies fall, the ability of domestic businesses to pay wages falls, but the CPI does not.

So the price index governing the ability of domestic businesses to pay wages is not the CPI, but the GDP deflator. As far as the discussion of wage increases is concerned, this difference is not so great if the two indices are moving similarly, but between 2000-2011, the CPI deflated by about 3%, while the GDP deflator revealed significant deflation of about 14%.

The worsening of terms of trade, as found by dividing the export price index by the import price index, has been cited as a factor in the divergence of the CPI and GDP deflator. The import price index rose, but the export price index fell. In any case, if we consider the drop in nominal wages in the 2000s, deflation as measured by the GDP deflator truly has had a great impact. Even if energy and imported food prices rise and the CPI goes up, domestic businesses' profits do not rise, so wages do not rise either. This point is a matter of course, but one that tends to get overlooked.

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Let's assume that conditions are right for increasing wages, with the Japanese economy on a genuine growth trajectory, and with rising productivity and a higher GDP deflator. Is base-raising with Japan's so-called seniority-based wages likely to happen? I suspect that any increase in base pay will be more generous to younger workers and more severe for middle-aged and older workers. I will explain why this is the case.

Wages tend to go up as the worker ages. The relationship between worker age and average wages is called the wage profile. It has been confirmed empirically that the slope of Japan's wage profile is much sharper than that of the United States. There are several economic theories to explain why average wages go up with worker age, but one important aspect is that workers upgrade their skills as they work and businesses recognize their accomplishments by raising their pay.

In the United States, with its high labor mobility, highly skilled workers go to other businesses if their wages are not raised commensurate with their skills. Even in Japan, where the labor mobility market is not so high, businesses cannot motivate their workers to accumulate skills unless their internal personnel system provides a clear relationship between skill accumulation and pay. Wage variability should increase with age, because workers who accumulate skills and attain high levels of productivity earn higher wages, and those who fail to do so should not see any pay increases.

Japan's steep wage profile does reflect workers who actively accumulate skills, but the reality is that the economic environment surrounding this kind of skill accumulation is changing.

During such times as the rapid growth period in the 1960s, the economic environment made it easy for Japanese businesses to link worker skill accumulation with higher productivity, in order to catch up with the advanced technologies of the West. But when the rapid growth has ended, and even more as Japan entered an era of slow growth in the first half of the 1990s following the collapse of its economic bubble, the economic environment directly tying worker skill accumulation to high productivity began to waver. This change in the economic environment forced a transformation of Japanese employment practices, which were characterized by long years of service at one company, a steep wage profile, and company-specific unions. Japanese employment practices are economically rational, and consequently they change when the economic environment facing the business changes.

The Figure shows the wage profile for full-time male workers in different generations by combining wage and price statistics for multiple years. It shows that the younger the generation is, the flatter is the wage profile. If we believe that long-term changes in the macroeconomic environment facing Japan's labor market are producing this flattening of the wage profile, it is easy to believe that the wage profile will continue to flatten unless something unexpected happens, like a return to the rapid growth period.

Figure: Japan's wage profileFigure: Japan's wage profile
Note: Ministry of Health, Labour and Welfare, Basic Survey on Wage Structure. Schedule cash earnings for general male workers adjusted at 2010 real prices using the consumer price index (CPI)

We shouldn't be surprised that even if base-raising happens this spring, plenty of businesses would take that as an opportunity to flatten their wage profiles. When there is inflation, leaving wages as is for middle-aged and older workers is effectively a cut in wages, and if wages for younger workers undergo base-raising, it could flatten the wage profile, so changing the wage system is relatively easy.

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Another factor that may predict a flattening of the wage profile is that the revised Act for Stabilization of Employment of Older Persons requires job security until age 65. There are three ways to provide job security: eliminate the mandatory retirement age, raise the mandatory retirement age, or provide post-retirement employment. Most businesses provide job security by having employees retire at the mandatory retirement age (60) and then rehiring them. This is because they can greatly decrease compensation when they rehire them. However, for reasons of personnel management, it is difficult to have rehired employees continue the work which they were doing before their mandatory retirement. Some workplaces design jobs specifically for rehired employees. The ways in which businesses are responding at this time are strongly characterized as transitional measures.

In the medium term, most likely, as the mandatory retirement age is hiked to 65, there will be a growing move to flatten the wage profile. In fact, research by Nihon University Professor Naohiro Ogawa et al. indicates that the wage profile was flattened when the mandatory retirement age was raised from 55 to 60 in the 1980s. In light of this historical experience, we might predict that businesses in general will respond to wage increases by considering making a distinction in the size of the increase for young workers on the one hand and middle-aged and older workers on the other, thus flattening their wage profiles.

As this article has suggested, even if conditions are right for increasing wages, it is highly possible that a wage increase this spring would not be uniform base-raising for all age groups but rather would be coupled with changes in the wage profile.

>> Original text in Japanese

* Translated by RIETI.

February 5, 2014 Nihon Keizai Shimbun

February 28, 2014