The Pressing Need for Introduction of a Monetary Solution for Employee Dismissal: Argument for Japanese Employment Reform

Faculty Fellow, RIETI

In January, Keidanren released its "2020 Report of the Committee on Management and Labor Policy." The report has garnered attention for endeavoring to engage in a reassessment of the Japanese employment system, a scheme characterized by the hiring of new graduates en masse, long-time & lifetime employment, as well as seniority-based wages.

In this article, I would like to consider the changes in the economic environment that led Keidanren to advocate for a reassessment of employment practices, difficulties that may arise when reforms recommended in the report are actually implemented, and possible responses to such difficulties.

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The key to understanding the characteristics of the Japanese employment system, particularly long-time & lifetime employment and seniority-based wages, is a concept known as "firm-specific skills," which are skills that are specifically relevant only to responsibilities within that company. At Japanese firms, employees in the field, who hold subordinate positions in the organization, are responsible for taking initiative to ensure the smooth running of daily operations. As knowledge is distributed among the respective worksites, incorporating that knowledge is essential for enhancing overall productivity. Thus, for the purpose of coordinating the operations of several worksites, generalists, who have gained a wide range of on-site experience through job rotation and other experiences, are needed.

Skills accumulated in this manner differ from the skills tailored to specific jobs. So, even though a worker has accumulated such skills, that skill accumulation does not necessarily raise his or her market value. If companies are focused on having their workers gain nonmarketable skills, then it is necessary for the company to create a system for evaluating and rewarding such skills.

To do that, companies must guarantee long-term employment. They need to objectively evaluate employees' skills in a manner that is not based on labor market mechanisms for the determination of wages. The system that Japanese firms have developed is a system of determining wages related to the position itself and coordination ability, which has therefore resulted in wages determined based on experience in the company and seniority.

The above explains the traditional Japanese employment system, using the key concept of firm-specific skills. An empirical basis for this includes aspects such as long average working years, wages rising significantly in conjunction with firm tenure, and high bonus rates as part of annual pay so that workers with firm-specific skills are able to be retained even during business downturns, all of which are in contrast to the systems in the United States. These attributes appear to be more evident at large firms.

Moreover, the treatment of non-regular employees, who are not included in this system, is also consistent with the above explanation in that they have low wage raises despite firm tenure, are subject to labor adjustments when demand decreases, and have low bonus rates, regardless of the size of the company.

The Japanese employment system demonstrates its true value in environments where a large number of small, incremental worksite improvements are the basis of increases in overall firm productivity. However, as economic globalization has advanced and IT, AI, and other new technologies have evolved significantly, the speed at which the economic environment changes has accelerated. This has thus increased the necessity for managers to make quick decisions and rearrange operations based upon such decisions.

However, in the current wage system, a problem has risen that hiring the personnel who will be involved in such operations has now become increasingly difficult. In addition, as the population of people aged 20 to 64 continues to decline, the percentage of women entering the workforce has risen, and both men and women have begun to seek a better work-life balance. Those changes have made it difficult to premise that all workers wish to work at one company for a long time.

Japanese employment practices also have gradually transformed in response to changes in the economic environment in which companies operate, as well as to the increasing diversification of workers. A paper by Hideo Owan, professor at Waseda University, and Kaori Sato, lecturer at Kokushikan University, concluded that "While the system of ‘lifetime employment’ at Japanese companies is robust, the range of workers covered under such a system continues to be scaled down."

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The Keidanren report, which was released against such a backdrop, found that, while the membership-type employees, who work under Japanese employment practices, continue to be central, a two-track system will be constructed and expanded, in which job-type employees, who work outside that system, are also able to thrive. Job-type employees refer to those employees who are employed only for limited positions or work locations, and, who can be terminated if the position or work location are no longer necessary, despite having an indefinite term of employment.

Because long-term incentives, such as future promotion and wage raises, are not as relevant to job-type employees in comparison to membership-type employees, short-term performance-based pay incentives need to be enhanced. That is why job-type employees will likely become more prevalent especially in occupations where performance can be easily measured.

As the number of job-type employees increases, several problems are likely to emerge. As performance-based pay elements are increased, the risks stemming from changes in performance will be borne by employees in the form of wage changes, and, because such employment is not premised upon long-time employment, the risks stemming from employment changes will also be borne by employees. Conversely, on average, it will become more difficult to secure good personnel unless high wages are provided.

In addition, coordination and supervisory work that does not lead to visible outcomes in the short-term will be done by membership-type employees. At first glance, a situation may arise also where, although the membership-type employees have greater responsibility, the job-type employees are given preference in terms of wages, making it difficult to maintain a sense of fairness among employees. The Keidanren report proposal, which suggests that the aim should be to have a "firm-specific type of employment" that is appropriate for the individual company's circumstances, appears to be a proposal that takes into account the theoretical difficulty of the coexistence of these two systems in the same organization.

Although not addressed in the report, there is also the issue of what to do about the significant number of membership-type employees. There is currently a large wage burden resulting from the large number of baby boomer children, now in their late forties, who are paid high wages. This high number of professionals of a similar age has led to postponement of promotions for younger generations. However, even though the abilities of such employees are not fully utilized at their current company, they chose to remain at the company on account of the high wages.

Setting aside the legal issues for a moment, the unilateral termination of employees or wage cuts would shake the very foundation of the Japanese employment system. If companies are going to proceed in that direction, then they have no other choice but to brace themselves for a rapid transition to a system where job-type employees are the mainstay.

On the other hand, if companies aim for a gradual transition and attempt to urge some membership-type employees to resign, then companies have no choice but to pay these employees the wages implicitly promised as a retirement indemnity and facilitate an amicable transfer to a new workplace. In so doing, it is necessary to determine appropriate compensation. A reference in such cases might be the monetary amount determined by courts when discussions have broken down between a firm and an employee, resulting in a wrongful dismissal court case.

In the book Reconsidering Unfair Dismissal in Japan edited by Shinya Ouchi, Professor at Kobe University, and the author, Keisuke Kawata, Associate Professor at The University of Tokyo, and the author calculated compensation amounts based on actual wage curves, and the calculated amounts utilize number of months of monthly salary as a unit of compensation. The chart below shows the main calculation results.

Monetary Compensation in the Case of Dismissal of a Male University Graduate Employee Who Joined the Firm at the Age of 23 (Unit - number of months of monthly salary)
Note: Values needed for the calculation were obtained from actual data for probability of employment termination for reasons attributable to the worker, discount rate, bankruptcy probability, death rate and the shape of the wage curve. The reason for the differences in monetary compensation depending upon the size of the workforce is due to differences in the shape of the wage curve.
Source: Reconsidering Unfair Dismissal in Japan, edited by Shinya Ouchi and Daiji Kawaguchi

John Mark Ramseyer, Professor at Harvard University, pointed out that it is not necessary for this kind of compensation system to be determined by a government; it is sufficient for companies to conclude individual contracts with workers. However, it would be difficult to convince an employee to enter into such a contract when they join a firm if they already anticipate dismissal for a variety of reasons in the future, and it would be difficult to demand that a court uphold such a contract. The system that has been created to avoid the conclusion of such complex contracts is the Japanese employment system. So, it would be appropriate for the government to indicate a yardstick for compensation amounts based upon the existence of such a system.

Large firms should not neglect their efforts to relocate or retrain personnel to avoid dismissal as they have always done, but there are also companies for which there are limits to such efforts. If the adoption of a system providing a monetary solution is postponed further, then the only thing some large firms can do is to continue the difficult work of changing course very slowly while saddled with an excess number of underutilized, middle-aged and older employees.

>> Original text in Japanese

* Translated by RIETI.

May 21, 2020 Nihon Keizai Shimbun

August 21, 2020