A Reconsideration of Japan's Growth Strategies: Boosting productivity in the service sector

MORIKAWA Masayuki
Vice President, RIETI

While economic doldrums have reasserted themselves in the wake of the most recent consumption tax hike, it is also true that Japan's unemployment rate is currently at its lowest level of this century. It is clear, then, that one important key to improving the economy is to boost the country's potential growth rate. The role of economic stimulus policy is to close the supply-demand gap by boosting demand under the assumption of a given rate of potential economic growth, and boosting mid- and long-term growth potential is beyond its capacity. Raising the growth ceiling under full employment conditions such as that seen today requires measures designed to improve supply-side performance.

With the working population in decline, productivity improvement is the key to raising potential growth. In today's advanced economies, productivity in the service sector is a major determinant of overall macroeconomic growth. Ongoing research into international specialization has made it clear that the existence of high-quality and highly efficient service industries at home significantly contribute to a country's international competitiveness. While Japan is still largely perceived as being an export-oriented economy dependent on the strength of its manufacturing sector, the fact is that the service sector accounts for over 70% of its economy and must play a major role in the overall growth strategy.

While numerous measures are being proposed for a new growth strategy, policymakers must be fully aware of the quantitative economic impact of each of those options on the menu if they are to establish a truly effective policy package. In this regard, a boost in service-sector productivity would have a large positive impact on the macroeconomy. Indeed, its potential effects would far surpass the possible benefits from a successful conclusion of the Trans-Pacific Partnership (TPP), reductions in corporate tax rates, and a greater number of women entering the work force.

It is not necessarily accurate to say that Japan's service-sector productivity must be raised because it is too low relative to comparable economies. What is certain, however, is that there is considerable room to elevate sector-wide productivity by raising the low performers and enhancing business reallocation.

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Due to the limited availability of high-quality data on service industries, as compared with those available for manufacturing industries, little empirical evidence has been accumulated so far. I have tried to overcome this obstacle by making use of establishment-level microdata, in an attempt to get a clearer view of the realities of service-sector productivity. A key implication of this research is that the following four factors are crucial to improving service-sector productivity: (1) urban agglomeration; (2) demand smoothing; (3) corporate governance; and (4) business reallocation. Underlying each of these factors is the simultaneity of production and consumption, a feature unique to service industries and not observed in manufacturing industries.

As services are consumed as produced, the geographic scope of services markets has a definite limit. Thus, unlike in the manufacturing industries whose products can be sold globally, productivity in the service industries is defined more strongly by the geographical distribution of population and overall economic activity. It has long been recognized that the service industries are inherently urban oriented. Indeed, when we measure the relationship between the population density of municipalities and the productivity of two types of service industries, namely, personal services and retailing, it becomes clear that the economic effect of population concentration is far greater in the service sector than it is in the manufacturing sector (See Figure).

Figure: Population Density and TFP at the Establishment Level
(Impact of a doubling of population density in municipalities on the productivity of establishments located therein measured in terms of TFP growth)
Figure: Population Density and TFP at the Establishment Level
Note: Created by the author based on tables in Morikawa, M., Productivity in Service Industries: Empirical analyses using microdata, Nippon Hyoronsha Co., Ltd.

Recently, how to correct the unipolar concentration in Tokyo has emerged as a key policy agenda in Japan as the government steps up efforts to revitalize rural regions. However, given the reality that Japan's overall population is declining, we need to take a select-and-focus approach, which in this context means seeking to maintain population agglomerations. This is because the dispersion of economic activity weakens the positive effect of agglomeration economies and hence puts downward pressure on economic growth.

In this context, the formation of compact cities would seem to offer large potential benefits. In terms of government policy, land use regulations and taxation of real estate can have a significant impact on service-sector productivity. Also, infrastructure projects--including both new constructions and renovations--must be screened and selected carefully with a view toward maintaining population agglomerations.

In recent arguments for decentralization, boosting the fertility rate is defined as one of the key policy goals. However, the guiding principles of the optimal policy mix suggest that two differing policy goals--i.e., improving productivity via agglomeration economies and raising the fertility rate--should be addressed by differing policy tools.

Specifically, a combination of measures designed to eliminate factors that inhibit population migrations and those to support childcare and schooling systems in areas where populations concentrate would constitute the optimal policy mix. In other words, in order to address the goal of boosting the fertility rate, the government should implement measures that would have a direct impact, such as making more childcare facilities available and enhancing public education, rather than counting on indirect measures such as population decentralization.

Production and consumption of services coincide not only in place but also in time. Thus, if we could smooth out demand over time by utilizing information technology, that would translate into improved productivity. This is evidenced, for instance, by the fact that occupancy rates are used as a key performance indicator in the hotel and taxi industries.

Meanwhile, unlike manufacturers, which can smooth out production volume by using inventories as a buffer to absorb demand fluctuations, service companies--whether retailers, restaurants, or hotels--must cope with demand volatility by means of workforce adjustments and hence they tend to rely heavily on non-regular workers. My analysis found that an increase in the proportion of non-regular workers is more likely to lead to improved productivity in establishments exposed to greater demand fluctuations. Looking at this from another angle, we can say that when faced with demand fluctuations, companies will move faster to adjust non-regular employment levels than they will to adjust regular employment levels. This means that there is a tradeoff between productivity boosting and employment stability.

Insofar as demand fluctuation is an inescapable reality of business, it is necessary to adopt a policy mix that takes this reality--and the corresponding existence of non-regular employment--into account. Rather than restricting non-regular employment as an undesirable employment mode, it would seem to be more effective to implement policies that offer training and other support to non-regular employees, so as to enhance their contribution to added value.

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The service sector is characterized by a large gap between high-productivity and low-productivity companies. This disparity can help identify the characteristics that lead to higher productivity, and that can be adopted by low-productivity performers so as to boost the overall level of the service sector.

Two mechanisms are available for raising business productivity: the external pressures of market competition and the internal practices of corporate governance.

In the manufacturing industry, the harsh realities of global competition apply a powerful driving force toward better management efficiency. Service companies also face competition, but competition between geographically separated companies--including global competition--is relatively weak. In my survey, the percentage of service companies replying that international competition was irrelevant to their business was more than double the corresponding percentage for manufacturing companies.

Research based on company-level data indicates that management quality is an important driver of productivity, and therefore it is sensible that the government's growth strategy incorporates corporate governance reform. Recent efforts in this direction include a push for a greater number of outside directors and female directors.

It is worth noting, however, that in the United States and in Europe, one of the major goals of corporate governance reform is to restrain managers from undertaking excessive risks. Japanese businesses, in contrast, tend to have the opposite problem--they take too few risks. Consequently, one would hope that Japanese reform measures would include systematic efforts to promote somewhat more risk taking--e.g., through a greater use of stock options and other performance-based awards.

The large existing disparities in productivity within an industry suggest that business reallocation and creative destruction--i.e., the establishment of more high-performing companies, the capture of increased market share by these companies, and the elimination of inefficient firms--can have a significant positive impact on the industry-wide productivity.

As confirmed by prior research carried out abroad, business reallocation--primarily characterized by new firm entries and exits of old firms--makes a greater contribution to productivity in the service sector than it does in the manufacturing sector. To date, however, it seems that the Japanese service sector has not yet benefited sufficiently from this reallocation-driven thrust to productivity. In order to facilitate business reallocation, numerous policy measures, including support for business start-ups, are already in place. Moving forward, it will also be important to work toward better matching in the labor market, and to make appropriate adjustments to the size-based business tax and the real estate acquisition tax.

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As such, service-sector productivity is linked closely and inseparably with the fundamental structure of our social and economic society. Therefore, policy measures designed to boost service-sector productivity are often accompanied by tradeoffs with other social values such as achieving balanced regional development or greater stability in employment and management.

There is no magic wand that will raise the growth rate without also inflicting some pain. Policymakers must weigh the benefits and costs amid the conflicting interests among various economic entities to devise and implement effective growth strategies.

>> Original text in Japanese

* Translated by RIETI.

January 22, 2015 Nihon Keizai Shimbun

February 27, 2015