Human capital management and human capital disclosure are often discussed in the context of how corporate behavior should be disciplined by capital markets in Japan. Regardless of how great a human capital strategy story a company develops, however, corporate value may not be improved without changes in employees’ awareness, behavior and skills. The most important target of human capital management is not investors, but employees, and companies should implement investment and measures that are understood and valued by employees.
I would like to begin with two different mechanisms that encourage investment as discussed in human capital theory.
The first is investment incentives that arise when companies enclose employees in a labor market where friction is large. Friction refers to factors in a labor market that inhibit competition and hinder efficient job changes. For example, the lack of standardization of jobs and skills in Japan leads to information asymmetry (i.e. companies not being able to observe the productivity of workers at other companies) and higher job search costs than in other developed countries. These, in addition to Japanese human resources practices such as seniority-based pay and slow promotion, discourage intercompany labor mobility.
If friction is large, turnover rates decline, as no wage increase is expected through job changes. As a result, the expected rate of return on human capital investment may increase, encouraging such investment. I refer to this situation as the “enclosure paradigm.”
The other important mechanism was demonstrated in a 1962 paper by the late professor Gary Becker of the University of Chicago, who laid the foundations of human capital theory.
If the labor market were frictionless and perfectly competitive, companies would have to pay wages at levels close to productivity and fail to reap the returns on investments in employee training. For this reason, companies would not provide employees with general training free of charge. If, however, during training periods, companies were able to recoup the cost of training by paying lower wages than justified by productivity, they could offer general training. Then, workers would flock to companies that opt to provide training opportunities to bring about higher lifetime incomes than other companies, leading to competition for human resources that would create incentives for investment.
I refer to the world where this premise holds as the “recruitment competition paradigm.” It is known that if human capital investment can be included in contracts in a perfectly competitive market, the investment will be efficient (reach a level that maximizes lifetime income).
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The effectiveness of the two mechanisms depends on (1) the degree of friction in the labor market and (2) the extent to which companies can commit to providing training opportunities. As labor market friction was large in the past and companies rarely promised to provide training when recruiting employees, it was believed that human capital investment would be greater in a country like Japan, where the labor market friction was large, based on the enclosure paradigm.
In fact, a number of surveys and estimates suggest that human resource development investment as a percentage of total labor costs at Japanese companies is far smaller than the average for major Western countries, meaning that the enclosure paradigm does not explain the current situation. In my view, two major changes in recent years are significantly shifting the framework away from the paradigm based on the premise of friction in the labor market.
The first major change is a steady decline in the abovementioned labor market friction (condition 1 above) due to the development of digital technology and other innovations listed below. Combined with the labor shortage caused by the declining birthrate, the labor market is becoming more competitive.
First, talent management systems introduced by large companies aggregate information on the experience and skills of individuals and communicate it to employees, while social networking services such as LinkedIn visualize experience and skill information to reduce information asymmetry.
Second, job-based employment leads to the standardization of jobs and skills, while the expansion of resume creation services, job recommendation tools, and scouting services by recruitment agencies promote the standardization and automation of job experience information, contributing to improving the efficiency of matching between job offers and seekers. These services may lower job search costs by reducing recruitment agency fees.
Third, flattening wage curves at Japanese firms reflects a reduction in seniority-based pay, resulting in a lower proportion of people whose lifetime wages fall significantly due to job changes.
The other major change is the widespread disclosure of talent development policies and measures, especially among publicly listed companies. Disclosure enhances accountability and strengthens the management's abovementioned commitment to investment in human capital development (condition 2 above). If both labor and management act on the premise of disclosed information, it is effectively no different than having it written in their contracts. This is referred to as a relational contract.
Reality is becoming closer to the premise of the Becker model, which was once considered unrealistic. There is a shift occurring from the enclosure paradigm based on the premise of friction to a recruitment competition paradigm where companies try to acquire human resources by providing better growth opportunities.
As the possibility of employees leaving their companies increases in line with a decline in the labor market friction of the enclosure paradigm, human capital investment is understood to decrease. In the recruitment competition paradigm, however, if rents can be expected through the formation of firm-specific human capital under a long-term employment relationship, relational contracts that include investment commitments will be formed and maintained, leading human capital investment to increase through competition (see the figure).
This is a difference when we look at the human capital investment made by companies. What about when we focus on the investment made by workers? When labor market friction is large, wages fail to respond strongly to the acquisition of skills, leading to low motivation for self-improvement. If labor market friction declines and worker skills become move observable, however, the acquisition of skills will lead to an increase in market wages, raising motivation for self-improvement. A decline in labor market friction can increase investment by workers as well as companies.
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As the use of artificial intelligence (AI) increases, many job descriptions are expected to change, requiring a growing number of workers to change jobs. Since rapid reskilling impacts the competitiveness of companies and countries, labor market reform that increases the motivation to invest in human capital is an urgent challenge. Policies aimed at reducing the labor market friction and disclosing more human capital information are conceivable elements of such a reform.
First, the standardization of jobs and skills should be accelerated. It is desirable to promote the use of existing data, including those available at the government-provided occupational information website (Japan’s version of O-NET (Occupation Network) in the U.S.) and vocational ability evaluation standards, while subsidizing standardization projects led by the private sector.
Second, it is necessary to support the development of matching and automation technologies. Since technological changes increase the economies of scale for recruitment agencies while cutting recruitment agency fees, government oversight will be essential to prevent monopolistic or anti-competitive behavior on the part of major recruitment agencies.
Third, career autonomy enhances professional motivation for self-improvement. Companies should implement job assignment systems that better reflect the wishes of employees. Advanced companies are increasingly using in-house job posting systems, free agent systems, and matching algorithms. Industry, academia, and government sectors should make efforts to disseminate these advanced practices to other companies.
Finally, further disclosure of human capital information should be encouraged and requiring additional disclosure items should be considered as appropriate, including human capital investment as a percentage of total labor costs.
Recent research has demonstrated that human capital investment can generate a higher rate of return than physical investment, demonstrating the need for labor market reform aimed at increasing human capital investment incentives.
>> Original text in Japanese
* Translated by RIETI.
August 26, 2024 Nihon Keizai Shimbun
