13. Priorities for Structural Reforms

Alessandro Zanello, and Daniel Citrin
Published Date:
November 2008
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Yougesh Khatri


Unresolved structural rigidities explain much of Japan’s low potential growth. Sector specific issues and economy-wide factors that inhibit competition, innovation, and entrepreneurship have combined to depress productivity (Chapter 2). After a decade of weak performance, a program of structural reforms was launched in 2001. It aimed at rationalizing public enterprises, reducing regulation, facilitating corporate restructuring and startups, and enhancing labor market flexibility. However, the gains so far have been limited as much remains to be done. This chapter examines the state of play with the reform agenda and policy options for enhancing productivity further, particularly in the service sector.

Overall productivity has been improving in recent years, but by less than in the United States. In particular, productivity in services remains well below that of manufacturing and below that in the United States. During 1995–2005, non-manufacturing labor productivity in Japan grew by 1 percent annually compared to almost 3½ percent in manufacturing (Figure 13.1). Total factor productivity (TFP) in services (which accounts for around 70 percent of GDP and employment) has also lagged.1

Figure 13.1Labor Productivity Gap between Japan and the United States

(by industry)

Source: Cabinet Office based on EU KLEMS database.

The potential payoffs from further liberalization are substantial. The Cabinet Office (CAO, 2007) estimates the benefits from deregulation since the 1990s to be around 5 percent of national income, mainly stemming from deregulation in telecommunications, transportation, and energy. Estimates of the potential additional gains from structural reforms over the medium term range from 5 percent to 8 percent of GDP, while the potential dynamic gains (i.e. additions to potential growth) are estimated in the range ¼ to 2½ percent (Table 13.1).2,3 The Japanese authorities seem in broad agreement with these assessments.4 Thus, in the teeth of the severe demographic and fiscal challenges ahead, comprehensive reforms will be key to boosting Japan’s growth prospects and international competitiveness. The government’s strategy for boosting productivity (by 50 percent in five years) is outlined in Box 13.1.

Table 13.1Estimates of the Potential Gains from Structural Reform in GDP Terms(%)
Year publishedBradford

Economic Planning Agency

(Shimpo and Nishizaki)


Static gain2.28.05.2
One-year gain (five-year horizon)
Overall gain (five-year horizon)
Main reform measure(s) or assumption:Eliminate tariffs

and nontariff barriers

Regulatory reform
Year publishedTFP Growth Reversion


Japan Center for

Economic Research


Dynamic gain2.20.32.4
One-year gain (five-year horizon)
Overall gain (five-year horizon)12.41.612.6
Main reform measure(s) or assumption:Reversion of TFP

growth to 1980s rate
Regulatory reform

mainly in public services
Deregulation and rapid

diffusion of IT

Economy-wide reform priorities

Indicators of structural rigidities or competitiveness suggest that Japan is in line with many European countries, but lags the United States and United Kingdom. Japan’s overall competitiveness ranking according to the World Economic Forum and the International Institute for Management Development show improvements in recent years. The OECD’s summary index of the restrictiveness of product market regulations also improved but Japan did not make the list of “relatively liberal” countries (Figure 13.2).5

Figure 13.2OECD Product Market Regulation Indicator

(ranging from 0 (least restrictive) to 6 (most restrictive))

Source: OECD

Economy-wide factors that depress productivity include barriers to labor market flexibility, competition, entrepreneurship, information and communications technology (ICT) use, and the framework for innovation. Removing these barriers could have self-reinforcing effects. Bloom and others (2007), for example, suggest that improved labor market flexibility and other factors that promote organizational change in the United States allow U.S. firms to use ICT more effectively—and help explain their faster productivity growth.

Box 13.1The Government of Japan’s Initiatives to Boost Productivity

Initiatives to boost productivity are spread across several fronts. The June 2007 Basic Policies for Economic and Fiscal Reform outlines a multipronged strategy to enhance Japan’s growth potential (aiming to increase labor productivity growth by 50 percent in five years) and reforms to manage the impact of globalization. The main points are:

  • Boosting productivity. Improved labor utilization and greater dynamism at small and medium-size enterprises (SMEs) and in services will be pursued (among other things) by encouraging the accumulation of human capital and fostering ICT investment and utilization. A “job card” system to facilitate hiring decisions and labor mobility through an official record of individual employment and training histories is under development, and long-term job-seekers will be provided “practical education programs.” Strategies for boosting innovation include building common infrastructures for e-business; and deregulation (focusing on areas such as medical services). Other elements involve university reform, and pro-innovation reforms.

  • Addressing globalization. To enhance Japan’s growth potential, the authorities aim to: (i) at least triple the number of Preferential Trade Agreements and Economic Partnership Agreements in force over the next two years; (ii) strengthen competitiveness of financial and capital markets (through development of comprehensive exchanges, and review firewall regulations related to banking and securities); (iii) establish an Aviation Liberalization Timetable (under the Asian open sky policy); and (iv) pursue the Asian Gateway Initiative (which includes reformulating policies relating to foreign students, and promotion of tourism).

Labor market flexibility

Labor market flexibility has advanced but much remains to be done. The dynamism of Japan’s labor market has benefited from a growing share of “nonregular” workers in total employment, improvements to the social safety net, more portable pensions, the expanded role of private placement agencies, longer contracts for short-term hires, and greater emphasis on performance in determining pay and promotion. Still, labor market rigidities remain for example in the form of a lingering presumption of lifetime employment and seniority-based wages. In fact, Japan ranks tenth in terms of employment protection in the OECD (OECD, 2006).

More flexible work hours and practices, compensated dismissals, and greater portability of pensions could enhance the efficiency of the labor market. In the context of a declining and aging labor force, policies to balance employment conditions between regular and nonregular workers, enhance participation rates, and liberalize employment of foreign workers could also play a role in easing labor and skill shortages, while a further opening of the education sector to competition could accelerate human capital development (Box 13.2).6

Overall competition policy

The Japanese authorities have taken steps to foster competition in product markets. In January 2006, a new anti-monopoly law came into force, and the independence of the Japan Fair Trade Commission (JFTC) has also been strengthened. Evidence of early benefits comes from reported savings in public procurement and prosecutions of bid-rigging. At the time of this writing, the Diet is also reviewing bills to address amakudari (the practice of retiring senior civil servants joining large corporations), which raises the risk of regulatory capture. Progress notwithstanding, several key service industries remain sheltered, particularly health, education, transport, and electricity (Jones and Yoon, 2006). Competition is also held back by Japan’s relatively low shares of imports and foreign direct investment (Box 13.3).

Box 13.2Labor Market Reforms

Labor market reforms are driven by the dynamics of global competition and demographic change, as well as a backlash against increasing income inequality. Japan’s population and workforce are now shrinking as well as aging—and doing so relatively more quickly than elsewhere. After peaking in 2006 at around 128 million, the population is expected to decline to around 100 million by 2050, while the workforce is expected to decline by 10 percent in the next 20 years. The share of the population aged 65 or over is projected to increase from about one-fifth currently to over one-third by 2050 (with two pensioners for every three workers). These demographic trends and the growth in the share of “nonregular” workers have also been driving increases in income inequality (OECD, 2006). Maintaining or increasing the contribution of labor to growth (and bucking the trend in income inequality) requires stemming the projected decline in the labor force, improving resource allocation, better matching skills to existing jobs, and upgrading “human capital.” How can this be done?

Increasing participation rates

  • Participation rates for women are relatively low (9 percentage points below those in the United States and United Kingdom) and could be boosted by family-friendly policies such as: more flexible working hours; targeted financial support for parents; affordable childcare (including through more flexible immigration rules); lower marginal tax rates for re-entrants to the labor force; and improved job search support.

  • Female participation rates could also be boosted further by reducing gender disparities in job opportunities and wages (building on the progress made since the adoption in 1986 of the Equal Employment Opportunities Law for Men and Women, and its recent amendment).

  • Participation of older workers could also be encouraged (e.g., by increasing the retirement age).

  • A review of the system of personal deductions for adult children living with their parents and social security contributions could strengthen market attachment.

  • Policies to increase access to foreign workers could offset in part the decline in working age population and help address skills shortages.

  • Addressing the low fertility rate is also an option. Underlying factors, such as the secular increase in the share of unmarried people, can be hard to tackle, but there is some evidence that proactive policies can make a difference: fertility and female participation rates can increase in tandem.

Improving the flexibility of the labor market requires:

  • Clarifying conditions for dismissing workers (including whether compensated layoffs are legal).

  • Improving the portability of corporate pensions. In particular, participation in defined contribution plans could be broadened (at present, employees of companies with corporate defined benefit pension plans cannot join these plans), and upper limits on contributions could be raised further.

Reducing skills mismatches and improving skills overall

The increase in structural unemployment since the early 1990s points to a possible increase in skill mismatches which could be reduced through further development of employment agencies, and appropriate job training.

As mentioned, a key trend in Japan’s labor market has been the growing share of “nonregular” workers (including part time, temporary, and contractual). While adding to labor market flexibility, this shift may hold back the accumulation of human capital because of short job tenure. There are currently large differentials between regular and nonregular workers in employment protections, wage rates, and benefits that are probably unrelated to differences in productivity. Better balancing these conditions would: reduce the incentives to use nonregular workers and support skills development; boost female participation rates (the large majority of nonregular workers are women); increase labor market flexibility; and help address the growing concerns about income inequality in Japan.

The above reforms could have significant payoffs. Matsui (2007) estimates that raising female participation rates to U.S. levels—or increasing the retirement age from 60 to 70—would increase trend GDP growth by around 0.3 percentage points over the next two decades (while both measures combined would boost trend GDP growth by around 0.4 percent).

As suggested by several observers, competition could be further strengthened by:

  • Further enhancing competition policy, including through adequate provision of resources to the JFTC; the monitoring of ex post indicators of competition (such as margins and concentration); and reviewing the effectiveness of the JFTC’s new or enhanced tools, such as higher penalties and a leniency program.

  • Opening up “government-driven” markets where possible, such as medical services, nursing care, and education, through further deregulation and more extensive use of market testing.

  • Accelerating the economy-wide roll-out of successful Special Zone reforms. There are some 400 Special Zones where deregulation is implemented on a pilot basis (although at times in very narrowly defined areas). Reforms to allow joint-stock companies to operate hospitals and schools and reforms related to some social services could be considered for more rapid rollout.

  • Implementing measures to introduce competition into markets with strong incumbents. The establishment of independent sectoral regulators in some industries could also be considered (OECD, 2006).

  • Promoting reforms to facilitate inward FDI including by accelerating regulatory reforms in product markets to facilitate entry. There is also scope for further easing restrictions on FDI, especially in the service and network industries.

Box 13.3Reforms to Strengthen Inward FDI and Trade Integration

FDI into Japan has picked up since the late 1990s but remains low (Table 13.2). The stock relative to GDP is less than one-tenth the average in other G7 countries. This may partly reflect limitations on inward (“out-in”) mergers and acquisitions (M&A), which is the main vehicle for inward FDI in developed countries. In particular, foreign firms were until recently unable to use their stock in “triangular” mergers to acquire Japanese companies. Under the new Corporate Code, triangular mergers have been permitted since May 2007 (but with only one major out-in M&A utilizing this method so far). The new Code, however, also increases possible takeover defenses for Japanese firms. Allowing greater foreign participation in sheltered sectors (such as healthcare) would be the next major step towards increasing inward FDI. Studies find that target firms of out-in M&A tend to become more productive and thus a pickup in overall out-in M&A might boost overall productivity.

Agriculture and trade. High protection in agriculture boosts domestic food prices while stifling sectoral productivity. The recent move towards direct support (from price support) in agriculture has begun to address the problem, but could achieve greater benefits if taken further, particularly with the liberalization of trade in agricultural products and reductions in overall support to farmers. (Chapter 14 of this volume has further details.)

The move to allow nationwide entry of joint-stock companies in agriculture could be supported by reforms of agricultural cooperatives. Steps could also be taken to promote economies of scale in land use.

On trade, the Doha Round offers opportunities for further liberalization. Japan could also move ahead with its 2005 commitment to duty-and-quota-free access on at least 97 percent of tariff lines for products from the poorest countries (particularly in areas such as agriculture). Preferential trade agreements could emphasize complementary liberalization on a most-favored-nation basis (to mitigate trade diversion) and be implemented with transparent, consistent, and liberal rules of origin.

Table 13.2Stock of Inward FDI(in % of GDP)
United States10.515.9
United Kingdom24.847.4
Source: IMF International Financial Statistics.
Source: IMF International Financial Statistics.

Barriers to entrepreneurship

Entrepreneurship and venture capital are relatively underdeveloped in Japan (OECD, 2006). Business start-ups account for around 4 percent of Japanese firms compared with around 10 percent and 14 percent respectively in the United States and Europe. Japan also fares poorly in international rankings of entrepreneurship.

Factors likely to affect new start-ups include the availability of risk capital, as well as the legal and administrative frameworks. Demographics also plays a role to the extent that younger people may be less risk averse. Despite several policy and capital market developments favoring start-ups (Callen and Nagaoka, 2003), venture capital investment as a share of GDP remains relatively low, while the share invested in hi-tech sectors is about half the OECD average. According to the World Bank Doing Business, starting a business in Japan involves more processes, takes longer, and costs more than the average in OECD countries.7 These indicators highlight the need to further develop capital markets and reduce legal and administrative burdens.

Role of ICT and innovation

ICT has been an important driver of growth in Japan (Box 13.4), both in terms of its direct contribution to production and indirectly through efficiency gains.8 During 1980-2004, ICT capital deepening is estimated to have contributed close to a ½ percentage point to gross value added growth. However, ICTs contribution has declined since the 1980s, before recovering somewhat during 2000–04. Factors that may be constraining the contribution of ICT include labor rigidities and barriers to its diffusion (Motohashi, 2005, 2007). As in most other countries, the ICT-related productivity gains in Japan have been for the most part in ICT producing sectors.9

Box 13.4ICT and Service Sector Productivity in Japan

ICT has contributed extensively to production, investment, and exports in Japan. ICT can contribute to growth directly through capital deepening and TFP growth in ICT production, and indirectly through ICT use in other sectors (which would boost overall TFP). The contribution of ICT capital deepening to growth has declined over time. TFP growth in ICT production is the highest among the major OECD economies (averaging nearly 7½ percent during 1995–2004), but because the share of the ICT production in total production is small (as elsewhere), its contribution to overall TFP is limited.

As regards the indirect growth effects of ICT, Fukao and Miyagawa (2007) point to the close correlation between ICT capital services growth and TFP growth for six industrial countries (including Japan) as evidence that ICT investment is associated with economic efficiency (Figure 13.4).

Low ICT capital deepening in services is likely to be a factor behind Japan’s low productivity growth in this sector. Various studies suggest that realizing the benefits of ICT requires the accumulation of complementary intangible assets, such as human capital, knowledge capital, organization capital, and social capital. Fukao and others (2007) estimate that the intangible assets have grown more slowly in Japan than elsewhere. Various indicators suggest ICT usage in Japan is also somewhat lower than in the United States and the United Kingdom. For example, the percentage of students in Japan using a computer at school regularly was among the lowest in the OECD (OECD, 2006). The use of e-commerce in Japan is also relatively low.

Figure 13.4Major Industrial Countries: TFP Growth and ICT Capital Services Growth, 1995–2004

Source: Fukao and Miyagawa (2007) using the EU KLEMS.

By many assessments, Japan needs to revamp policies to encourage innovation. Research and development (R&D) intensity is relatively high, but the returns are low. Possible reasons include: the weak link between business and research institutions; the low degree of trade and investment openness; the inflexible education system; and stifling regulatory frameworks (OECD, 2006). Conway and Nicoletti (2006) estimate the impact of non-manufacturing product market regulations on ICT-using sectors in Japan to be among the highest in the OECD. Thus, knowledge-intensive industries account for only 17 percent of value added (compared with 23 percent in the United States). Productivity in services is also held back by a low share of services in business R&D (Figure 13.3).

Figure 13.3Share of Services in Business R&D, 2003

(in %)

Source: OECD Science, Technology and Industry Scoreboard 2005.

Realizing fully the benefits from ICT and innovation requires strengthening framework conditions. Initiatives should aim to improve organizational flexibility within firms; support investment in intangible assets and risk/venture capital; increase openness; and improve education and knowledge diffusion (OECD, 2006).10

Some sector-specific priorities for deregulation

Wholesale, retail, and personal and social services are the least productive among the service sectors (Figure 13.5). A breakdown of value added by sector also shows low TFP growth, and a relatively low contribution of ICT.

Figure 13.5Contributions to Growth in %, 2000-05 average)

a All industries excludes government services and private non-profit services to households.

Source: Cabinet Office.

One reason may be that these sectors face weak competitive pressures. For example, HøJ and Wise (2004) find mark-ups (particularly in construction and utilities) and the overall price level to be internationally high. This is also reflected in high concentration ratios and stability in market shares.

These sectors also have more restrictive product market regulations than the OECD best performers. Japan was a relatively early mover in terms of deregulating its telecoms, railways, and airlines. However, the speed and depth of reforms still lag that of the United States and the United Kingdom. For energy, transport, and communications, Japan is not on the list of “relatively liberal” countries based on the OECD index of non-manufacturing product market regulations.

In light of the low productivity, the restrictiveness of their regulatory frameworks, and the contributions to output and employment, the priority sectors for reform include distribution (retail, wholesale, transportation) and network industries, which are key inputs to other sectors. In addition, there is ample scope for reforms in government services in sheltered sectors, such as healthcare which accounts for around 8 percent of public spending.

Distribution (retail and wholesale trade, and transportation)

Deregulation in retail and wholesale trade has focused on relaxing restrictions on licensing and store size. The result has been an increase in the number of large stores and discount outlets, and the replacement of “mom and pop” stores with vertically integrated franchises (Høj and Wise, 2004). In addition, steps have been taken to ease sale restrictions in a variety of product lines (e.g. liquor, drugs, cosmetics).11 Nevertheless, despite this progress, productivity in distribution remains relatively low (at less than 60 percent of the U.S. level) and points to an unfinished agenda. Certain marketing practices, such as standardized prices and rebates, may still be restricting competition and the number of large stores remains relatively low, perhaps because of recent regulatory backpedaling.

Productivity in distribution could be raised through:

  • more consistent and transparent application of government regulations on large store location at all levels of government; and

  • fuller utilization of ICT, which is a major driver of productivity in retail trade. Removing the barriers to accumulating complementary intangible assets and greater labor and product market flexibility would facilitate the diffusion of ICT benefits.

As noted by the OECD, deregulation in transportation has also proceeded, but user charges remain high. In the 1990s, entry barriers and charges in the trucking, airline, railways, and taxi industries were lowered. Harbors were also allowed to operate around the clock, the Japan Highway Public Corporation and Narita Airport Corporation were privatized, and landing charges at Narita were reduced in 2005. Nevertheless, despite these improvements, airport, port, and toll road charges in Japan remain high by international standards.

Measures to promote competition could lower transportation costs further. As recommended by the OECD, this could be done by deregulating the distribution, pricing, and settlement of airfares; promoting greater competition between ports, including through outright privatization; and operating toll roads on a cost recovery basis rather than through cross-subsidization.

Network industries

Network industries (electricity, gas, and postal services) in Japan are dominated by vertically integrated firms that have deterred new entrants. To ensure competition and non-discriminatory access, there have been calls for legal or ownership separation. The OECD (2004, 2006) proposes industry specific reform priorities for spurring competition, and highlights the potential benefits of independent regulators.


Initiatives are underway to improve efficiency in healthcare services. These include measures to: increase utilization of ICT (such as by moving to online receipts and improving availability of information on medical institutions);12 increase the share of generic drugs; and reduce the approval time for new drugs and medical devices. Also, joint-stock hospitals were approved under the Special Zones regulatory reform initiative in July 2005, but so far only one has been set up due to the restrictive conditions that such hospitals provide highly specialized and advanced medical services not covered by national health insurance.

Reforms thus far have had a limited effect on containing healthcare costs. These have been rising along with age-related illness and length of hospital stays. Without for-profit hospitals, the role for competition in promoting efficiency, improving service standards, and containing costs remains limited.

Studies by the Cabinet Office suggest greater use of commercial providers and ICT holds much potential for boosting healthcare efficiency. This would involve:

  • Allowing a broader scope for the operation of medical joint-stock companies.13 Consideration could be given to allowing medical joint-stock companies to provide more mainstream medical services in Special Zones, with a view to expanding this nationwide. The currently stringent conditions on the areas in which medical joint-stock companies can operate limit the potential benefits of private sector participation in healthcare.

  • Improving the functioning of the insurance system. Insurers could play a more active role in the healthcare market as informed agents of patients. Further outsourcing of health insurance could be promoted (Iwamoto, 2003).

  • Reforming the pricing system. This should aim to improve transparency of the reimbursements system and, through engagement of industry participants, ensuring a pricing system that supports innovation in pharmaceuticals and medical devices.

  • Improving information disclosure. Disclosure and dissemination of information by healthcare service providers, deregulation of advertisement, and mandatory issuance of receipts with descriptions of treatments, would help patients participate in their own treatment in a more informed way (Imai, 2002; Council for the Promotion of Regulatory Reform, 2006).


In sum, the objective of boosting productivity growth in Japan would best be achieved through a comprehensive and mutually reinforcing set of deregulation measures. Additional efforts to promote innovation and ICT utilization, product and labor market flexibility, inward FDI and trade integration, as well as financial market development, are at the core of the reform agenda. The priority sectors are services, particularly distribution, network industries, and healthcare. The potential returns from broad-based deregulation are substantial and would play an important role in enhancing Japan’s growth potential and international competitiveness as the pace of globalization quickens. Broad-based reforms also hold out the promise of an orderly adjustment of global current account imbalances and a rebalancing of world growth.14


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Services are defined in the broad sense of the tertiary sector, and this chapter focuses on nonfinancial services.

Summaries of various studies referred in the table are in Callen and Nagaoka (2003), Walker (2004), and Organization for Economic Cooperation and Development (OECD) (2005).

A recent OECD (OECD, 2005) study considers the GDP per capita gains if all external and internal barriers throughout the OECD were reduced to “best practice” levels. The study finds the potential static gains for Japan would be almost 4½ percent: 2.4 percent from regulatory reforms, 1.3 percent from cuts in tariff barriers, and 0.7 percent from easing restrictions on foreign direct investment (FDI). The study abstracts from the potential dynamic gains, thus the overall payoff could be substantially higher.

Japan’s Ministry of Economy, Trade and Industry (METI, 2006) suggests that a broad set of reform measures, as outlined in its “New Economic Growth Strategy,” could boost potential output by around 1½ percent. Japan’s Basic Policies 2007 broadly outlined a strategy aiming to boost labor productivity by 50 percent by 2011 (to 2.4 percent from the average for the last decade of 1.6—mainly through higher TFP).

Summary indices of structural rigidities or competitiveness have generally been found to have a significant explanatory power in cross-country growth regressions (Dutz and Hayri, 2000).

Many of the Special Zone reforms relate to the education sector suggesting demand for greater flexibility. Opening up the tertiary sector would help upgrade competitiveness of Japanese universities (OECD, 2006). Reforms to increase participation rates, improve search, and reduce mismatch (through vocational training, etc.) would help reduce the negative growth contribution of the labor force.

For example, starting a business in Japan involves 8 processes, takes 23 days, and costs 7.5 percent of gross national income (GNI) per capita, compared to 5 processes, 5 days, and only 0.7 percent of GNI per capita in the United States.

Chapter 1 of this volume discusses the evolution of potential output growth and TFP.

Recent research suggests that the United States’ higher productivity growth from ICT since the mid-1990s is related to the organization of U.S. firms that permit more efficient use of new technologies (Bloom and others, 2007).

Innovation 25 is a long-term government strategy paper aimed at boosting innovation and potential output through regulatory and other reforms.

The OECD summary index for restrictiveness of retail distribution regulation improved from 5.1 in 1996 (the highest among the major industrial economies) to 2.4 in 2003 (within the range of the other major industrial economies). This improvement was mainly driven by reduced barriers to entry and operational restrictions.

In March 2007, the revised “Grand Design for the Use of Information Technologies in Medical, Health, Long-term Care, and Social Welfare Fields” was announced (an update of the 2001 plan).

The Three Year Plan for Promoting Regulatory Reform of June 2007 also considers this proposal. Imai (2002) suggests that restrictions on service provision should be eased substantially to promote restructuring—including direct restrictions (such as on the number of hospital beds, medical students, etc.), and indirect restrictions, notably the prohibition on “for-profit” companies running hospitals.

Chapter 15 of this volume discusses Japan’s policies from a multilateral perspective.

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