Chapter 9. Japan: Low Growth and an Aging Population

Hamid Faruqee, and Krishna Srinivasan
Published Date:
August 2013
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Mitali Das1

Japan has sustained fiscal deficits over many years that have led to a dramatic increase in public debt. Large fiscal deficits have resulted from persistently low growthreflecting a trend decline in productivity, a shrinking labor force, and low investmentas well as the needs of a rapidly aging population, and a series of policy missteps. At the same time, private saving has remained high, helping Japan maintain persistent external surpluses. Unsustainable fiscal imbalances pose risks to domestic stability, and also carry risks for the global economy. Growth-enhancing structural reforms (to boost investment and potential growth) and fiscal consolidation measures (through a combination of entitlement reform and tax measures) are needed to reduce imbalances and anchor sustainability.

The collapse of asset markets in the early 1990s marked the origin of a prolonged period of economic stagnation in Japan. From 1973 to 1991, Japan was one of most dynamic economies of the G20, growing at an average annual rate in excess of 4 percent. But growth came to an abrupt halt with the bursting of the asset-market bubble in 1991. Private demand collapsed, leading to repeated fiscal stimulus over a decade to sustain overall demand. Despite steadily widening fiscal deficits and policy rates that were brought down to nearly zero, output remained largely unresponsive, growing at an average annual rate of 1.1 percent from 1991–2001. Japan suffered from a string of negative output gaps and intermittent deflation during the period. Growth improved modestly in 2002–07, averaging 1.8 percent annually, before the financial crisis caused a severe contraction in output.

Low growth, deflation, and large fiscal deficits have had adverse implications for public debt. The steady increase in primary deficits—from an average of 1.7 percent of GDP in the 1990s to an average of 5 percent in 2000–07—is reflected in the evolution of the net debt ratio, which rose from 12 percent of GDP in 1991 to 81 percent in 2007 and from 67 to 188 percent in gross terms.2 This is by far the highest debt ratio among advanced economies (Figure 9.1).

Figure 9.1Gross Debt for G20 Advanced Countries, 2010

(Percent of GDP)

Source: IMF staff calculations.

In the decade following the asset-price collapse, rising deficits were primarily a consequence of increasing expenditures (including fiscal stimulus) and a series of tax cuts, with a lower (relative) contribution from revenues. In the late 1990s, the cyclically adjusted deficit began to widen significantly, as entitlement spending began to rise with an aging population and structurally low revenues played a more significant role (Figure 9.2). The share of social security expenditures in GDP rose from 10 percent in 1991 to 16 percent in 2007.

Figure 9.2Japan: Structural Balance of the General Government

(Percent of potential GDP)

Source: IMF staff calculations.

More recently, the deep recession and the fiscal response that followed the global financial crisis pushed debt to unprecedented levels. Following the crisis, net debt escalated sharply to 130 percent in 2011. The rise in the public debt ratio reflected the combination of a steep decline in nominal output, a drop in revenue, fiscal stimulus (around 2½ percent of GDP in both 2009 and 2010), and automatic stabilizers. Recovery from the financial crisis was interrupted by the March 2011 earthquake, which brought fiscal balances under further pressure. Reconstruction efforts are likely to add fiscal costs of around 3 percent of GDP over the next several years.

Despite substantial public dissaving, Japan’s external balance has remained in surplus for over two decades. This has occurred because deteriorating public balances have been roughly offset by rising private sector surpluses (Figure 9.3). In particular, deep structural changes effected by the asset-price collapse led both national saving and national investment to fall about 7 percentage points of GDP between 1992 and 2008. More recently, during the financial crisis, the rapid increase in public expenditure resulted in a much larger decline in national saving than investment, temporarily compressing the external surplus.

Figure 9.3Japan: Sectoral Financial Surplus

(Percent of GDP)

Sources: Haver Analytics; and IMF staff calculations.

The trend decline in national investment has been driven by the private sector. Private capital formation fell from a high of 26 percent of GDP in 1990 to 18 percent in 2008, reflecting deep structural transformations in the economy, including the unwinding of overinvestment in the asset-price-bubble era, a protracted process of corporate deleveraging, and expectations of low growth.

Public investment was a key stimulus measure in the years immediately following the asset-price bust, rising about 2 percentage points of GDP over 1990–95 to 8 percent in 1995. Thereafter, the public investment ratio steadily declined to around 4 percent in 2008, and the share of public investment in stimulus measures was relatively small in the recoveries following the Asian crisis, the dot-com bubble crash and the recent financial crisis (where it contributed one-half of a percentage point of GDP in the 2009 stimulus package).

The decline in national saving has been led by large public sector dissaving. In particular, private saving rates ranged between 20 and 26 percent for nearly the entire period of 1990–2008,3 while gross public saving declined 7 percentage points from 1990–2004, before rising modestly in the years before the financial crisis.

The composition of private saving rates, however, underwent a dramatic reversal during this period. Household saving rates declined from 8 percent of GDP in 1991 to under 3 percent in 2009, reflecting an aging population and stagnating incomes, while corporate saving rates surged from 16 to 21 percent as a result of a sustained drive toward restructuring and favorable financial conditions.

Fiscal imbalances are projected to remain large going forward. Following the global financial crisis and the March 2011 earthquake, IMF staff have projected that a near-term decline in GDP and reconstruction efforts will push the net public debt ratio to 160 percent by 2015 (IMF, 2011a). Reflecting the relatively slow recovery, projections are for private saving imbalances to persist as well at high levels over the medium term.

Root Causes of Imbalances

The fundamental reasons for major imbalances in Japan’s economy and public finances are the long duration of the economic slump and adverse demographics. Large and rising fiscal imbalances in Japan are fundamentally a reflection of persistently low growth. Low growth has spurred public spending and depressed tax revenues over many years, perpetuating a cycle of adverse debt dynamics. Low growth has also made it politically difficult to introduce corrective measures: until recently, Japan had had no major (revenue-raising) tax reforms in more than 20 years. Fiscal imbalances have persisted due to high private saving, strong home bias, and the existence of stable institutional investors.

Anemic Growth

Stagnating output reflects the confluence of a trend decline in total factor productivity (TFP), a shrinking labor force, low capital investment, and inadequate policy adjustment after the asset-price collapse. In real terms, output grew just 25 percent between 1990 and 2007 and the contraction experienced during the recent crisis reduced real output in 2010 to its 2005 level (in nominal terms, to its 1995 level) (Figure 9.4).4

Figure 9.4Japan: Gross Domestic Product

(Trillions of yen; base year 1990)

Source: IMF staff calculations.

TFP growth decelerated steadily after the collapse of asset markets in 1991 (Figure 9.5).5 Japan’s low aggregate productivity is largely a consequence of low productivity in services, as manufacturing has witnessed sustained productivity gains over the last decade. The slowdown is significant not just because of its impact on output growth but because, by lowering the expected rate of return on capital, it has hindered private investment. While some of the TFP deceleration may have been inevitable after exhaustion of technological catch-up after the 1980s, policy distortions have played a significant role. These include government policy schemes that subsidize inefficient firms through credit guarantees; barriers to entry in key service industries that inhibit competition and limit incentives for firms to invest in productivity-enhancing technology;6 and restrictions on inward foreign direct investment (FDI) that limit spillovers such as transfer of technology. Credit guarantees to small and medium-sized enterprises (SMEs) have perpetuated the problem of “zombie” firms that started in the 1990s—namely, inefficient enterprises have lingered, constraining investment by healthier firms.7

Figure 9.5Japan: Growth Accounting


Sources: Japan Cabinet Office; and IMF staff calculations.

Note: TFP = total factor productivity.

Demographic change has also been inimical to growth. The growth of Japan’s labor force has steadily declined since the early 1990s, turning negative in the early 2000s, with direct consequences for output and growth potential (Figure 9.6). Participation rates have also been on a trend decline. Trends in the labor force reflect an aging population and declining fertility. The share of the elderly in the population rose 14 percentage points from 1980–2010 (in part due to rising longevity), making Japan the oldest as well as the fastest-aging population in the world, while fertility rates fell from 1.75 births per woman to 1.3.8

Figure 9.6Japan: Labor Force Size and Participation

Source: IMF staff calculations.

Against this backdrop for productivity and labor, private investment has also been weak. While investment by large manufacturers, particularly in the export sector, has seen brief periods of expansion, investment by SMEs has stagnated for decades. Structural changes in the Japanese economy from lower potential growth to deflation (and its effect on real interest rates) and distortions in the regulatory environment lie behind these trends. Notably, inadequate restructuring of SMEs has held back investment. In the late 1990s, large manufacturing firms restructured aggressively, spurred by pressures from competing in global markets and helped by favorable overseas conditions. However, restructuring in insulated sectors of the domestic economy—notably among SMEs in services—has been much slower. In part, this reflects credit guarantees for SMEs that limit incentives for bank-led workouts and restructuring.9 As a consequence, balance sheet problems and high leverage have lingered in SMEs, making it difficult for them to secure financing for investment. Meanwhile, the practice of directing the bulk of credit guarantees to established firms has acted as a barrier to entry against new and more productive firms, further restraining investment.

Investment has adjusted to expectations of lower trend growth. The decline in the growth of the labor force, and expectations of a continued slowdown, have implied slower steady-state growth of the capital stock and lower trend growth expectations for the years ahead. Low growth expectations in turn have resulted in a downward adjustment of investment. Export-oriented manufacturing has been less affected by domestic prospects, as its brighter growth prospects, lower production costs, and bigger markets abroad have encouraged firms to substitute FDI for domestic investment.10 But even in this sector, investment has been subdued barring brief episodes (e.g., 2003–07), while weak domestic prospects have dampened investment demand by domestically oriented firms, notably SMEs in the services sector.

Policy missteps have played a part, too. Monetary policy could have been eased faster in the years following the asset-price collapse. Real policy rates were lowered only gradually, from over 5 percent in 1990 to 1 percent in 1995, providing inadequate stimulus to revive demand and prevent the emergence of deflation. In addition, the stop-start nature of fiscal policy dampened its effectiveness. With only nascent signs of recovery in 1997, fiscal stimulus was withdrawn and a consumption tax to initiate fiscal consolidation was put in place on the eve of the Asian crisis. But the contraction in output that followed the outbreak of the crisis led to a resumption of stimulus measures. Moreover, weak corporate governance, along with delays in recognizing the severity of nonperforming loans and balance sheet damage for over a decade after the asset-price collapse, also proved costly, both in terms of taxpayer funds and in holding back a recovery, as zombie firms lingered, constraining investment by sound firms.

In the near term, many factors that have contributed to Japan’s growth slowdown are likely to persist or intensify. Pressures from demographics are going to increase, concerns about growth expectations will be amplified by the sluggish global recovery and recovery from the earthquake, and major reforms will be needed to comprehensively address much-needed SME restructuring.

Adverse Debt Dynamics

Weak output growth, in turn, has eroded tax revenue collection. A declining revenue share of GDP has played a significant role in the buildup of public debt. This share fell 3 percentage points from the peak of the asset-price bubble to the late 1990s, and then stagnated until the mid-2000s (Figure 9.7). Stagnant revenues in the 1990s resulted from a series of tax cuts, while a narrowing of the household tax base has played an important role since. The household compensation share in GDP was fairly constant from the 1980s through the mid-1990s, but thereafter, with stagnating incomes in the 2000s, it declined 2 percentage points by 2007. As a consequence, the elasticity of household tax revenue vis-à-vis GDP deteriorated (Table 9.1).11

Figure 9.7Japan: Cumulative Contribution to Net Debt

(Percentage points of GDP)

Source: Japan Cabinet Office.

Note: On a general government basis.

1Residuals reflect, for example, transfers from outside of the general government.

TABLE 9.1Japan: Trends in Tax Elasticity(Percent average)
Total tax elasticity1.291.31−0.960.554.150.97
Household income tax elasticity1.271.56−5.063.48−2.051.77
Corporate tax elasticity1.341.40−3.872.198.1213.59
Household compensation share in GDP0.540.540.540.530.520.53
Household property income share in GDP0.
Corporate profit share in GDP0.
Sources: Japan Cabinet Office; and IMF staff calculations.Note: Tax elasticities are vis-à-vis GDP.
Sources: Japan Cabinet Office; and IMF staff calculations.Note: Tax elasticities are vis-à-vis GDP.

Tax buoyancy has also changed. Household tax elasticity in the 1990s was initially large and negative during the period of positive growth, then large and positive during the recession in the late 1990s, as reflected in a significant drop in tax revenues over the decade as a whole. The main reasons appear to be the provision for the deduction of asset market losses and progressivity of the income tax system.12 From 2003–07, with relatively healthy GDP growth, household tax elasticity vis-à-vis GDP turned large and negative, drawing revenues down further. Decomposing this elasticity into the elasticity of household tax revenues vis-à-vis the household tax base, and the elasticity of the household base itself vis-à-vis GDP, reveals that the deterioration was largely driven by a severe narrowing of the household tax base. In particular, household incomes stagnated even as output grew at a healthy pace, resulting in a significant drop in tax revenues.13 The high volatility of total tax elasticity over the last two decades is indicative of ongoing structural changes in the economy, and thus gives little indication of the impact of future taxes on future tax revenues.

Further pressure on fiscal balances has come from entitlement spending. Since the early 2000s, Japan’s non-social-security spending has been well contained and, at about 16 percent of GDP in 2010 (Figure 9.8), was the lowest among G20 advanced economies. Meanwhile, social security benefits have risen steadily due to population aging. Social security spending rose 60 percent from 1990–2010, accounting for about half of consolidated government expenditure in 2011.14 Moreover, a sustained increase in the old-age dependency ratio has implied larger social security payments supported by a shrinking pool of workers, which has rapidly deteriorated the social security balance.15

Figure 9.8Japan: Distribution of General Government Expenditures

(Trillions of yen)

Source: Japan Cabinet Office.

Private Saving Imbalances

The high aggregate private saving rate embeds a deep imbalance. In particular, it reflects a high corporate saving rate, which trended up from 13 percent of GDP in 1981 to 21 percent in 2009, and a very low household saving rate, which declined from 10 percent of GDP to less than 3 percent over the same period (Figure 9.9).16 Spending retracted during the financial crisis, pushing the private saving rate up to 23 percent in 2009, highest among the advanced G20 countries.

Figure 9.9Japan: Private Sector Saving Rates

(Percent of GDP)

Sources: Japan Cabinet Office; and IMF staff calculations.

The decline in household saving rates reflects a rapidly aging population and the stagnation of household incomes. After growing at an average annual rate of 5 percent in the 1980s, nominal disposable income growth slowed to an average 2 percent in the 1990s and was flat from 2002–07. Stagnating household disposable income has been accompanied by a rising consumption share of disposable income and declining saving among younger households, which has reinforced dissaving by elderly households.

The rise in corporate saving reflects a sustained drive toward restructuring after the excessive indebtedness built up during the asset-price bubble, and has been facilitated by wage moderation and a long period of low interest rates. Strong demand from China, and periods of real effective depreciation associated with deflation and a weak yen, along with the strong and stable income balance from corporate overseas operations, contributed to a sharp rise in profitability (measured by asset turnover and profit margins) for a sustained period between 2002 and the start of the financial crisis.17 The increase in corporate gross saving led to a rise in corporate excess saving (i.e., net lending) as well, reversing many years of net borrowing through the 1980s and 1990s.

BOX 9.1Have Japanese Households “Pierced the Corporate Veil”?

The striking decline in household saving rates over the period from 1981 to 2009—and by approximately the same magnitude as the increase in the corporate saving rate—suggests that Japanese households “pierced the corporate veil” by adjusting their own saving plans to offset the saving by corporates on their behalf. The argument is that, as ultimate owners of firms, sophisticated shareholders understand that an increase in corporate saving (retention of earnings rather than paying them out as dividends) increases their own net worth and reduces their private saving, re-optimizing in accordance with the life-cycle model of consumption.

Well-known limits to this theory are that households may be myopic, liquidity-constrained, and imperfectly informed about changes in corporate saving, as well as have differential propensities to consume out of wealth versus disposable income. Furthermore, even if shareholder households successfully pierce the corporate veil, their marginal propensities to save may be different from nonshareholder households (Poterba, 1987). In Japan’s case, specifically, the corporate veil argument may be harder to rationalize because the share of equities and trusts held by households is about 10 percent of total household wealth (compared to 40 percent in the United States and 20 percent in other G5 economies).

Nevertheless, determining whether household and corporate saving in Japan is indeed fungible is ultimately an empirical question. Ongoing regression analysis indicates that Japanese households’ piercing of the corporate veil is incomplete. In particular, a ¥1 increase in corporate saving reduces household saving by between ¥0.65 and ¥0.8.1 These estimates are higher than the estimated degree of substitutability between U.S. households and corporates (Poterba, 1987).

1Regression of household saving rates (as a percent of disposable income) on covariates that include corporate saving (share of GDP), household wealth (share of GDP), output gap, old-age dependency ratio, dividend payout (share of GDP), and the real interest rate.

Globalization of labor and product markets and deregulation in domestic markets have restrained wage growth. Real wages stagnated, growing just 1 percent from 1996–2007. As a consequence, the labor income share dropped from 65 percent in 1991 to 60 percent in 2005 (Sommer, 2009). These wage developments must be viewed in the context of a longer-term decline in the labor income share in advanced economies. In particular, historically, Japan’s labor income share was significantly higher than that in other advanced economies. But it has since declined and is now at the G7 average. The integration of large emerging market economies into the global economy facilitated the relocation of manufacturing to regions with low production costs, keeping manufacturing wages flat despite impressive gains in productivity. In nontradables, stagnating productivity and a rapid rise in the hiring of temporary, low-wage, and nonregular workers (facilitated by deregulation) put downward pressure on wages in Japan, which helped maintain lower wages in the tradable sector as well.

Favorable financial conditions also aided the rise in nonfinancial corporate saving (Figure 9.10).18 The surge in profits was partly a result of a striking decline in interest payments, which dropped from 12 percent of GDP in 1991 to less than 2 percent in 2009, reflecting both lower borrowing rates and a protracted process of corporate deleveraging. Corporate profitability and saving were also boosted by lower tax payments, resulting from a decline in statutory corporate tax rates since the late 1980s and stagnant dividend payouts, which have persisted between 1–2 percent of GDP in periods of stress as well as in boom years. Corporates have also devoted an increasingly smaller share of profits to upgrading or expanding their capital stock. Japanese nonfinancial corporates were net borrowers continuously from 1980–97, but then increased their net lending position from 1 percent of GDP in 1998 to 5 percent in 2009. Notably, in this time period, slightly more than half the increase in net lending emerged from a decline in capital investment rather than an increase in saving.

Figure 9.10Japan: Nonfinancial Gross Saving and Payments

(Percent of GDP)

Sources: Japan Cabinet Office; and IMF staff calculations.

Against a backdrop of high profitability, the subdued level of nonfinancial corporate investment is tied to both cyclical and structural factors. From a cyclical standpoint, corporates may have viewed high profitability as unlikely to be sustained going forward and, thus, held back investment in light of growth expectations. This appears to be corroborated in the Bank of Japan’s Tankan surveys conducted during 2003–07, where firms revealed relatively subdued growth in sales.

More structurally, corporates may have increased saving to reduce dependence on external financing. Faced with high debt ratios since the collapse of asset markets, Japanese nonfinancial corporates have used profits to repay debt. Moreover, concerns about vulnerability to volatile financial market conditions have spurred firms to reduce their dependence on external financing. This is supported by Tankan surveys that reveal that, since 2003, only a small majority of corporates have viewed lending conditions as accommodative.

Private Saving Financing Public Dissaving

Despite the large and increasing public debt, the government’s interest burden has remained low. Between 1992 and 2009, the net debt ratio rose about a 100 percentage points while nominal yields on 10-year Japanese government bonds (JGBs) steadily declined and stabilized at less than 2 percent (Figure 9.11).19 These developments in the government bond market reflect the confluence of several factors. In effect, while high private saving (equivalently, low private spending) has forced a government that wants to maintain output to run large deficits, low risk appetite and the strong home bias of institutional investors20 has led to a large domestic base for JGBs that has enabled the government to finance its debt at very low cost.21 Notably, in 2009, 95 percent of outstanding JGBs were held by domestic financial institutions and households. Without recourse to this vast pool of savings, funding costs and debt service would have arguably risen faster, and possibly forced an earlier resolution of fiscal imbalances.

Figure 9.11Holdings of Japanese Government Bonds, as of end-2009

Source: Ministry of Finance.

Government-owned saving and insurance institutions have provided a captive domestic base for government financing needs. Japan Post Bank and Japan Post Insurance remain fully government-owned and, until 2007, were not subject to regulation by the Financial Services Authority under the same set of rules, risk controls, and disclosure as other financial institutions. In return, funds have been required to be invested in safe assets, particularly JGBs.22 The recent suspension of plans to privatize Japan Post and proposals to double its deposit ceiling potentially increases the demand for JGBs. At the same time, it threatens to increases the size of an already large financial institution, raising the potential for systemic risk.

In summary, large fiscal and private saving imbalances primarily reflect Japan’s inability to resolve multiple structural weaknesses. Low and declining trend growth, low productivity, mild deflation, and the declining labor force must be tackled simultaneously, given that these structural weaknesses are mutually reinforcing.

Are Japan’s Imbalances a Problem?

Large fiscal imbalances pose risks to domestic stability and also carry risks for global external positions and sovereign bond markets.

Domestic Risks

Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable. Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift. In Japan, two scenarios are possible. In one, private demand would pick up, which would lead the Bank of Japan to increase policy rates, in which case the interest rate–growth differential might not change much. The other is more worrisome. Market concerns about fiscal sustainability could result in a sudden spike in the risk premium on JGBs, without a contemporaneous increase in private demand. An increase in yields could be triggered by delayed fiscal reforms, a decline in private saving (e.g., if corporate profits decline), a protracted slump in growth (e.g., related to the March 2011 earthquake), or unexpected shifts in the portfolio preferences of Japanese investors. Once confidence in sustainability erodes, authorities could face an adverse feedback loop between rising yields, falling market confidence, a more vulnerable financial system, diminishing fiscal policy space, and a contracting real economy.

With regard to public balance sheets, with exceptionally low nominal yields on JGBs, interest payments in 2010 were still 2 percent of GDP (Figure 9.12). An increase of just 100 basis points in average yields would raise the interest bill by an additional 2 percent of GDP, or more if there were a contemporaneous increase in debt. Absent an offsetting effect from more rapid growth, debt dynamics could deteriorate precariously.

Figure 9.12Japan: Public Debt and Interest Payments

(Percent of GDP)

Source: IMF staff calculations.

As regards private balance sheets, a JGB bond shock, particularly if accompanied by an equity price drop, would imply large capital losses for the principal creditors, which are Japanese banks and pension funds. Capital losses could raise counterparty risks and force banks into abrupt deleveraging. IMF staff analysis suggests that if the shock is sufficiently large, bank credit would contract as well (IMF, 2011b). Moreover, should banks’ deleveraging extend to their positions abroad, exchange rate appreciation could follow, further squeezing aggregate demand.23

Multilateral Perspective

A spike in JGB yields could result in an abrupt withdrawal of liquidity from global capital markets and possibly disruptive adjustments in exchange rates. Japan’s private net international investment position is significant at about $1.5 trillion, consisting primarily of the outward investments of banks, life insurers, and corporate pension funds. Capital losses following a spike in JGB yields could trigger rapid deleveraging from positions abroad.

In the event of a rise in JGB yields, Japanese banks may need to cut their foreign credit lines. For example, analysis in the IMF 2011 Spillover Report for Japan indicates that an extreme shock (e.g., a 450 basis-point increase) would cut Japan’s credit to foreign borrowers by close to 50 percent, assuming that foreign loans are cut first. G20 economies, notably the United Kingdom and Korea, would be among the most exposed to the loss in funding (IMF, 2011b).24 Also, given evidence from past bouts of global turmoil, abrupt adjustments in exchange rates of major economies are likely to follow.

Finally, the rise in JGB yields could put upward pressure on sovereign yields elsewhere. The risk of transmission of sovereign debt shocks has increased considerably since the 2008 crisis, including from Japan to other sovereigns. Contagion could thus translate a rise in JGB yields into higher interest rates elsewhere. Sovereign bond yields in economies where public debt is already high tend to be the most vulnerable.

How to Address Imbalances

To address imbalances and anchor strong, sustainable, and balanced growth, Japan needs to undertake growth-enhancing structural reforms and growth-friendly fiscal consolidation. Over time, these reforms should help close the output gap, thereby helping to end deflation, encourage investment, and rebalance the economy toward domestic demand. In the short run, however, a key challenge will be to fiscally consolidate while minimizing the negative effects on aggregate demand.

Growth-Enhancing Structural Reforms

Raising productivity is crucial to raising Japan’s potential growth over the medium term. Policy priorities include restructuring SMEs and reducing barriers to entry (particularly for start-ups) to improve productivity in services; removing distortions that impede investment; and raising labor force participation. Anticipation of higher productivity could itself encourage business investment, strengthening aggregate demand. These three priorities are developed in more detail below.

  • Strengthening competition in the services sector. To strengthen competition and raise productivity in insulated industries, Japan needs regulatory reforms that lift barriers to entry in key service industries (medical care, education, transport, utilities); policies that encourage competition, including through stronger penalties for antitrust violations; broader trade and financial liberalization (such as participation in the Trans Pacific Partnership); and weaker restrictions on inward FDI (e.g., lower equity restrictions and easing merger and acquisition rules) (OECD, 2006).

  • Restructuring SMEs and phasing out credit guarantees. Establishing asset management companies to purchase distressed loans would promote bank-led restructuring and reduce SME leverage. Phasing out credit guarantees and assisting the exit of unproductive SMEs would remove a key barrier to entry for more efficient firms and create space for new investment.

  • Raising labor force participation. Japan has the lowest level of female labor force participation among member countries of the Organization for Economic Cooperation and Development (OECD), reflecting in part the lack of childcare services and unfavorable tax treatment that discourages female labor participation. Reducing dualism in the labor market, increasing childcare services, and reforming aspects of the tax code that reduce work incentives for secondary earners would encourage more women to join the workforce. The labor force could also be increased by allowing for greater immigration.

Fiscal Consolidation

The Fiscal Management Strategy adopted by the government in June 2010 is a step in the right direction, but a more ambitious strategy is required to maintain confidence in public finances. The government’s plans—including targets for halving the primary deficit (in percent of GDP) by 2015, raising the consumption tax rate from 5 to 10 percent, increasing the pension retirement age, and adjusting pension benefits for deflation—are welcome. Further tax reform has also been announced more recently in 2013. However, the plans do not specify steps beyond 2015 for meeting the final of reducing the debt ratio starting in 2021 at the latest.

Given limited scope for cutting expenditures, fiscal adjustment would need to rely mainly on new revenue sources and limits on spending growth. Japan’s non-social-security spending is lowest among G20 advanced economies and capital spending has fallen to modest levels, leaving little room for spending cuts. Meanwhile, tax revenue is among the lowest in the advanced G20 economies, primarily reflecting lower consumption and personal income tax revenue.

Among various revenue measures, raising the consumption tax (the value-added tax –VAT) is the most appealing. The consumption tax rate in Japan, at 5 percent, is the lowest among the advanced G20 countries. IMF staff analysis indicates that a gradual increase in the consumption tax from 5 to 15 percent over several years could provide roughly half of the fiscal adjustment needed to put the public debt ratio on a downward path within the next several years.25 Raising the VAT would dampen growth in the short run, but this could be offset over time by improved confidence in the fiscal outlook.26 Containing public spending growth and reforming pension entitlements in line with rising life expectancy could generate additional saving. IMF staff analysis indicates that freezing central government contributions to the public pension system in nominal terms, including by raising the pension retirement age (currently 65), could yield 1/2 percent of GDP in savings over 10 years (IMF, 2011b). Additional saving would come from freezing non-social-security spending in nominal terms and introducing caps on social transfers.

Toward Global Action

To best contribute to healthier global growth and rebalancing, Japan needs both fiscal adjustment and structural reform. Fiscal adjustment would depress growth in the short run, while structural reforms could buoy growth after a transitional period during which the measures take hold and begin to produce positive effects. While consolidation would likely strengthen the current account surplus, it would significantly reduce attendant risks tied to fiscal sustainability concerns down the road. Growth effects could be particularly severe if Japan were hit by a sovereign risk premium shock. Possible policy elements toward contributing to an upside scenario would include both fiscal consolidation and structural reform.27

A comprehensive and simultaneous approach toward fiscal consolidation and structural reforms could be mutually reinforcing and generate considerable gains in growth over the medium term. Although fiscal consolidation has short-term costs, the potential long-term benefits are considerable and reforms that raise potential growth could support consolidation.


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Mitali Das is a Senior Economist in the IMF Research Department. This chapter was written with guidance from Josh Felman and support from Eric Bang, David Reichsfeld, and Anne Lalramnghakhleli Moses.

Net public debt is gross financial liabilities less gross financial assets of the general government (central and local governments, and the social security fund), while gross public debt refers to gross financial liabilities of the general government. Net public debt is the more relevant concept for long-run debt sustainability, while gross debt is the key indicator from a market perspective, given Japan’s large rollover requirements. The latter measure tends to be more comparable across countries as well.

Private saving abruptly and briefly spiked to 31 percent of GDP in 1998.

As a reference, between 1990 and 2007, real output grew 33 percent in Germany, 37 percent in France, 53 percent in the United Kingdom, 64 percent in the United States, about 300 percent in India, and about 500 percent in China.

Estimates of TFP over 1990–2008 vary widely, but most economists agree that TFP growth has slowed considerably since the 1990s; see Hayashi and Prescott (2002), Jorgenson and Motohashi (2005), and Naoki (2011). Calculations here are based on a standard Cobb-Douglas production function, with capital share of output set at 0.32 (average from 1980–89).

Services sector investment is notably low in research and development, and particularly in information and communication technology, which was instrumental in accelerating productivity elsewhere (e.g., the United States).

A widespread practice in the 1990s had Japanese banks lending to these unprofitable firms known as “zombies,” whose presence discouraged entry and investment by healthier firms. See Caballero, Hoshi, and Kashyap (2008).

That the decline in the growth rate of output since the asset-price collapse has been much smaller in per capita terms than in level terms only underscores the importance of demographics in Japan.

Credit guarantees to SMEs have ceilings and duration limits from seven to 10 years, but the credit guarantees are sometimes granted with limited evaluation of potential credit risks. See McKinsey Global Institute (2000).

Although outward FDI as a share of GDP is small, the share steadily increased from 0.5 percent of GDP in the 1990s to more than 1 percent over 2000–07.

Tax elasticity calculations in this section are done with respect to central government revenue.

See Mühleisen (2000), who notes that loss carry-forwards may have depressed corporate tax elasticity in the mid-1990s.

While the corporate tax base has progressively grown since the 1990s, it is significantly smaller than the household tax base.

Estimates put old-age-related expenditures at about 70 percent of social security spending.

The social security system is partially funded. The social security balance refers to the difference between social security contributions (plus government transfers) and social security payments.

The evidence indicates that households partially pierced the corporate veil in this period. See Box 9.1.

See Kang, Tokuoka, and Syed (2009) for a more detailed discussion of this period of corporate profitability.

The gross saving ratio in the financial sector was on a mild upward trend between the asset-price bust and 2009, and did not contribute significantly to the large increase in corporate saving.

Given mild deflation (consumer price index inflation averaged −0.3 percent from 2000−10), real long-term bond yields have also been low, ranging from 0.1 to 2.7 percent over the same period (calculated as nominal long-term bond yields less CPI inflation).

This includes banks, pension funds, and life insurance funds, where the vast majority of household financial assets are held.

Some argue that historically high real estate prices in Japan have encouraged private investors, notably households, to accumulate JGBs to achieve the correct portfolio balance between risky assets (i.e., housing) and safe assets (Iwaisako, Mitchell, and Piggot, 2004). The share of currency and deposits in households’ financial assets was 55 percent in 2008.

As of end-2010, Japan Post Bank held about 76 percent of its assets in JGBs (amounting to 19 percent of outstanding JGBs), and Japan Post Insurance held about 66 percent of its assets in JGBs (amounting to about 8 percent of outstanding JGBs).

If the risk premium shock were accompanied by an equity price drop, large capital outflows by residents could induce net depreciation and offset some of the decline in demand.

As emphasized in IMF (2011b), however, it must be noted that since Japan’s cross-border banking links are relatively limited, a sudden withdrawal of funding from Japan, in isolation, is unlikely to threaten systemic stability of any other banking system.

See Keen and others (2011) for more information on the recommended adjustment strategy.

Relative to the no-adjustment case, IMF staff estimates are that a gradual increase of the VAT (alongside other fiscal consolidation measures) would reduce growth modestly (compared to the baseline) by 0.3–0.5 percentage points per year in the near term but carry long-term benefits. See IMF (2011b)

Preliminary simulations by the OECD (2006) show that if reforms were implemented rapidly, they could add about 0.7 percentage points to growth within a few years. This assumes that Japan’s framework gradually converges to best practices in terms of barriers to FDI, regulation of network industries, and barriers to entry in services (especially retail trade and professional services). Further work could explore the implications of restructuring SMEs.

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