Chapter 6. Japan’s Growth Challenge: Needs and Potential

Dennis Botman, Stephan Danninger, and Jerald Schiff
Published Date:
March 2015
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Stephan Danninger and Chad Steinberg 

Potential growth steadily declined over the past two decades as the effects of Japan’s shrinking labor force outweighed the contributions from solid productivity gains. The average GDP growth rate of 0.8 percent in the 2000s was below that of France, Germany, the United States, and many other developed economies. Deflation, lingering effects of the asset bubble burst in the late 1980s, and structural constraints in domestic markets are commonly thought of as the main culprits. Yet, economic fundamentals have also been less favorable than in other countries; in particular, faster and earlier population aging weighed on growth (see Chapter 3).

But higher growth is needed to bring down Japan’s high debt-to-GDP ratio and sustain stable inflation at the Bank of Japan’s 2 percent target. This chapter poses three questions in this regard. Does Japan have a growth problem? How much faster can Japan grow based on international experience? And how can Japan raise growth?

International evidence indicates that comprehensive structural reforms can raise potential growth by up to 1 percentage point over the course of a decade. In this chapter we find that Japan’s productivity growth has been comparable to that in other countries, but the decline in the labor force has been a major drag on overall GDP growth. Considerable scope therefore exists for raising trend growth, although macroeconomic policies can only play a limited role. As previous chapters discuss, necessary fiscal consolidation will quite likely depress growth for some time, while the zero interest bound constrains conventional monetary policy. A key avenue for increasing potential growth is to pursue mutually reinforcing structural reforms (Abenomics’ third arrow) aimed at raising labor supply, opening up domestic sectors for greater competition and corporate dynamism, creating an environment for new growth sectors to flourish (such as energy, environment, and health care services), establishing a more growth-supporting financial sector, and integrating further with Asia.

Does Japan Have a Growth Problem?

The significant deceleration of growth in Japan stands out compared with that in other advanced economies (Figure 6.1). Potential growth fell precipitously from an average of 4 percent in the 1980s to less than 1 percent in the 2000s. Trend growth also declined in other large advanced economies, but the decreases were more modest.

Figure 6.1Real GDP Growth, G7 Countries

(Percent; year-over-year change)

Source: IMF, World Economic Outlook database.

Note: G7 = Group of Seven.

A decomposition of long-term growth shows that the slowdown in Japan occurred in two waves (Figure 6.2). In the early 1990s—the first decade after the asset bubble burst—growth fell by over 2 percentage points, primarily as a result of a rapid deceleration in capital formation and a reduction in total factor productivity (TFP) growth. In the second phase, beginning in the late 1990s, TFP growth began to recover, but its effects were offset by declining labor input and weak investment growth. More recently, the effects of the global recession in 2008–09 have depressed investment, as in many other countries.

Figure 6.2Japan: Potential Annual Growth Rate

(Percent; year-over-year change)

The main reasons for the decline in trend growth during the last two decades were:

  • A drawn-out resolution of Japan’s banking crisis and balance sheet repair. Following the collapse of asset prices in the late 1980s, banks and nonfinancial corporations were slow in addressing balance sheet problems (including sizable bad debt and high leverage). Low nominal interest rates allowed banks to roll over credit to nonviable “zombie” firms, and a muted policy response facilitated the accumulation of bad debt on banks’ balance sheets (Hoshi and Kashyap 2010). With lending constrained because banks needed to rebuild capital buffers, private investment declined and growth fell, requiring repeated fiscal stimulus to keep the economy going (see Chapter 4). Only after decisive financial sector reforms in the early 2000s under then-Prime Minister Junichiro Koizumi did credit conditions ease again.

  • Demographic changes. Population aging accelerated in the mid-1990s and the shrinking labor force reduced potential growth (Chapter 3). The growth penalty from population aging has been larger than in other advanced economies (OECD 2010) and will remain a headwind. The aging effect is projected to level off in the 2020s as the old-age dependency ratio approaches 50 percent in 2030 compared with about 35 percent now.

  • Mild deflation. For over a decade, mild deflation lowered growth expectations and slowed private investment by raising real levels of debt and higher-than-warranted real interest rates. By lowering tax revenue and raising real social spending (as many benefits are not adjusted for falling prices), deflation also aggravated fiscal problems (Chapter 4).

On the upside, government spending and labor market reforms supported growth. Public infrastructure spending after 1995 boosted the public capital stock, although the impact on trend growth has likely been small owing to declining marginal productivity gains (Doi and Ihori 2006). Amendments to the dispatched labor law in 1999 and 2003 eased employment conditions for temporary and part-time workers and created new employment opportunities. Indeed Ono (2010) finds that, although job mobility remains considerably lower in Japan than in other advanced economies, the prevalence of lifetime employment has steadily decreased. He also finds evidence that the economic stagnation of the 1990s disproportionately affected women and younger workers. These effects of government spending and labor market reforms were most visible in the manufacturing sector, where labor’s contribution to growth increased (Hoshi and Kashyap 2010).

Stripping out the effects of population aging, Japan’s growth was solid until the global financial crisis. During the 2000s, growth per capita was at par with the United States and TFP growth was comparatively high and at similar levels to Germany. The global recession interrupted this overall positive development, hitting Japan particularly hard. Demand for high-end consumer durables and capital goods were especially affected and a sharp decline in investment and labor supply reduced potential growth to an estimated ½ percent in 2012 (Table 6.1). This is far below the 2 percent growth widely considered the threshold for Abenomics to become successful.

Table 6.1Potential Growth in Japan
Potential GDP growth1.40.51.0
Contributions from:
Source: IMF staff estimates.

Under current policies.

Total factor productivity.

Source: IMF staff estimates.

Under current policies.

Total factor productivity.

Lifting the potential growth rate to 1 percent over the medium term is already a major task as it requires a strong acceleration of private investment and steady productivity growth. Raising it even further requires a broad and ambitious effort amid headwinds from further declines in the working-age population. Possible dividends from a sustained exit from deflation are a difficult-to-quantify upside risk. Given the uncertainty about potential growth, estimates of the output gap vary widely. Most estimates suggest a relatively modest gap at end-2014, as evidenced by the relatively tight labor market conditions.

Although productivity growth is high, Japan could grow faster given several favorable factors. The country has close ties to Asia, the world’s fastest-growing economic region; strong balance sheets among large corporations; and a steady current account surplus. About 50 percent of exports go to Asia, and businesses are well placed to meet the needs of a growing middle class in the region. Innovation has remained an important driver of growth as a result of comparatively high spending on research and development (Figure 6.3).

Figure 6.3Research and Development Spending

(Percent of GDP)

Source: Organisation for Economic Co-operation and Development (OECD).

Note: AUS = Australia; CAN = Canada; DEU = Germany; FRA = France; GBR = United Kingdom; ITA = Italy; JPN = Japan; KOR = Korea; OECD = OECD country average; USA = United States.

How much Faster can Japan Grow Based on International Experience?

Sustained increases in potential growth over a decade are rare among advanced economies, but not unprecedented. Using the IMF’s World Economic Outlook database, we find eight country cases since the 1980s in which real trend GDP growth increased by more than 1 percent over a decade and the increase was sustained over at least five years (Table 6.2). Several of these growth improvements came after a deep economic crisis—as in Finland, New Zealand, and Sweden, for instance—which triggered broad-based growth reforms.

Table 6.2Sustained Potential Growth Rate Increases(Percent)
Potential rate
DecadeInitialEnd of decade
New Zealand1985–951.93.4
Source: IMF staff estimates.Note: For advanced economies only. Defined as a 1 percent increase in the growth rate over one decade sustained for five years.
Source: IMF staff estimates.Note: For advanced economies only. Defined as a 1 percent increase in the growth rate over one decade sustained for five years.

The factors behind the potential growth gains differ substantially across the eight country cases. A decomposition of the growth accelerations by contributing factors shows that the main sources of growth were TFP gains and increases in the contributions from labor (Figure 6.4). But the winning formula was quite different across countries. Much of the improvement in New Zealand, for instance, was the result of labor market reforms that raised labor force participation (Brooks 1990). In the Netherlands and Sweden, where reforms stand out as having been particularly durable, the improvements came from greater labor contributions and higher productivity growth. A deep recession in the Netherlands (1980–82) and a banking crisis in Sweden (1990–92) triggered a change in macroeconomic policies and supply-side reforms. Public expenditure-to-GDP ratios were reduced significantly, allowing a reduction of large fiscal deficits and high tax levels; labor markets were made more flexible with increased incentives to work; and product markets were reformed to boost competition. As a result, Sweden experienced two decades of rapid growth and the Netherlands became known for its employment miracle.

Figure 6.4Growth Accelerations and Sources of Increase

(Percentage difference in potential growth rates over a decade)

How can Japan Raise Growth?

To raise potential growth significantly, Japan’s growth reforms will most likely need to proceed simultaneously on multiple fronts. The government needs to proceed with measures under the first and second arrows of Abenomics—ending deflation and restoring fiscal sustainability—to establish macroeconomic conditions supportive of higher growth (Figure 6.5).

Figure 6.5The Three Arrows of Abenomics

Source: IMF staff.

Note: TFP = total factor productivity; TPP = Trans-Pacific Partnership.

For the third arrow, however, there appears to be no single measure that could raise growth substantially and quickly. But there are well-defined areas for reform that are essential to make a growth strategy successful. These include:

  • Labor reforms to increase employment and make labor markets more efficient to counter the effects of a shrinking labor force resulting from population aging (see Steinberg and Nakane 2011, 2012);

  • Reforms that promote competition by opening up protected sectors and easing regulations to enhance productivity and investment;

  • Financial sector reforms to raise the provision of risk capital to foster business creation, new investments, and productivity increases;

  • A more dynamic business sector spurred by corporate governance and tax reform; and

  • Stronger regional economic integration to take advantage of Asia’s growth potential.

Important synergies exist between aggressive monetary easing, medium-term fiscal consolidation, and structural reforms. In the structural sphere, growth will only increase if complementarities are exploited. These exist between deregulation efforts aimed at developing new markets and greater domestic and foreign labor supply in aging-related services, between providing risk capital for new investment and opening of markets to greater competition, and between trade agreements and efforts to spur greater business dynamism. Indeed, Berger and Danninger (2007) explore the effects of labor and product market deregulation on employment growth. Their empirical results, based on an Organisation for Economic Co-operation and Development (OECD) country panel from 1990–2004, suggest that lower levels of product and labor market regulation foster employment growth, including through sizable interaction effects. The rest of this chapter briefly reviews key structural reforms that, in combination, could have a measurable impact on growth. Following chapters will have a fuller discussion of many of these issues.

More Foreign Labor

Given the decline in the labor force, increasing participation needs to be an integral part of any growth strategy for Japan. There is much the country can still do to mitigate the decline in the size of its workforce relative to other OECD countries, since both immigration and female labor force participation are low (Figure 6.6). Chapter 7 discusses options for raising labor force participation and the efficiency of labor markets, including by reducing the duality between workers with regular and nonregular employment contracts.

Figure 6.6Immigration and Female Labor Participation

(Percent share of foreign labor and percent share of women in labor force)

Sources: Organisation for Economic Co-operation and Development; and International Migration Database.

Note: AUS = Australia; AUT = Austria; CAN = Canada; CHE = Switzerland; CZE = Czech Republic; DEU = Germany; DNK = Denmark; ESP = Spain; FRA = France; FIN = Finland; GBR = United Kingdom; GRC = Greece; HUN = Hungary; JPN = Japan; KOR = Korea; NOR = Norway; USA = United States.

A complementary reform option is to raise the level of foreign labor.1 In 2013, the government introduced a points-based, preferential immigration treatment system to attract highly skilled foreign professionals. Broadening eligibility criteria to include a spectrum of different skill sets could overcome employment bottlenecks in nontradable sectors such as construction, childcare, and long-term care for the elderly. Substantial scope exists to increase the percentage of foreign-born workers, currently about 1.7 percent of the total work force.2

Highly skilled immigrants could also be an important source for innovation in traditional sectors. Kerr and Kerr (2011) report that, in the United States, immigrants represented almost one half of the engineering workforce based on the 2000 census and several studies connect high-skill immigration to growth in innovation in cities or states. Foreign labor has also become a key in providing long-term care for aging populations. The vast majority of studies suggest that immigration does not exert significant effects on native labor market outcomes, either on employment or earnings. Japan could consider a more ambitious, targeted immigration policy for high-skilled workers and implement it within the newly established special economic zones.

With the aging of the population and associated fiscal costs, one advantage cited in other economies is the positive impact of immigration on public finances. In Japan, this would be particularly relevant. Although new immigrants improve public finances by raising output and paying taxes, they also consume social services, and so the net effect is difficult to quantify, with most recent studies showing mixed results (Kerr and Kerr 2011).

Potential labor market displacement effects may also emerge because of an increase in the labor supply. In general, this should put downward pressure on overall wages, with the impact largest on relative wages or employment of natives for whom immigrants are close substitutes. This overall effect on wages needs to be weighed against the benefits from higher aggregate demand and stronger growth (see Chapter 3). In the health and old-age care industry, where wages are already 25 percent lower than other industries, there is a strong concern that immigration would put further downward pressure on wages or at least prevent them from rising. International evidence of these effects, however, is mixed, with the majority of studies unable to substantiate a significantly large impact (Kerr and Kerr 2011). Boubtane, Coulibaly, and Rault (2011) empirically examine the interaction between immigration and host-country economic conditions. They use a large annual dataset on 22 OECD countries over 1987–2009 and provide evidence of migration contributing to host economic prosperity (positive impact on GDP per capita and negative impact on aggregate unemployment, native- and foreign-born unemployment rates). They also find that migration is influenced by host economic conditions (migration responds positively to host GDP per capita and negatively to the host’s total unemployment rate).

Beyond increasing the size of the labor force, immigration can also have non-traditional positive impacts on the economy. Saiz (2007) has shown that immigration raised housing prices in the United States, and an emerging literature is linking immigration to increased entrepreneurship (OECD 2011). In addition, although recent immigrants tend to have lower earnings than natives, the increasing use of point systems—in, for example, Australia, Canada, and the United Kingdom—raises the skill level of immigrants. Finally, immigration can boost entrepreneurship through self-employment and job creation.

One specific sector that would benefit substantially from greater immigration relates to the provision of long-term care for the aged. Long-term care is a small but growing sector globally (Figure 6.7). The OECD (2010) estimates that, in 2008, average long-term care expenditure accounted for 1.5 percent of GDP among its member countries. Spending will quite likely more than double over the coming decades and could exceed 4 percent of GDP in Japan by 2050. Since long-term care is labor intensive, labor demand will probably grow rapidly in line with rising demand for these services.

Figure 6.7Projected Demand for Long-Term Care Workers

(Percent of labor force)

Source: Organisation for Economic Co-operation and Development.

Note: As a percentage of full-time nurses and personal caregivers to total projected working population.

Long-term care programs globally have steadily evolved and are increasingly shifting to cash benefits with more user choice. There are many different arrangements, but the trend is to move away from fully covered institutional care—which is costly—to more flexible, at-home care arrangements. New cash-for-care programs provide consumers with more choice and control over services (OECD 2010). Recent reforms in Austria, Finland, and Germany, for instance, provide cash benefits for targeted groups, such as disabled elderly, which they then can use to hire home-care help from private providers. Services vary and usually imply some private cost sharing.

Because of domestic shortages, many countries rely on immigration to supply long-term care services. In Europe, labor mobility within the European Union and simplified licensing requirements provided a boost for such activities. From a growth perspective, a flexible long-term care program can raise growth by:

  • Freeing up captured labor or preventing family caregivers from dropping out of the labor market, while providing employment for the underemployed. The availability of qualified in-home care for the elderly reduces demands on family members, mostly women, to provide care. A study on Australia estimates the opportunity cost of forgone earnings as a result of unpaid family care of the elderly as equivalent to nearly 10 percent of the total expenditure on formal health care in the country (Manaaki 2009). In several countries, trained foreign workers meet the growing service need, but this could also be a source of employment for underemployed domestic labor.

  • Creating a new private service market. Country experiences, such as in Austria, show that long-term care programs with cash benefits, adequate choice, and quality control address a rising unmet demand (Riedel and Kraus 2010). Although the funding for these services still comes primarily from the public sector, they reduce the demand for more costly institutional care and increase private spending. A well-functioning market could draw in private household saving and generate a new services market that could in turn produce substantial employment and income.

Competitiveness Reforms: Opening Protected Sectors and Easing Regulations

Japan’s domestic-oriented sectors account for more than 80 percent of activity. Comparisons of productivity levels across countries, especially of services, are unreliable and differences in preferences (such as for more labor-intensive services) may play a role. But time-series data show that productivity growth in Japan’s tradable sector has been much higher than in services (Ogawa, Saito, and Tokutsu 2012) (Figure 6.8). One reason for the slower productivity growth in services could be the lingering effects of past public support policies—for example, exemptions and weak penalties in the Antimonopoly Act—which have limited competition. Promising initiatives include:

Figure 6.8Japan Labor Productivity Index

(2000 = 100)

Source: Organisation for Economic Co-operation and Development.

  • Special economic zones. The designation in 2014 of large parts of the Japanese economy for these zones, including nine regions in Tokyo and Osaka, could accelerate deregulation and enhance dynamism. The small size of areas dedicated to pilot projects or an ineffective decision-making process have hampered past efforts to reduce red tape. The government’s new approach of exploiting economies of scale could overcome these problems, although it will take time to assess whether this will be successful and be used as a laboratory for nation-wide reforms.

  • Reforming the agricultural sector. Although affecting only a small share of the economy, reforming the agricultural sector could have an important catalytic effect for broader reforms. To promote land consolidation, the government in late 2013 approved a bill setting up a land consolidation bank for each prefecture. The establishment of land banks could help consolidate farmlands by allowing renters to combine plots through leasing them. The government is also phasing out subsidies that provide incentives to maintain small land plots. While it is difficult to assess the overall economic impact of these reforms, productivity increases within the agricultural sector could be substantial. Naomasa (2013) estimates that productivity improvement from greater economies of scale could exceed 60 percent, based on estimates derived by comparing TFP rates across regions with different average agricultural plot sizes.

  • Reforms in the energy sector. These have proceeded swiftly. Legislation passed in late 2013 and early 2014 laid out a road map for opening the electricity grid to other suppliers, tariff regulation, and an eventual separation of the network from electricity production. The new legislation is a fundamental departure from the past structure of Japan’s energy market. It aims to infuse more competition into the sector and promises substantial efficiency gains if protected areas can indeed be opened up.

The growth benefits of deregulation could also be seen in downstream industries. Reforms would not only generate efficiency gains in the directly affected sectors, but also have positive spillover on sectors that use services as inputs. A recent cross-country study finds that greater service sector competition is associated with greater output growth, productivity gains, and exports in downstream sectors (Barone and Cingano 2011). Across industries, the effect is more pronounced in energy provision and through regulation of professional services. In terms of the size of firms, there is a particular need to reform the small and medium-sized enterprise (SME) sector, including restoring incentives for corporate restructuring to facilitate firm entry and exit (see Chapter 8 for a fuller discussion).

Financial Sector and Corporate Governance Reform

More effective financial intermediation and a greater willingness to allow SME restructuring could foster innovation, raise investment, and help generate new markets. The availability of credit appears ample, but the pervasive risk aversion of financial institutions and underdeveloped risk management tools have constrained financing for more risky investments in new growth areas. At the same time, a reluctance to let nonviable zombie firms fail and government involvement in credit intermediation (for example, through credit guarantees) have weakened credit assessment capacity, limited SME turnover, and kept corporate debt levels among SMEs high. Chapter 9 discusses how financial sector policies can help promote growth.

Japanese companies have high savings compared with other Group of Seven countries and comparable tax rates on dividend income (Figure 6.9). But the preference for holding large amounts of cash prevents them from increasing wages (Chapter 7) and investment (Chapter 9), holding back aggregate demand and potential growth. This view is consistent with Shinada (2012), who uses Japanese firm-level data for 1980–2010 to analyze the impact of cash holdings on business performance. His results suggest that conservative cash management—regardless of large investment opportunities—increases “side-line” cash and firms cannot fully utilize investment opportunities to maximize return on assets.

Figure 6.9Composite Taxation on Dividend Income, 2014

(Percent; corporate plus individual tax rate)

Source: Organisation for Economic Co-operation and Development.

The existing literature suggests that corporate governance is a significant determinant of cash holdings and that Japan fares worse compared with other Group of Seven countries on firm-level governance attributes; for example, boards, audits, shareholder rights, ownership, and compensation. Aoyagi and Ganelli (2014), using a panel of Japanese companies, suggest that improving corporate governance—proxied in the regression by an index summarizing company disclosure of governance data—could reduce corporate cash holdings and contribute to the recovery. Reform options include complementing the recently introduced stewardship code for institutional investors with a corporate governance code for firms, and expanding the use of outside directors.

As noted in the previous chapter, taxation might also play a role in affecting corporate cash holdings since Japan has one of the highest statutory corporate tax rates among advanced economies. Reducing the corporate tax rate could help stimulate investment demand but, given high public debt, fiscal implications need to be taken into account. Tax reforms also need to take incentives for debt financing into account, which could keep firms cash holdings high. Kunieda and Shibata (2005) argue that higher corporate taxes make debt financing more attractive than other means of financing, thus reducing free cash flows.

Tapping into Regional Dynamism

On the international stage, Japan has not taken full advantage of its growth potential in a number of areas. During the last decade, export market shares have declined and inward foreign direct investment is low, which has reduced gains from technology spillover and limited competition in domestic sectors. According to the OECD, Japan had the lowest import penetration rate for services in 2003 and the lowest growth rate of service imports during 1997–2005. Taking advantage of Asia’s economic dynamism should therefore be a centerpiece of growth reforms. Measures to better tap into overseas growth potential include:

  • Pursuing free trade or economic agreements. Japan has lagged in signing trade agreements, especially with the United States, the euro area, China, and Korea. It did, however, make a breakthrough in 2014 with a new trade deal with Australia. The most promising development on the multilateral front has been Japan’s decision to join membership negotiations of the Trans-Pacific Partnership free trade agreement. This is envisioned as a highstandard, twenty-first century trade agreement that includes commitments covering all aspects of trade and investment. It includes many regional trading partners like the United States, Canada, and Mexico. As such the partnership is seen as a starting point for a broader free trade area in Asia and the Pacific.

    The Trans-Pacific Partnership requires unfettered market access for foreign companies to domestic markets, including agriculture and services, potentially triggering domestic reform and efficiency gains. The immediate economic effects from lowering tariffs are estimated to be 0.2–0.3 percent of GDP based on estimates derived from the Global Trade Analysis Project model. The analysis is static in the sense that it only captures the economic efficiency impact of a tariff removal, but no allowance is made for more dynamic adjustments, such as incorporating the impact of capital accumulation and productivity improvements. The main economic gains may be substantially larger (see Schott, Kotschwar, and Muir 2013) and come from efficiency increases associated with the opening of domestic markets by fostering more competition and innovation. Any such gains will quite likely accrue gradually, in line with the usually extensive phase-in periods of trade agreements.

  • Promoting inward foreign direct investment. This should be pursued by reducing legal and nonlegal impediments, especially in services, and strengthening the business environment. Trade agreements could help with the harmonization or mutual recognition of licenses. Agreeing on common standards and qualification requirements would also substantially enhance market integration and reduce setup costs of foreign firms.


Japan’s growth performance over the past two decades has been robust if population aging is excluded. However, higher growth is needed to bring down the high debt-to-GDP ratio and sustain stable inflation. International evidence shows that comprehensive reforms can raise potential growth up to 1 percent over the course of a decade, but only few advanced economies have achieved this. Attaining higher growth requires raising labor supply—to counter the effects of a declining population—complemented by deregulation to increase competition and innovation, a greater supply of risk capital to fund new activities, corporate governance reforms, and closer economic and trade integration with the region to take advantage of Asia’s high growth momentum. Since these reforms will take time, steady progress on the third arrow of Abenomics is needed. Only then can Japan overcome its growth challenge.


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Raising potential growth by ½ percent would require additional employment of ½–1 million (out of an 80 million person labor force) per year.

The actual share is likely much lower, with second-generation Japanese and long-term Korean residents accounting for a significant part of this number.

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