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Human capital, technology and sectoral policies for growth.

This chapter takes up some key regulatory issues concerning the network sectors as well as policy questions more directly linked to growth, including human capital formation and the arrangements for R&D and for university research. The first section examines reforms of the network sectors -- telecommunications, electricity and gas and posts. In the context of growth, the sectors are playing different roles. Telecommunications prices and the availability of services has a direct connection via costs with the diffusion of information and communications technologies (ICT). Despite the hype of the late 1990s, the diffusion of ICT appears to have an effect on productivity and growth although the process is complex, and can involve productivity gains in traditional sectors. The linkage of the other network sectors to growth is less direct. Electricity prices are high by world standards so that a reduction in costs due to competition would be expected to raise the steady state level of real incomes so that the direc t impact on the growth rate would be only temporary. The postal sector is important because of its control of a huge amount of savings. However, in other countries courier and fast mail services have been an important growth sector. The second section deals with human capital formation covering not only tertiary education but also skill formation more generally that has traditionally been provided by enterprise training. The third section covers the difficult and hard to define area of technology including how policy and institutions affect the way enterprises go about furthering their research and innovation capability. The incentive structure the universities face appears to be an important determinant of their behaviour, and recent policies to improve the productivity of these institutions are also reviewed.

Promoting competition and thereby lower prices in the network sectors

Progress in establishing competition in the network sectors has been mixed, with the greatest progress being in the telecommunications field. In other sectors, resistance from incumbents is proving to be intense and their lobbying activity effective. The government has maintained its policy of retaining the previous ministry in the role of regulator for the relevant sector, albeit with input from the FTC through the joint issue of guidelines.

Telecommunications

In the fast changing telecommunications market it is important that the authorities continue to develop the regulatory framework in line with changing circumstances. Even though prices are generally tending downwards as in other countries, they remain relatively high in comparison with other countries, especially in some market niches (Figure 28). (124) Market dominance remains an issue to be resolved both in the less competitive basic services and in the newer, more competitive sectors where the issue is the potential by the incumbent for leveraging power from one market to another. Rapid progress is also important in view of the government's strategy to promote the use and diffusion of ICT as part of its overall policy for future growth, and several recent regulatory moves will benefit consumers by stimulating competition.

Last year's Survey noted that an important step forward had been taken with the new Telecommunications Business Law that established the principle of asymmetrical regulation based on market power and also addressed the issue of universal service obligations and dispute settlement. However, the Survey also noted that a great deal would depend on how the enabling regulations are formulated and implemented by the regulator, the Ministry of Public Management, Home Affairs, Posts and Telecommunications (MPHPT). Clearly defined ex ante controls of anti-competitive behaviour needed strengthening, with particular emphasis on constraining the behaviour of the dominant incumbent.

In a welcome move, the regulator (MPHPT) and the FTC have now issued competition guidelines, which attempt to bring together telecommunications law and competition law in a comprehensive framework. However, this ex post synthesis reveals several weaknesses. First, since the telecommunications sector is still dominated by a powerful incumbent, adequate powers of investigation and enforcement are crucial. Enforcement must be credible through, for instance, the ability to exact heavy fines. (125) Moreover, for competitors it is essential that the dominant player be subject to restrictions on anti-competitive behaviour on an ex ante basis and not rely on injured parties to bring a case. In these areas both the FTC and the MPHPT operate with weak laws, and their weakness is compounded by their lack of specialised staff. Second, the new law and the associated regulatory system have been built around the essential facilities concept (i.e. the importance of bottlenecks), and they are consequently focused on the owner ship of such facilities. It is therefore logical that the regulatory framework has emphasised access to buildings (colocation) and the determination of interconnection fees and conditions. (126) But the underlying issue is the potential for the abuse of dominance by the incumbent, including its subsidiaries and affiliates. Here the current law is, if anything, too explicit and its lack of clear guidance based on competition policy principles might at some stage undermine the enforceability of the associated guidelines. The latter recognise that problems arise from the possession of essential facilities and from "carriers that are assumed to have market power that comes from big market share and other factors". Observers have noted that the authorities do not possess a clear methodology for determining the relevant market for telecommunications services and for assessing market power -- other than the ownership of facilities. A new law is under preparation which is intended to address some of these issues.

A crucial feature of the current NTT law is the possibility for the two NTT regional companies, NTT East and NIT West to expand into new competitive areas of business even though they are regarded as dominant carriers enjoying considerable market power in their primary market. The scope of operations can be widened on condition that this does not detract from their usual business (especially the provision of universal service) and that fair competition is ensured through, for instance, firewalls (2001, Survey, p. 131). The enacted Jaw thus moved away from the original intention of only allowing the NTT group into new activities in return for first establishing effective competition in its major markets where contestability is weak. The implementing regulations include a criterion -- "the maintenance of competition" -- which appears to assume that there is already a satisfactory level of competition. The regulations and the practice to date also appear to switch the onus of proof to the regulator who must argu e why NTT should not be allowed into new activities rather than shifting the burden of proof to the company. It will be important to assess the situation not only one market at a time but to consider that power in one level of the overall market will often confer power in other sectors. An example of what may be involved concerns the advantages the incumbent enjoys from its customer data base. To encourage further competition in high speed net access, NTT will be required to let new entrants use its customer information relating to connection requirements.

In the absence of measures to change the structure of the NTT group by, for example, breaking it up into competing entities, a great deal of emphasis has been placed on firewalls with little actual physical separation. Last year's Survey was sceptical that such procedures would be strong enough to prevent cross fertilisation, information sharing, joint marketing and bundling in view of the commercial pressures at work. (127) Indeed, in summer 2001 the MPHPT was forced to issue administrative guidance three times over unfair marketing practices associated with carrier pre-selection. If firewalls are less than secure, regulatory oversight of ex ante rules becomes even more important. The fact that NTT was forced to enter the DSL market and to undercut its existing market in leased lines and ISDN (integrated services digital network) should be seen as a regulatory success. Policies designed to open the local loop to competition (unbundling and line sharing) enabled other companies that provide broadband services to enter forcing NTT to react. Although the incumbent has now achieved a 40 per cent market share, this is low compared which incumbents in other OECD countries. In such a situation, it will remain important to make sure that NTT does not leverage its power in other markets to gain an advantage in this competitive segment at some stage.

The introduction of a fund to ensure universal service remains on the agenda but needs to be considered carefully. In a market where the majority of the population owns a mobile phone, the case for subsidising fixed line services even in out of the way places needs to be considered by reference to both the costs and benefits involved. In the United Kingdom, for example, it was found that the benefits to the incumbent from being a universal service provider outweighed the costs of being designated to maintain these services.

The Telecommunications Dispute Settlement Commission set up in November 2001 has examined 24 complaints in its first eight months of operation, mostly dealing with colocation and therefore interconnection disputes. The scope of the Commission is limited to contractual matters. It has power to ask for information, and can also recommend to the Minister of MPHPT to force a response. However, it has no power of subpoena and cannot look at anti-competitive behaviour as such, which is the role of the regulator.

A major problem in the past has been access to rights of way such as to ducts and poles, which constitute in many instances essential facilities. The competition guideline now classifies them as such, which is an advance over past practice. Moreover, the MPHPT has also insisted that an electricity company, which has entered the telecommunications field, make its poles available at a cheap price to competitors. (128) However, the pricing methodology for other rights of way appears to be unclear. As in other aspects of enforcement, it appears that a complaint must be brought for unfair restriction of access rather than access being an obligation in the law with exceptions to be ruled after a dispute. Rights of way will, however, become less of a problem if the government proceeds with its plans to widen access by private companies to the government network, including those at local level. This should be confirmed in the next amendment to the business law to be submitted in 2003.

Promoting the effective diffusion and use of ICT

By some measures such as numbers of secure servers and PC intensity per hundred inhabitants Japan lags behind other countries in ICT use (Figure 29). As regards the change in PC intensity, a measure used in the Growth Project, Japan is in the bottom group of countries in the OECD area. Indicators more oriented to business use are also poor: the ratio of regular employees per personal computer is five to one and about 80 per cent of firms reported problems in implementing IT investment. (129) In other areas there has been considerable progress. In the last six months, broadband connections have been increasing by 300 000 per month driven by intense competition by a new entrant, which offers access costs of only 20 dollars per month, the least expensive rate in the OECD. This is in no small way due to MPH PT forcing NIT to give access to its local loops at low prices. There is also a very high penetration of cell phones that have full time, constant mobile access to the Internet. Convenience stores have also be come focal points for B2C e-commerce, serving as payment and distribution centres, as well as Internet access points through multi-media terminals. This has led at least one observer to conclude that a significant, though unique, electronic infrastructure is coming into place. (130)

The barriers to ICT diffusion have been identified by the Growth Project (Box 9) and are also applicable to Japan. Communications costs have been high through the 1990s -- and remain relatively high in some niches -- (Figure 30) (131) but internet costs have come down rapidly during the past year. There are also a number of barriers which appear to be specific to Japan and that are being examined by the inter-ministerial IT Strategic Headquarters. There appears to be a problem with keyboard literacy, though this might be related to the higher age of many executives compared with other countries. Many firms also report difficulties in acquiring computer literate staff (NLI, op. cit.). The lack of trained staff might well prove temporary until students graduate in larger numbers. But given the structure of wages paid in Japanese firms that favour seniority, starting wages in these highly skilled areas might be too low to encourage a major increase in supply. (132)

The government believes that ICT use will be a major force driving future growth and socio-economic developments and to this end has announced a national broadband initiative. The programme sets a goal to promote the deployment of high speed/ultra high speed Internet infrastructure to cover some 40 million households by FY 2005. If achieved, this could make Japan "the most advanced IT nation in the world". Part of the programme simply involves projections about what the private sector is expected to attain by way of the extension of fibre optic networks, the development of DSL, the prices they will likely charge, and the response of households. Corresponding to changes in the telecommunications market, the Telecommunications Council has proposed to scrap the difference between those with and without their own networks (i.e. type I and type II business categories) and to deregulate market entry, moving from the present permission system to a simple registration/notification procedure. This move will also suppo rt the government's ICT programme. Internet firms could also expand to telecommunications. Under the proposed amendments, the MPHPT will also supervise carriers affiliated with power companies, which are not subject to the telecommunications law at present. Another crucial part of the programme foresees public investment in network infrastructure to cover those regions and activities not covered by the private sector, and some cases where public money will support the private sector. One of the most important components of the programme is the introduction of e-government by FY 2003 with extensive public local area networks (LAN) connecting public institutions including schools. Local governments are to develop their plans with the central government setting standards and providing finance. The task is huge: there are for example 36 000 forms currently in use. The government will thus have to learn the lesson from the private sector that the ways of doing things will also have to change and to be simplified.

It is too early to assess this potentially ambitious programme since many details are not yet known. For example, it remains to be seen how public funds will support certain activities by private competing firms; how government networks will be developed and integrated with the infrastructure more generally; and indeed, how private competition will in fact develop. The government should serve to help set standards and remove regulatory barriers as it did with the rapid development and dissemination of the Fax (Porter et al.). What needs to be avoided is any temptation to trade-off the development of a vibrant competitive telecommunications sector in favour of one which would be amenable to meeting the government's programme targets for extension of connections to less favourable areas.

Electricity and gas

Progress in liberalising the electricity sector has been delayed, despite high electricity prices, because the reform process is relying for advice on an unwieldy panel that includes a variety of interest groups. These companies are reluctant to consider the separation of their generation and transmission activities. Selling to large customers, accounting for 26 per cent of the market, has been liberalised since March 2000. However, the system remains a virtual monopoly with new players only accounting for 0.4 per cent of the total market. New players must pay high transmission fees to each grid crossed, which has been an important barrier to establishing a nation-wide market. Moreover, there are also back-up fees to ensure supply by major generators when there are power shortages. This assurance would be provided better by time-of-use tariffs, as these would allow the more efficient use of power at periods when it is in short supply. (133) High transmission fees and low market share for the newcomers has not prevented the existing companies from taking action to raise barriers to entry. Such behaviour has led the FTC to become more active in cases involving newcomers. Three such cases have been examined since last November, which led to incumbents changing their actions. The government foresees reform proposals being finalised by the end of this year so as to prepare legislation for 2003. However, the Electricity Industry Committee, although having agreed on a phased liberalisation of the retail market, has yet to reach a consensus. Issues that need to be considered according to the government's initial planning include the precise form of a power exchange and how to ensure non-discrimination by the integrated owners of the transmission grid. In addition, as the Regulatory Reform Review of Japan recommended in 1999, terms and conditions of access to transmission and distribution networks and provision of ancillary services should be regulated, with prices reflecting the underlying costs; the networks and the (po tentially) competitive activities such as generation should be separated; and the regulation of the sector should be independent from policy-making functions and electricity promotion functions, with transparent decisions and due process for the review of decisions.

Gas liberalisation is tied to the progress in the electricity sector, since natural gas is both an input into and, in part, a competitor to electricity. It is more difficult for gas companies to enter electricity markets than vice-versa. The gas sector is more fragmented with more than 200 companies. More than two thirds of imported gas is brought in by the electricity companies. Most of the remaining one third is imported by the few general gas companies that have facilities for receiving and storing liquefied natural gas. Thus access to regasification facilities and transmission are important for the development of competition in this sector.

Postal services and reform of the post office

Laws covering reform of the businesses run by the post office and the corporatisation of the entity (saving, life insurance and postal services) were passed by the Diet in July, and allow competitors to enter new areas of delivery services in competition with the postal agency. These bills illustrate the difficulties facing the Koizumi government and the complex issues involved. The Prime Minister viewed the bills as setting the framework for limiting the scope for what the public sector should do, a key element of the government's overall strategy, and for preparing the way ultimately for privatisation. Facing opposition, the government sent the bills to the Diet without prior approval from the ruling LDP which then negotiated changes during passage. Under the bills only businesses with approval from the Ministry of Public Management, Home Affairs, Posts and Telecommunications (MPHPT) will be allowed to deliver postal mail. To win approval, companies will have to provide uniform services nation-wide (uniform price and 100 000 mailboxes everywhere), including small out of the way places. Entry requirements thus appear to be restrictive. As with some other utilities they would also have to submit their business plans to the MPHPT for approval. A key issue is how mail is to be defined. Initial statements from the MPHPT indicate that credit card deliveries and some direct mail such as catalogues will continue to be regarded not as post and so can be handled as at present by private delivery firms. Express mail delivery has also been opened to competition but the conditions concerning minimum prices and maximum time for delivery will limit the size of the market. (134)

As the postal corporation will be a dominant player with substantial monopoly powers, there is a danger that it will distort competition in the liberalised sectors and engage in cross subsidisation. This has already happened in Europe and in the telecommunications sector in Japan. The threat is even greater in view of the generous financial treatment of the new corporation. While in principle it will be required to pay the equivalent of a corporate tax, this is due only every four years and will be waived if it will harm the financial stability of the corporation. A reason for restricting market opening in the mail sector and in opposing reforms of the postal savings bank is the concern of the authorities to finance universal service obligations. However, financing such obligations through cross subsidisation and market closure is highly inefficient. In the telecommunications sector, universal service obligations will be financed in a transparent manner by all operators. But in this sector there is at least s ome connection between the existence of the fixed network and the operations of new corners. This is not true in postal services while in postal saving there is nothing to prevent direct contractual relations with private banks. Universal service obligations should therefore be paid directly by the government but only after first assessing the relevant costs and benefits and putting incentive structures in place to ensure efficient provision of such services. In sum, although the limited opening of some market segments is welcome, the Diet has at the same time created an effective monopolist (which also offers banking and insurance products) with potential to distort competition. In these circumstances, plans for privatisation are premature until a clear, independent, regulatory framework including asymmetric regulation is established to ensure that competition develops in a fair and non-discriminatory way.

The banking and insurance sections of the post will be fully integrated in the new corporation and not handled separately as recommended in last year's Survey. In addition to the preferential rules regarding taxation of the comoration, the banking side may also benefit from not having to pay the equivalent of deposit insurance premiums. The post office is currently negotiating with the government on this, although it is hoped that broader considerations regarding competition in the financial sector will prevail.

Transport infrastructure

Regulatory inefficiency is apparent in both the operation of airports and harbours with Japan having the highest charges in the world. These constitute a major burden on the economy and act to limit trade. This has remained the case despite evidence that earlier deregulation in road transport and in domestic aviation has had a positive effect on productivity. (135)

The regulatory deficiency in running airports has been compounded by the enormous cost of building facilities due in part to weak enforcement of land acquisition laws and high construction costs. Rather than improving, the situation could deteriorate due to the inflexible slot allocation system run under the auspices of the Ministry of Land, Infrastructure and Transport. In essence, Tokyo has only one international airport, Narita, where slots are in excess demand. Yet with the completion of a new short runway the two strips are being treated as if they were two non-competing airports by allocating slots for each runway. An agreement with local communities limits options, but by not using the limited possibilities that are available to encourage small aircraft to stop using the main airstrip, the capacity for the larger aircraft remains limited raising scarcity rents. (136) Problems are also being created in the future when the small strip is lengthened since current operators (of small aircraft) will have gr andfather rights. In sum, the regulatory system does not promote economic efficiency. The problem might be compounded in the context of privatisation of public corporations (Chapter II). One proposal is that the terminal operators will be fully privatised eventually, but a public corporation will oversee land development for the three major airports and cover existing debt, which will be serviced from rental income. In this case charges will remain high at Narita to help pay for the 1 trillion yen in debt already owed by the loss making airport at Kansai.

Maintaining a high level of human capital

Although the Japanese system of education, employment and training has contributed to dynamic growth in the past, the increasing importance of knowledge and the associated change in technology and business organisation including employment practices are challenging the traditional methods of human capital formation.

The traditional system of human capital formation has been successful up till now...

The Japanese educational system has been successful in a number of areas even though at the tertiary level it often plays mainly a screening role. (137) School under-achievement has been reduced, and the average educational attainment has been raised. In the post-compulsory tertiary system, the estimated returns to education have been reasonably positive, which suggests that students and parents have received the appropriate signals to carry out what is sometimes a large investment in education. (138) Nevertheless, the actual role of tertiary education per se, other than screening, is rather limited as firms play a large part in human capital formation after recruitment. This has significantly weakened the incentive for universities to improve the quality of education. The proportion of post-graduate students at universities is also relatively low compared with some other OECD countries. (139)

A key feature of human capital formation in Japan is that firms have a strong commitment to job training, which is often accompanied by frequent job rotation within firms. The life long employment system, together with a progressive wage profile based on seniority, penalises quits and effectively guarantees firms a return to their investment in the human capital of their employees. This system has contributed to the strong competitiveness of the manufacturing sector, where skill and knowledge accumulation by workers has played an important role in raising product quality and in promoting process innovation. Smaller firms especially in manufacturing also carry out job training, sometimes in co-operation with larger enterprises they supply. Traditionally, the government has supported the system by paying training subsidies to firms (only for off-the-job training), grants to individuals being very limited. This reflects the institutional arrangement that many of those subsidies are funded by the employment insur ance schemes where funds for training subsidies are provided only by employers, rather than by employees. A downside of the system is that since human capital accumulated within firms is mainly related to firm-specific skills, such human capital can depreciate significantly once workers leave the enterprise.

... but pressures for change are rising

Firms have reduced their job training during the 1990s. While it remains to be seen how far this is a temporary reaction to cyclical factors, changing attitudes are already evident. According to a survey conducted by the Ministry of Labour, the proportion of firms which conducted particular training for their employees fell from 86 per cent in 1993 to 61 per cent in 1997 as firms intensified restructuring efforts. (140) Although 76 per cent of firms answered that they should be responsible for human capital formation of their employees, an increasing number of firms thought that individual employees should be more responsible for their own human capital formation in the future (the Japan Institute of Labour). Some experts have expressed concerns about the possible erosion of human capital in restructured firms, which could result in lower competitiveness of those firms in the long run. This concern could be exaggerated since there are many other forces currently at work.

The forces driving these changing attitudes include a much greater sensitivity to overall labour costs, an increased need on the part of firms to react quickly and changing demands for skills. Costs and flexibility considerations have led to an increase in non-regular forms of employment such as part-time work and temporary workers from agencies (known as dispatched workers in Japan). Since workers on part-time or temporary contracts tend to receive relatively little training, the increase in the numbers of those workers could raise efficiency concerns, unless their temporary status is only a transition period to a more usual work contract. However, temporary workers are not necessarily unskilled workers -- just workers trained elsewhere and possibly on their own account. Greater mobility of workers and increased demand for ICT skills have also led to fears that company training might be reduced, but they appear to be misplaced.

The fear often expressed in Japan is that the diffusion of ICT will lead to reduced job tenure and to weaker incentives for firms to invest in human capital. Such a fear appears to be misplaced since the incentives for individuals to seek their own training have also risen. However, micro data suggests that the diffusion of ICT is not necessarily associated with reduced tenure/greater mobility across all categories of jobs. An OECD study has found that tenure for skilled workers has tended to increase in many OECD countries, while tenure for unskilled workers has tended to decrease. (141) Regarding the impact on incentives for training, many studies including Arnal et al. (2001) and CAO (2002) find that the incidence of training is higher in firms that have adopted new work practices suggesting that it facilitates the process.

Firms have shifted their method of acquiring human capital from on-the-job training to off-the-job training as the increased importance of new technologies requires higher skills and knowledge which cannot be provided efficiently by the firm itself. (142) This trend is reinforced by the shift of the economy from manufacturing to the service sector, where the incidence of off-the-job training is much more important. Many firms think that professional graduate schools should play a bigger role in providing opportunities for training (METI, 2001). At the same time, the attitude of employees towards job training has begun to change as they feel more insecure about their jobs. The incentive for employees to invest in their own human capital outside of their employment has risen as they wish to obtain professional skills in order to increase their employability. However, the opportunities for vocational education are limited as universities and graduate schools provide few short programmes designed for employees. M any workers who want to take training courses outside their firms also claim that they are very costly. (143)

Policy needs to strengthen the post-compulsory education system

Although the role of tertiary education was limited in the traditional system of human capital formation, the increased importance of specialised knowledge and skills for the economy both now and in the future requires universities to play a bigger role, including greater emphasis on post-graduate work. There are several implications. Universities will need to strengthen their research capabilities and to improve the quality of their education. Moreover, the diffusion of knowledge and skills accumulated in universities needs to be promoted by improving the knowledge transmission mechanism between universities and businesses. Since universities are subsidised by the government regardless of their performance, they are lacking the incentive (at least the state-run universities) to compete with each other to improve research and education. Lack of flexibility in management of personnel and the design of courses, which partly reflects restrictive regulations, also undermines the capacity of universities to adapt to the changes in technology and in the demand for education.

Responding to the need to rectify these weaknesses, the government has begun to promote reform of the state-run universities since the end of the 1990s (Table 28). The most important concept underlying the reform is to introduce competition between state universities. The government plans to select around ten to twenty "Centres of Excellence" in 10 major subjects based on a performance assessment by a third party, and to allocate more funds to them so as to provide a strong incentive to improve the quality of their research. Competition among universities for students should also be enhanced by the planned transformation of national universities into independent agencies in 2004, which will allow them more flexible management and greater autonomy. Another step forward has been the establishment of professional business schools. Since the easing of restrictions in 1999 covering the nature of education to be offered, six new professional graduate schools have been set up and they have started providing courses such as business management, finance and accounting, and public health. In line with reforms of the legal profession, there are plans for law schools to be founded.

Demand for vocational education is also increasing as both firms and individuals are more willing to acquire specialised skills and knowledge which can be utilised in the private sector. However, the remaining restrictive regulations still discourage the establishment of new schools and professional institutions as well as the provision of short courses for post-graduates. Above all, new educational institutions in the urban areas have been prevented by the requirement that they maintain open land equivalent to at least 300 per cent of the space occupied by their buildings. In addition, more than a half of the land has to be owned by the schools themselves. Establishing new schools or new courses also requires that numerous other conditions set by the authorities be met, and approval has to be obtained from government councils.

While improving individual training outside the firm

Policy should facilitate greater provision of training outside firms to meet the increasing demand. Although there is evidence for the OECD area of externalities arising from human capital formation, the benefits accruing from vocational training mainly belong to firms and individuals. Policy measures should therefore focus on creating a more supportive environment for employers and employees to invest in training, rather than directly intervening in the market. In this sense, a key priority should be given to removing constraints on the provision of training and to limiting the distortion from public intervention in the market. In particular, it is crucial to take further steps to ease restrictions on the establishment of new institutions in the urban area to facilitate vocational training and professional education for adults. At the same time, the scope of training courses provided by public institutions needs to be limited to those for less-favoured groups who have little chance for training in the market . Public training programmes should also be accompanied by an ex post assessment of performance in order to reduce deadweight loss and to improve efficiency. Minimally interventionist measures also include information dissemination about training programmes and provision of certification that facilitates the recognition of skills acquired through training. In this area, the government has actively expanded its scheme for providing certifications, which covers a variety of skills for both white and blue collar workers.

Policy has begun to switch its focus from enterprise subsidies to direct payments to individuals. The education and training benefits system was introduced in 1998 to provide direct support to individuals who pay or have paid contributions to the employment insurance scheme. The benefit covers 80 per cent of training costs with a ceiling of 300 000 yen. From April 1999 to October 2001, 558 719 people received subsidies while 22 183 training courses were designated by the authorities for this scheme (Figure 31). This figure shows that the subsidy has successfully stimulated the demand by individuals for vocational training. However, as noted above, it remains to be seen whether it is cost-effective and some drawbacks to the overall policy stance are apparent. (144) Since most public training programmes are free, the relationship between private and public training schemes might be distorted. Another problem is that the subsidy is limited to those who are members of, or who join, the employment insurance scheme ; people outside the employment insurance such as jobless new graduates are not eligible. Even though these people can participate in public training schemes for free, their opportunities for joining private training schemes could be limited. If a subsidy is justified on externality grounds, then it should apply to all. To avoid these problems, it is desirable to expand the scope of the scheme or to introduce vouchers to cover a broader range of individuals and to allow more options for private training schemes.

Enhancing productivity through strengthening technology and innovation

In terms of R&D expenditures, patents issued (145) and the number of market-leading firms in the world, Japan is one of the key technological powers in the OECD (Figure 32). R&D is mainly financed by business (around 70 per cent) so that it has been focused and applied. The government is also a significant player both directly through funding research as well as through its role in running 99 universities and a number of National Research Institutes (NRI). In FY 2000, budget expenditures amounted to 3 1/2 trillion yen and the plans are for 24 trillion to be spent over the next five years in four sectors: IT, environment, biotechnology and nanotechnology. Although joint research programmes and government co-ordination may not have been as effective as was at first believed, (146) the overall system has been very effective with the Growth Project results pointing to a large contribution of R&D to productivity and growth. However, the lack of adequate market fundamentals might have lowered the actual impact on g rowth outcomes.

There are nevertheless concerns that the development and application of new technology by enterprises, and the returns to public funds invested in research capabilities, might be falling behind international developments. And evidence is not hard to find. Real R&D spending, although high as a share of GDP, has been stagnant through the 1990s and the number of patents, which is only a very crude indicator of innovation, has fallen relative to those in other countries (Figure 33). Japan also appears to lag in harnessing science to the development of ideas which can be patented (Figure 34) and, at a time of greater international collaboration, it appears to be insular. Japan has the smallest percentage of scientific publications with a foreign author and the lowest percentage of patents with foreign co-inventors. These indicators are not only a product of country size. Even after allowing for size and R&D intensity, one study still found that Japan remained insulated at a time of increased internationalisation o f research. (147) The question is whether these are only private sector issues and amenable to policy or not--or whether they are mainly related to universities and NRI and can be handled by policy measures.

Private sector R&D activity

By around the end of the 1980s Japanese firms appeared to be well over the period of catch-up and a number have now moved to be active innovators.

The distribution of R&D across the categories of process versus product development and basic versus applied research converged to the US distribution by the mid-1990s and many large firms have established their own basic research facilities. (148) The new stage of development changes the requirement for qualified personnel and some studies have indicated that the relative scarcity of such staff (i.e. post graduates) and the lack of mobility on the part of researchers might have contributed to lower productivity in basic research departments noted in field work by Branstetter and Nakamura. However, Japanese firms, at least some large ones, appear to be well aware of the problems they face and, in line with trends in other countries, a number have taken steps in setting up overseas research centres and establishing R&D alliances with foreign companies. The results of Branstetter and Nakamura suggest that, for their cross-section of companies, increased international knowledge flows are strongly correlated with higher levels of innovative performance.

Policy can directly influence private sector behaviour in this area in at least three ways: R&D expenditures, intellectual property rights (IPR) law and enforcement, and through taxation. The efficiency of the first is to be put to the test with the new five year programme. However, whether the intention of the government to focus funds only on four schemes will stimulate spending by firms (i.e. is in line with their priorities), or whether it reflects bureaucratic inertia, is unclear. It would be better to look at company priorities first and to allocate accordingly. With respect to IPR, the evidence from the viewpoint of the economy is at best mixed. The scope for patent right protection was greatly widened in 1988. The number of patents per invention has increased but Sakakibara and Branstetter find no evidence of an increase in either R&D spending or innovative output that could plausibly be related to the reform. (149) The protection of IPR is of course important in collecting rents associated with an in novation, although many companies appear either to license the patent immediately or just use trade secrets.

With the R&D system financed predominantly by industry, the question of tax treatment is important and there are a number of proposals to raise benefits (see Chapter II). The tax system appears to be relatively neutral at the moment with a subsidy of around 2 per cent of business R&D spending (higher for small companies) which is less than for about half the OECD countries (Figure 35). It is difficult to establish best practice fiscal treatment of R&D although the costs and benefits of different measures are well recognised. (150) The Japanese system is based on the increment to R&D and involves tax credits. (151) The incremental method holds down fiscal costs and reduces the possibility of dead-weight cost (supporting research that would have been done anyway) but it may be more costly to administer relative to a flat rate system (i.e. a fixed percentage of actual R&D expenditures) which, depending on the tax credit rate, would entail greater foregone tax revenue. Tax credits tend to favour large companies ( since in general they make profits) and have the advantage that they are more transparent and are therefore likely to stimulate R&D. However, they do not benefit new high-tech firms which do not usually make profits in the initial stage of development. Since FY 1999, a modified tax incentive has been in force, which is aimed to cope with the decline of private R&D by increasing the number of applicable companies and lifting deductions. According to the National Tax Agency, the total tax cost only amounted to 41 billion yen in FY 2001.

Experience in the OECD area indicates that tax incentives to promote R&D (and also human capital formation) have a number of advantages over the wide variety of potential measures available although the judgement depends on accepting market outcomes as efficient. (152) Studies still support the assumption that the social return to R&D is greater than the private return but they do not give a clear indication about how large the support for R&D should be. Under current fiscal conditions attention will also have to be given to prioritising tax measures, including whether to cut the overall corporate tax rate of around 41 per cent. (153) What needs to be avoided is the proposal to limit new R&D tax breaks to only particular areas such as nanotechnology and biotechnology, which would introduce distortions to the current system, and which starts policy down the slippery path of attempting to pick winners.

Science-based innovative activity by companies could be expected to strengthen the need for contact with universities and national research institutes (NRI) but this has been weak (at least formally) in Japan (Figure 36). (154) In part this could be due to the development of their own basic R&D capacity in the larger firms during the late 1980s. But there are also barriers. In a survey carried out by the Science and Technology Agency in 1998, the most frequently reported obstacle to co-operation with NRIs was the issue of ownership of R&D results, while the slowness of research at universities was the most often cited obstacle. (155) Universities and NRIs have been classed up till now as public sector institutions subject to central budget laws and civil service employment status (see below) which together have reduced the incentive for staff to undertake collaborative research with industry, at least formally. (156) For the universities and NRIs, research contracts were not popular since revenues covering in direct expenses were paid to the Treasury and contracts could not last longer than a fiscal year. In the same survey, speed was not an issue for research co-operation with foreign universities, the major barrier appearing to be communication difficulties. Research results from universities and NRI's were obtained mainly through "academic societies" and through personal contact. Indeed, the OECD (2002) concluded that informal relations between professors and large firms have been important: "Research funding was provided often based not on contract research with specified rights and obligations but on personal, tacit agreements between professors and firms. The professor published the research findings and the intellectual property was often given free to the industrial user." This system worked for some large firms although not for smaller and new firms so that pressures have arisen for a more open and transparent industry-science relationship. With respect to technology transfer, the most cited impediment co ncerned uncertainty about property rights although a number of firms felt that research results from universities and NRIs could be better disseminated. Surprisingly, less than 10 per cent of venture firms made use of patents owned by universities and NRIs, although more than 60 per cent of such firms had expressed an interest. (157)

Improving the returns from universities and national research institutes

The thrust of policy has changed toward promoting greater efficiency via improved incentives in the university and NRI system. Since FY 2000, a portion of research funds received from industry stays with the university, and contracts can now run longer than a fiscal year. However, the sums involved remain small. Firms can now be up to 50 per cent co-owners of patents originating from contracted research (since 1998) with universities and will retain preferential rights for a ten year period following patent application. Civil service status meant that researchers were not allowed to take up positions in for-profit firms. Since April 2000 this provision has been relaxed for researchers from universities and the NRIs. Property rights usually belong to the inventor unless special funding has been provided by the government or special government facilities have been used. This feature of the system is perhaps controversial. Other countries are now moving more to a system where the institution retains the property rights but the researcher shares in the revenues. The allocation of public funds to universities via competitive tendering for R&D is to be doubled and the number of young researchers who receive financial support will be increased from the current level of 10 000 persons. An attempt to improve mobility for this group through greater use of fixed-term appointments has not been entirely successful. University evaluation is to be improved, and to this end national guidelines were revised in November 2001. Such assessments should play a crucial role in the government's plan to consolidate funding of the nation's 99 state universities to promote some 10-20 of them as premier world class institutions. (158) However, it is not clear whether the assessments will be truly at arm's length.

Fostering clusters and regional dynamism

In recognition of the success of the US system, Technology Licensing Offices (TLO) have now been established (there are 27 at present) to promote the transfer of research to firms. Although public subsidies are available for a limited period of time, sustaining TLOs until inventions generate sufficient revenues appears to be a challenge. The government has set targets, inevitably a questionable exercise, for the establishment of 1 000 venture companies stemming from universities within three years and to increase tenfold within a decade the number of intellectual property rights granted by universities. In addition to the measures implemented above, the targets are to be achieved by supporting incubators and venture capital for university-derived venture businesses. These measures will not obviate the need to lower entry barriers more generally for all activities and not just those associated with the four priority areas set by the government.

According to the CAO 2001, about 46 per cent of fast growing firms, whose sales are increasing by more than 10 per cent for two consecutive years, are located in Tokyo and its adjacent prefectures (Kanto). (159) The number of those firms per head in the Kanto area is 30 to 100 per cent higher than other areas. The ratio of start-ups to the number of enterprises shows no big difference among the regions but their sectoral pattern is quite different. Moreover, many of the regional economies other than the Kanto area tend to depend heavily on public works, which produce more than ten per cent of value added in those regions.

The importance of creating good framework conditions for entrepreneurship in local areas will increase as the government implements its policy to cut back on wasteful public works programmes and to reform fiscal relations between the central and local governments. This move will make it necessary for local government to go beyond the passive tradition of the past, which relied on public works. (160) In an increasing number of OECD countries, fostering the agglomeration of entrepreneurs and intellectual networks is recognised as an important policy option for local governments since such clusters might stimulate innovation and start-up activity, and promote the subsequent growth of the enterprise. (161)

Although a number of industrial clusters already exist, the importance of fostering innovative clusters had not been widely recognised among Japanese policy makers until recently. In the past, regional industrial policy favoured such measures as building infrastructure and developing sites to attract large manufacturing companies. The initiative for such programmes was often led by the central government rather than by local governments as it required substantial central government funds. This kind of approach is no longer effective or feasible as manufacturing companies tend to locate their new plants outside Japan, and budget constraints in both local and central governments do not allow significant locational subsidies. The importance of building close relationships between firms and local universities was recognised even in the 1980s. Indeed, the government promoted the creation of industrial sites comprising knowledge-based industries in some local areas (technopolis programme). This programme, together with tight restrictions on building new plants in urban areas, led many electronics companies to locate their plants in Tohoku and Kyusyu areas. However, since the aim of this programme was to attract existing firms rather than to promote start-ups and enterprise development, the most important potential role of a cluster (to promote enterprise growth and start-ups, and to foster innovative entrepreneurs by taking advantage of externalities) was completely ignored.

Local governments have been active in establishing business incubators, which provide venture firms with office space, technical advice and, in some cases, financial support. Indeed there are now 203 incubators set up by both public and private bodies, the third highest in the world (Table 29). However, many of them do not actually play the role of an incubator, providing only office space and not technical advice and financial aid. According to a survey (JANBO), 34 per cent of public incubators and 50 per cent of private ones do not provide any services other than office space. Moreover, among the public incubators, only 23 per cent of them have managers and co-ordinators.

The experience to date of both TLOs and incubators shows that the serious lack of specialists and co-ordinators has constrained the development of local clusters. In response, METI has launched a programme (Industrial cluster programme) which allows their staff at local offices to play a role of co-ordinator in local clusters. However, it appears that the original concept might be flawed. Rather than building clusters around existing skills and competencies, many projects are aiming at creating essentially an industrial park like that in other locations with a preference for high tech, including biotechnology. An example of a successful cluster (Kyoto, Box 10) illustrates both the need to build on local skills and the fact that they do not spring simply from government decisions.

Overall assessment of policy

Progress in developing efficient low cost network sectors is most advanced in the telecommunications sector. This sector is growing rapidly, in part stimulated by past regulatory reform, with new market opportunities expanding in a dynamic manner. The allocation of access to dark fibre (unused glass fibre lines) of NTT to competitors at a reasonable price was an important step forward. These measures will aid the diffusion of ICT, which in turn should underpin productivity. However, there is still a need to better control the dominant carrier through greater reliance on ex ante regulation. To be effective, however, regulation must be backed by strengthened powers of enforcement and better disclosure by NTT of indicators which reflect the degree to which effective competition is developing. At a minimum, MPHPT should collect and publish statistics on the number of unbundled local loops or lines being shared by the incumbents with competitors, and the time required for providing circuits to competitors and to N TT clients. These indicators are published by most regulators in the OECD area.

In other areas reform success is mixed. Progress has been poor in the electricity sector with the current market incumbents given too great a role in deciding the regulatory reform route. With respect to postal services, a large part of the delivery system has been effectively ring fenced by restrictive entry requirements for the incumbent, which is now to be corporatised. While market opening has occurred in the express delivery part of the system, the incumbent will remain active in them. The experience overseas and in the domestic telecommunications sector that the dominant player will leverage its position of power into other markets has not been reflected in the legislation. There is therefore a need to establish a clear regulatory framework including asymmetric treatment of the dominant player. Moreover, the corporation will retain its integrated character in both banking and in insurance, raising similar regulatory concerns in these competitive markets. In view of the close connections with the Ministr y it must be doubted whether it will establish credibility as an impartial regulator when it comes to inevitable conflicts.

Whether an "independent" regulatory body can achieve credibility in the fast developing markets while remaining part of a ministry, only time will tell. As far as international experience is concerned, only Japan and Korea have not established an independent regulator in the sensitive telecommunications field. However, there are other reasons why administrative independence from the ministry should be considered. Experience overseas has shown the need to employ highly specialised staff in regulatory activities. This fits poorly with the tradition of the civil service with generalists being shifted to new functions every two years. Independence would allow the new regulatory institutions to search for specialist staff and to employ them in a more flexible manner.

The demand for and the supply of human capital is evolving in line with new business strategies and technologies. While companies might have less incentive to provide in-house training, this is not necessarily negative since the incentive for individuals to acquire human capital, which is portable between firms, has also increased. The role for public policy is to ensure that the supply of training is improved by, inter alia, dropping restrictive regulation for building new educational institutions and allowing them greater flexibility about what they teach. Reform of the universities is important but in an attempt to establish premium institutions for research and teaching, care will have to be taken that assessment is at arms length (i.e. that the reform has content and not just form). Public support of training will also need to be reoriented from supporting firms to aiding individuals including those who have less opportunity for training such as part-time workers.

The enterprise-based R&D system has been very successful and is already evolving to meet new challenges such as the increasingly international nature of research. Whether they are basing their work enough on science is an open question, although if this is an important issue, commercial pressures should be sufficient to bring about necessary adjustment. Any further tax measures should remain balanced, and the government should allocate its considerable funding more in line with the efforts of businesses than the four priority areas specified by the bureaucracy. Such a change would be in line with the recommendations in Chapter III. There are, however, clear problems with the universities and the national research institutions. The government's move to create a more open and transparent industry-science relationship and to remove the disincentives to co-operation facing the universities and the NRIs goes in the right direction. However, it is too early to judge the effectiveness of the measures taken. The dema nd for more transparency might simply suffocate the current informal system of professors with companies without putting anything better in its place. The assessment of universities might not be at arms length and setting targets for university-based new start-ups might simply create new administrative distortions. Greater efforts have to be made to internationalise universities and to open opportunities for new staff. Above all they should focus on quality research and expand post-graduate education.

The lack of regional dynamism is a key issue, which will come to the forefront as wasteful public works spending is gradually cut back. All too often authorities have reacted by demanding new industrial parks (usually termed innovative clusters) based on high tech, and university TLOs are also viewed in this manner. More attention needs to be paid to facilitating or invigorating existing national clusters based on current skills which would be just as effective at promoting dynamism of existing firms as attracting new start-ups.

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Table 28

The reform of higher education

Reform of Universities (National Universities)

* Reorganisation and merger of national universities
* Corporatisation of national universities
  Introduction of management skills from the private sector
  Participation of outside professionals in management
  Flexible personnel management through limitation on tenure and
  open recruitment
* Introduction of Centres of Excellence (COE)
  Assessment of performance of COE by third party
  Promotion of competition through fund allocation based on the
  assessment

Establishment of professional graduate schools

* Since 1999, the establishment of professional graduate schools
  which are specialised in two-year master courses has been
  allowed
* Establishment of one year master course is also being considered

Easing the restrictions on establishment of universities
(planned)
* Procedures for authority's approval for changes in departments
  and courses are to be eased further
* Regulations which require universities to have open land space
  are to be eased

Promotion of technology transfer through Technology Licensing
Organisation (TLO)

* In 1998, TLO have been established by the law
* Researchers in national universities have been allowed to work
  for private companies and to become business partners

Source: Cabinet Office.

Table 29

International comparison of incubators

                         Japan     US     UK  Germany

Number of incubators       203    850     90      300
Firms at incubators      2 247  6 458  1 710       --
Average number of staff    0.7    2.8    5.8       --

Source: METI (SME) 2000, Sakata et al. (2001).


(124.) Figure 28 converts yen prices to dollars using the exchange rate for August 2002. The MPHPT makes its calculations using purchasing power parity which has the effect of lowering prices.

(125.) For example, the regulator in Britain has the power to impose fines of up to 10 per cent of UK turnover for up to a maximum of three years.

(126.) Long run incremental cost (LRIC) has been adopted as the methodology for determining interconnection prices although the precise form of the technique is still under discussion. See Survey 2001 for a discussion of LRIC A and B methods.

(127.) An example of bundling would be combining new products, which are subject to competition, with the existing local exchange business, which is not subject to competition.

(128.) The logic here is that the right to place poles was given free by the authorities to the electricity companies so they should not be left in a position to extract scarcity rents from telecommunications operators. Charges related to operations are permitted.

(129.) See "Corporate IT investment and internet usage gain momentum: The NLI Survey of Business conditions", NLI Research, No. 140, 2000.

(130.) H. Joffe, "Japanese business models for electronic commerce-laying the foundation of a ubiquitous networking infrastructure with mobile phones and convenience stores", Vierteljahrsheft, 4-2001, DIW. Berlin.

(131.) More recently, ADSL (asynchronous digital subscriber line) and DSL have been spreading due to lower prices following local unbundling and better access to facilities (colocation).

(132.) For highly qualified engineers, treaties have been signed with India, Korea and China which should allow work permits to be granted more readily.

(133.) This was the recommendation of the 1999 Regulatory Reform Review of Japan.

(134.) Competition will be allowed in express mail delivery services where the mail item is charged I 000 yen or above; items weighing 4 kg or more or with a combined length, width and depth of more than 90 cm and; where the delivery time does not exceed 3 hours.

(135.) See OECD Survey, 2001 Table 6 which is in turn drawn from CAO, The economic impact of recent regulatory reform, Tokyo, April 2001.

(136.) At present 96 per cent of slots on the longer runway are subject to coordination rules set down by IATA. However, raising slots by some 4 per cent would still be a significant change for an airstrip which is already suffering from capacity constraints.

(137.) Students invest a great deal of money and effort to pass difficult entrance exams for prestigious schools and the investment does pay. Employers, however, do not assess graduates on the basis of their university performance but on the basis of being at a given university. See H. Ono, "College quality and earnings in the Japanese labour market", SSE/EFI Working Paper, 395, Stockholm, 2002.

(138.) Blondal, Field, Girouard and Wagner (2001), estimate that the private rate of return to tertiary education in Japan, which is based on pre-tax earnings and the length of study, is around 8 per cent. This is below the average of sample countries but higher than in Germany and Italy. The social rate of return to tertiary education in Japan is 5 1/2 to 6 1/2 per cent. Private rates of return to tertiary education for men 45 years and older are negative as is the case in other non-Anglo-Saxon countries. This reflects the high opportunity cost for older workers due in part to the steep age/wage profile in Japan.

(139.) The ratio of post-graduates leaving universities each year to normal graduates is a little over 10 per cent.

(140.) Ministry of Labour, Minkan kyoiku hunren jittai chosa, Tokyo, 1993, 1997.

(141.) Arnal et al. suggest that employment tenure can be affected by two conflicting forces: a change in industrial structure towards low tenure industries and an increase in tenure within industries. E. Arnal, W. Ok and R. Torres, Knowledge, work organisation and economic growth, OECD, Paris, 2001.

(142.) Ministry of Labour, White Paper on Labour, Tokyo, 1996.

(143.) Y. Higuchi, Koyo to Sitsugyo no Keizaigakn, Nikkei press, Tokyo, 2001.

(144.) Ohtake, 2000, "Special Employment Measures in Japan", Japan Labour Bulletin, December 2000.

(145.) For example, seven of the top ten companies by patent applications in the United States in each of the last five years were Japanese. US patents are used because of a break in the Japanese patent series after 1988. Since then more patents are required to protect the same intellectual property. Patents have been adjusted for quality by measuring the number of citations received by a patent from subsequently granted patents over four years, information that is available in the US data bank. See, L. Branstetter and V. Nakamura, "Has Japan's innovative capacity declined", Forthcoming in M. Blomstrom, J. Corbet, F. Hayashi, A. Kashyap (eds.), Structural Impediments to Growth in Japan, NBER, 2002.

(146.) Porter et al., op. cit. Underpinning this conclusion is econometric work which suggests that co-operative R&D projects did not yield productive outcomes when they involved close competitors (who presumably use a similar technology).

(147.) D. Guellec and B. van Pottelsberghe de la Potterie, "The internationalisation of technology analysed with patent data", Research Policy, 2001, 30.

(148.) Gijutsu Yoran, Tokyo, 2000.

(149.) M. Sakakibara and L. Branstetter, "Do stronger patents induce more innovation? Evidence from the 1988 Japanese patent law", RAND Journal of Economics, Vol. 32, 2001.

(150.) For a discussion as well as estimates of the value of R&D tax measures in the OECD see Tax Incentives for Research and Development: Trends and Issues, OECD, 2002.

(151.) An earlier study of marginal effective tax rates indicated much the same pattern and noted that short run R&D projects were more favourably treated in Japan as elsewhere. K. Gordon and H. Tchilinguirian, 'Marginal effective tax rates on physical, human, and R&D capital", OECD Economics Department Working Papers, No. 199, 1998.

(152.) For a discussion of the advantages and disadvantages of various measures to support R&D, see OECD, op. cit. Although it is often claimed that tax measures are ineffective in raising R&D, this is not supported by more recent empirical evidence which suggests a short term elasticity of 0.16 but a long run elasticity of 1.1, See OECD, 2002, for references and N. Bloom, R. Griffith and J. van Reenan, "Do R&D tax credits work? Evidence from an international panel of countries 1979-1994", The Institute for Fiscal Studies Working Paper, W99/8.

(153.) The statutory business profits tax is 30 per cent for the central government and 9.6 per cent for local government. There is also a local residential tax amounting to 17.3 per cent of the corporate tax payments, but which is tax deductible. This leaves the effective statutory tax rate at 40.87 per cent.

(154.) The number of joint research projects between industry and universities increased by 29 per cent in FY 2000 to 4 029 while research commissioned by companies grew by 8 per cent to 6 368. However, the sums involved were not large.

(155.) For a summary see "Industry-science relationships in Japan", in Benchmarking Industry-Science Relationships, OECD, 2002.

(156.) Since April 2001 the NRIs have become administrative legal entities which will increase management flexibility. University reform is to be implemented from 2004.

(157.) 1007 venture firms (42 per cent) replied to the questionnaire. A venture firm is defined as: introducing a unique technology or know how; achieving high growth in recent years; being relatively young or having recently changed its line of business.

(158.) The policy is meant to also cover private universities. However, a fundamental problem has not been addressed, namely, unlike public universities they are taxed on private research contracts.

(159.) Geographical agglomeration is important in most countries but Japan appears to be highly concentrated. In the United States, a much larger country, 380 local clusters are reported to produce approximately 60 per cent of the country's output. Opening speech by Donald Johnston, Secretary General of the OECD. at the World Congress on Local Clusters in 2001.

(160.) For a description of the local political dynamic which is oriented to obtaining central government projects regardless of how they could be used locally see A. Kerr, Dogs and demons: The fall of modern Japan, Penguin, 2001. The major deficiencies of the fiscal transfer system are documented in OECD, Economic Survey of Japan, 2000, Chapter III.

(161.) The new theories of growth and trade also point to the importance of geographical agglomeration. Knowledge spill-overs are often restricted geographically, leading to the spontaneous development of clusters around the world. This has led to numerous policy initiatives to create clusters.

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RELATED ARTICLE: Box 9. Which factors aid diffusion and effective use of ICT: lessons from the Growth Project

With technological advances in ICT available universally, the degree of uptake and use of ICT appears to depend on structural factors. Recent work by OECD (see Colecchia and Schreyer) points to differences in flexibility of product and labour markets and the business environment as explanatory factors behind differences in the uptake and diffusion of new technologies among some OECD countries. Widespread diffusion of ICT as well as the development of the ICT producing industry are closely linked to a tradition of open and competitive markets for telecommunication services as well as the liberalisation of other product markets. Countries that moved early to liberalise their telecommunications industry now have much lower communications costs and, consequently, a wider usage and diffusion of ICT technologies than those that followed later on. OECD finds that firms in the United States and Canada have enjoyed considerably lower costs of ICT investment goods in the 1990s than firms in European countries and in Japan. Barriers to trade, in particular non-tariff barriers related to standards, import licensing and government procurement, may partly explain cost differentials. Higher price levels in other OECD countries may also be associated with a lack of competition within countries. For example, Nicoletti et al. (1999) find that countries with a high relative price level of ICT investment tend to have a lower degree of competition, as measured by indicators of economic regulation. Over time, however, international trade and competition should erode some of these cross-country differences.

Evidence from Finland and Australia, admittedly partial, suggests that microeconomic reforms have helped ICT adoption, and that ICT diffusion is interacting with organisational and innovation factors in generating a positive impact on productivity. Contrary to Finland, the ICT producing industry plays a negligible role in Australia yet there is a direct and significant impact of ICT on Australian output growth. One explanation of this large impact is again in the complementarity between microeconomic reforms and ICT. Regulatory reforms and open market policies brought about rationalisation and restructuring of business processes, and ICT is thought to have been instrumental in this process. A similar pattern can also be seen in the United States where productivity gains in the competitive retailing sector were due in good measure to the adoption and use of ICT by Walmart (McKinsey, 2001).

Source: A. Colecchia and P. Schreyer "ICT investment and economic growth in the 1990's: Is the United States a unique case? A comparative study of nine OECD countries", STI Working Papers, 2001/7.

McKinsey, US Productivity Growth 1995-2000: Understanding the Contribution of Information Technology Relative to Other Factors, McKinsey Global Institute, Washington, 2001.

Box 10. A successful case of a local cluster: Kyoto

Kyoto is located near the second largest city in Japan, Osaka, and has 1.5 million inhabitants. Kyoto is now known for its successful hi-tech cluster, comprising firms such as Kyocera, Nintendo, Omron and Sanyo Chemical. The Kyoto region also boasts Japan's greatest concentration of higher education institutions; it has 33 universities and 11 junior colleges. Porter and Takeuchi (2000) suggests the following points as key for the success of the Kyoto cluster.

-- The city is geographically distinct and is modest in size. The absence of large dominant firms allowed smaller firms to prosper. The central government's large co-operative R&D programme ignored Kyoto companies. Religious organisations, academics and artisans hold as much power in Kyoto as do government officials and business leaders. This dispersion of power has forestalled rigid hierarchies and encouraged the creation of intimate networks.

-- Small Kyoto businesses, unable to penetrate the closed keiretsu networks, were forced to identify and market to foreign customers.

-- Since Japanese banks were unwilling to lend to small firms with no collateral or keiretsu affiliation, Kyoto-based firms tended to raise capital through the equity market.

They concluded that the case of Kyoto illustrates the importance of competitive pressure in a business environment that is characterised by high quality inputs and institutions, and which is open to innovation and dynamism.
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