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Key challenges to sustaining the expansion in Japan.

The economic expansion, the longest in Japan's post-war history, remains on track, though at a slower pace. The upturn is driven by business investment and exports, while other components of demand remain sluggish. Although growth is projected to continue at a 1 1/2 to 2% rate through 2009, Japan must address a number of problems to sustain the expansion over the medium term. This chapter identifies five key challenges: i) ensuring a definitive end to deflation under the new monetary policy framework; ii) achieving progress in fiscal consolidation in the context of high public debt and rapid population ageing; iii) implementing a comprehensive tax reform to increase government revenue, while promoting economic growth, addressing rising income inequality and improving the local government tax system; iv) enhancing productivity growth in the service sector; and v) reforming the labour market to reverse rising dualism and boosting labour force participation to offset demographic trends.

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The current expansion, which began in early 2002, reversed a decade of economic stagnation in Japan. Output growth had averaged less than 1% a year during the decade from 1992 to 2002, the lowest in the OECD area, as Japan worked through the aftermath of the collapse of the asset price bubble (Table 1.1). Consequently, Japan's ranking in terms of per capita income fell from fifth highest in the OECD in 1992 to nineteenth in 2002. During the current expansion, GDP per capita has increased at a 2.1% rate, matching the OECD average over the period 2002-07. The improved performance of Japan during the last five years has been driven by the acceleration of productivity growth, which nearly doubled from the 1% rate recorded during the 1992 to 2002 period, promoted by progress in structural reform (see Annex 1.A1). Nevertheless, the labour productivity gap relative to the United States was large at 30% in 2006 (Figure 1.1).

This expansion has been led by business investment, which has accounted for almost 40% of the rise in output since 2002, thanks to growth at an annual rate of more than 5% (Table 1.1, Panel B). A number of factors have sustained business investment. First, the restructuring of the corporate sector reduced excessively high levels of debt, production capacity and employment, which, in turn, had depressed capital expenditures during the decade 1992 to 2002. Successful restructuring released pent-up demand for capital goods. Second, the improved financial soundness of the banking sector has supported business investment. A sharp increase in non-performing loans had undermined the capital base of the banking sector, contributing to a steady decline in bank lending beginning in the mid-1990s. With the progress in reducing non-performing loans since 2002, bank lending started to increase again in 2005. (1) Third, the acceleration in export growth from less than 4% in the decade beginning in 1992 to nearly 10% during the past five years has boosted corporate profitability and created demand for additional capacity, thus encouraging greater business investment. Exports have been sustained by Japan's increasing integration with Asian economies, which have accounted for more than half of Japan's export growth during this expansion. In addition, the significant decline in the yen between 2005 and mid-2007 has supported export growth. In sum, the external sector has accounted for about one-third of increased output during this expansion.

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The corporate-led expansion has sustained growth at 2.1% over the past five years, a pace substantially above Japan's potential growth rate of about 11 1/2 per cent, despite a weak contribution from the household sector and a small drag from fiscal policy. Private consumption has increased at a 1.4% annual pace, about the same as during the decade 1992 to 2002 (Table 1.1), as the benefits of the long expansion led by business investment and exports have not spread fully to the household sector. Indeed, sluggish wage growth has reduced labour income as a share of GDP to its lowest level since 1990. On the fiscal side, the government faced a deficit of 8% of GDP in 2002, reflecting weak economic growth and a sharp increase in public spending, which had accounted for half of the increase in GDP during the decade 1992 to 2002. To reduce the deficit, the growth of government consumption was halved during the period 2002 to 2007, while public investment declined at an 8% annual rate.

The economic expansion is projected to remain on track through 2009. After discussing the short-term outlook, this chapter analyses a number of imbalances in the economy that pose risks to a continued expansion. The chapter then outlines the key economic challenges facing Japan.

Recent economic trends in Japan and the short-term economic outlook

After expanding at a 4% annual rate between the third quarter of 2006 and the first quarter of 2007, the economy slowed, with in the third quarter of 2007 slightly below that in the first quarter. This long-lasting expansion has already overcome soft patches in 2003 and 2004, when output stagnated or actually declined, (2) and it is projected to rebound again with output growth of between 1 1/2 and 2% during 2008 and 2009 (Table 1.2). Business investment is likely to continue to lead the expansion, given the overall high level of confidence, capacity utilisation and profits. The pre-tax profits of listed companies are expected to rise by nearly 6% in FY 2007, setting a record high for pre-tax profits for the fifth consecutive year. The large gap between the rate of profitability and borrowing costs should support continued capital spending (Figure 1.2). The gap reached 4 percentage points for large manufacturers in mid-2007 and 2 points for large non-manufacturing firms (Panels A and B). In addition, improved growth expectations have been driving demand for new capacity (Panel C). At the beginning of this expansion in 2002, manufacturers expected demand to increase at only a 1% annual rate over the following five years, while non-manufacturing firms were even more pessimistic. By 2006, growth expectations in both sectors had risen by almost 1 percentage point. These factors should sustain business investment, though at a pace well below the nearly 7% annual rate recorded between 2004 and 2006.

Export growth has been strong, increasing at an 11.6% rate in value terms in 2007 despite weak demand from the United States (Figure 1.3). Buoyant export growth with little increase in sales to the United States reflects the downward trend in the US share of Japanese exports, from 30% in 2000 to 20% in 2007, while the share of Asian countries rose from 41% to 48% over that period thanks to China (Panel B). Export growth has also been supported by the depreciation of the yen, which fell by 18% in effective terms between the end of 2004 and the second quarter of 2007 (Panel C), partly as a result of the yen carry trade (Box 1.1). However, the downward trend in the yen was reversed during the second half of 2007. Export growth is projected to continue to support economic activity in 2008-09, although its momentum is likely to slow as the impact of past exchange rate depreciation fades (Table 1.2).
Box 1.1. The yen carry trade and its economic impact

A carry trade is generally defined as a trade in which an investor
borrows funds in one currency (the funding currency) at a low
interest rate and invests in higher-yielding assets in another
currency (the target currency) to take advantage of interest rate
differentials. There are two potential sources of instability in a
carry trade; a leveraged investment and an exposure to foreign
exchange risk, as it is unhedged. (1) The Japanese yen has been one
of the most favoured funding currencies in the context of
persistently low interest rates close to zero in Japan. The yen
carry trade has been used by large international financial
institutions, such as hedge funds and investment banks. A second
aspect has been carry trades by Japanese domestic investors,
including both financial institutions and individuals. For example,
life insurers purchase foreign bonds to support yen-denominated
liabilities, while individual investors have been shifting a share
of their wealth away from bank deposits or other low-yielding yen
investments towards foreign bonds and equities. Given the lack of
data on the outstanding size of yen carry trade positions, it is
difficult to quantify the amount of carry trade. Nevertheless, it
appears to have been an important factor explaining the doubling of
Japanese holdings of foreign equities and bonds from 150 trillion
yen in 2000 (30% of GDP) to 297 trillion yen (58% of GDP) by
mid-2007. In addition, the net outward yen-denominated assets held
by Japanese financial institutions sharply increased from $100
billion at the end of 2003 to $255 billion in mid-2007.

The impact of the carry trade on financial markets, notably for
foreign exchange, appears to have been significant. The build-up of
short open positions in yen--an un-hedged selling position in
yen--tends to weaken the yen, while strengthening the target
currency. The impact can be seen in the trends in the yen/dollar
exchange rate, given that the dollar has been one of the major
target currencies of the yen carry trade, especially since 2004.
Indeed, the US short-term policy rate rose from 1% at the beginning
of 2004 to 5 1/4 per cent by the second half of 2006, significantly
expanding the interest rate differential with Japan. The dollar
appreciated 8% relative to the yen over that period, compared to
its 4% fall in effective terms. Another example is the 40% rise in
the Korean won against the yen between the end of 2003 and
mid-2007, as the increase in the Korean policy rate from 3 1/4 to
5% over this period widened the interest rate gap between the two
countries. Over the same period, the balance of yen-denominated
loans held by the Korean banks increased by around 40% in response
to strong demand from private-sector investors wanting to take
advantage of the large interest rate differentials. In sum, the yen
carry trade has put downward pressure on the Japanese currency,
thus contributing to the easing of monetary conditions in Japan and
helping to sustain the current expansion.

The increased liquidity resulting from the yen carry trade also
affects asset prices, notably bonds and equities in target
countries, while tending to reduce the risk premium in global
financial markets. However, there is a risk that a sudden unwinding
of the yen carry trade--which implies the selling of the target
currency accompanied by the purchase of the funding currency--might
adversely affect financial stability and ultimately damage the real
economy. The risk stems from the possibility of a rapid unwinding
of leveraged and un-hedged positions accumulated over time. Such an
unwinding could result from a significant rise of the yen that more
than offset the gains from the interest rate differential or from a
narrowing of the interest rate differential. If a significant rise
in the yen triggered the process, the unwinding of the yen carry
trade would reinforce the upward pressure on the yen, leading to a
vicious circle and a significant spike in volatility in foreign
exchange markets. (2) Such a development would negatively affect
Japanese exports and could strengthen deflationary pressure.
Moreover, the unwinding of the yen carry trade could spark a
sell-off in financial markets of target countries, resulting in a
sharp fall in those markets.

Despite these risks, there is an incentive for the yen carry trade
to continue as long as there is a substantial gap in interest rates
between Japan and other countries, other things being equal.
However, it is neither desirable nor possible to curb such capital
flows in globally-integrated financial markets. Given the potential
risks for financial markets and consequently for economic activity,
the authorities should closely monitor financial markets to limit
the risks associated with the yen carry trade.

(1.) Holding an unhedged position allows the investor to fully
realise the gain from the interest rate differential. Such an
approach has been encouraged by the relatively low volatility of
exchange rates in recent years.

(2.) For example, the sudden reversal of speculative "short
positions in yen" in 1998 led to a sharp rise in the yen from 137
yen per dollar in September to 115 yen per dollar in October.


In contrast, private consumption has been somewhat sluggish in 2007, constrained by increased taxes (3) and a renewed decline in wages. After turning positive in 2005-06, wages dropped by 0.7% in 2007 (Figure 1.4) despite a fall in the unemployment rate to 3.9% in 2007--the lowest level since 1998--and a job-offer-to-applicant ratio above unity. The decline in wages in the context of a tighter labour market reflects several structural factors. First, the increasing proportion of lower-paid part-time workers has reduced the overall average wage level. Second, the large-scale retirement of baby boomers is resulting in the replacement of high-paid workers by younger workers at lower wages. However, these structural factors depressing wages are expected to fade, leading to wage increases during 2008-09. Indeed, the proportion of non-regular workers (which consist primarily of part-time workers) is unlikely to continue its steady upward trend now that it has risen to one-third of the labour force. In addition, the number of baby boomers reaching retirement age will peak in early 2008. Rising wages are projected to help sustain private consumption at a rate of around 1 1/4 per cent during 2008-09.

[FIGURE 1.2 OMITTED]

A sharp drop in construction activity, though, is likely to be a drag on business investment and private consumption in the short term. A revision of the Building Standards Law in June 2007, aimed at improving the inspection process after a scandal in 2005, is causing severe bottlenecks in the approval process. Consequently, housing starts fell by 37% (year-on-year) in the third quarter of 2007 and this was immediately reflected in a 27% decline (seasonally-adjusted annual rate) in residential construction in the second half of 2007 (Table 1.2). This regulatory change also reduced corporate construction starts by 41% in the third quarter, thus dampening business investment, which nevertheless recorded a strong rise. The projection assumes that, with the correction of the regulatory problem, residential construction will begin expanding at a 6% annual pace from 2009. (4)

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[FIGURE 1.4 OMITTED]

Despite the continued economic expansion and the decline of the yen, prices are still falling. After turning positive during 2006, both the headline and the official Japanese measure of core consumer prices (excluding fresh food only) decreased during the first three quarters of 2007 on a year-on-year basis (Figure 1.5), before jumping up by 0.5% in the fourth quarter, primarily due to higher oil prices. (5) The OECD definition of core consumer prices, which excludes both food and energy, continued to decline in each quarter of 2007 as it has in every quarter since 1998. Price deflators for GDP and private consumption are falling at a faster rate. One factor putting downward pressure on prices has been the decline in unit labour costs at a 2% annual rate since 2002. With the expected return to positive wage growth, unit labour costs are projected to stabilise by 2009, reducing downward pressure on prices. The continued expansion should push inflation into positive territory, although it is likely to remain at between 0 and 0.5% until late in 2009.

[FIGURE 1.5 OMITTED]

In sum, after somewhat weak growth between mid-2007 and mid-2008, reflecting the sharp decline in construction activity and falling wages in 2007, the expansion is projected to pick up, keeping annual growth rates at between 1 1/2 and 2% through 2009. However, the risks to the expansion appear to be larger than before. On the external side, the increased turbulence in world financial markets since mid-2007 may result in a decline in overseas demand and slower export growth. A sudden and marked appreciation of the yen as the current account surplus rises to over 5% of GDP in 2009 could have a similar impact. Maintaining buoyant export growth is important to revitalise domestic demand. However, a delay in the expected rebound in wage growth in 2008 would weaken private consumption. There is also uncertainty about how quickly the regulatory problem in the Building Standards Law will be fixed, allowing housing and corporate construction starts to stabilise. In addition to these risks, the increasing polarisation of the expansion by sector, size of firm and region poses a threat to the continued expansion.

The polarisation of this economic expansion poses risks

The narrow base of this expansion and the key role of exports help to explain the significant divergence in performance between sectors and regions. The unbalanced nature of growth is reflected in the widening gap between the manufacturing sector, which has benefited from buoyant exports, and the non-manufacturing sector, which depends more on domestic demand. Indeed, the rate of return on assets in manufacturing, which was 2.6% at the beginning of the expansion in 2002--slightly below that in non-manufacturing--reached almost 6% in 2007, the highest since the 1980s (Figure 1.2, Panels A and B). In contrast, the rate for non-manufacturing increased only modestly. The difference is even more marked in terms of profits per employee, which were around 0.3 million yen in both sectors in 2002 (Figure 1.6, Panel A). By 2006, profits per employee in manufacturing were double those in the non-manufacturing sector. Firms in non-manufacturing have been more affected by rising input prices, notably for energy and raw materials, given that they have more difficulty in passing those price increases on to domestic consumers due to weak domestic demand and deregulation. Low productivity growth in the service sector has also squeezed profitability. (6)

[FIGURE 1.6 OMITTED]

Given that 90% of small and medium-sized enterprises (SMEs) are in non-manufacturing, the dichotomy between different sectors has also created a significant gap between large and small firms. Indeed, the Bank of Japan's indicator of business conditions shows a large and growing disparity by size of firm (Figure 1.6, Panel B). Business sentiment in small manufacturing firms has fallen close to zero, while remaining in negative territory for those in non-manufacturing. The growing variance in performance by firm size is also reflected in a divergence in wage growth (Panel C). At firms with less than 30 employees, wages have fallen 9% since 2000, compared to only 3% at those with 30 or more employees. This has widened the already significant wage gap between small and large firms.

The dualistic expansion has also increased the disparity between regions in Japan. In its January 2008 Regional Economic Report, the Bank of Japan stated that the economy as a whole was on a "moderate expansion trend" although there are regional differences. Consequently, the Bank downgraded its overall assessment for four of Japan's nine regions, while leaving the other five unchanged. (7) Growing regional disparity is particularly evident in the labour market. For example, in Hokkaido, the northern island with little manufacturing activity, the job-offer-to-applicant ratio was only 0.6 in December 2007, only slightly higher than at the beginning of the recovery in 2002 (Figure 1.6, Panel D). In contrast, the ratio jumped from 0.7 to 1.5 over the same period in the region of Nagoya, which includes many large manufacturers. Regional disparity is also reflected in land prices, which rose in the three major urban areas in 2007, while falling in the rest of the country (Figure 2.4).

Another important dualism in the economy is found in the labour market. As noted above, the proportion of non-regular workers rose to one-third of employees in 2007. The sharp increase in the share of non-regular workers, who earn significantly less than regular workers, is a key factor reducing average wages, while contributing to the rising trend in income inequality. In addition, the lack of training for non-regular workers, many of whom are under the age of 30, has negative implications for Japan's growth potential over the medium term.

Key challenges facing the Japanese economy

In addition to overcoming these imbalances, sustaining the upturn over the medium term requires meeting a number of difficult challenges, which are discussed in this Economic Survey:

* Achieving a definitive end to almost a decade of deflation under the new monetary policy framework introduced in March 2006 (Chapter 2).

* Ensuring fiscal sustainability in the context of exceptionally rapid population ageing (Chapter 3).

* Implementing a comprehensive tax reform to achieve the medium-term fiscal consolidation targets, while supporting economic growth, addressing the deterioration in income equality and improving the local government tax system (Chapter 4).

* Enhancing productivity growth in the service sector (Chapter 5).

* Reforming the labour market to reverse the trend towards dualism and to encourage labour force participation (Chapter 6).

Underlying each of these challenges is the rapid ageing of Japan's population. Population projections through the year 2050 are presented in Box 1.2.
Box 1.2. Population projections for Japan

Rapid demographic change has already made Japan's population one of
the oldest in the OECD area. Since its peak from 1991 to 1993, the
working-age population (15 to 64) has fallen by 3.7%, and the
annual pace of decline accelerated to 0.5% in 2005. This boosted
the share of the elderly (over age 65) to 20.2% of the total
population in 2005. The increase in the share of elderly from 7% to
20% was exceptionally rapid in Japan, taking only 35 years (1970 to
2005). In comparison, this transition is projected to take 86 years
in the United States and 156 years in France.

Japan's total population peaked in 2004 at 127.8 million and is
projected to decline at an accelerating pace through the middle of
this century, according to the government's official projection
(Table 1.3). Indeed, by 2050, Japan's total population is expected
to be less than 100 million, boosting the median age from 43 years
at present to 57 years. Population decline is driven by an
accelerating drop in the working-age population, which is projected
to fall to less than 50 million in 2050. Consequently, the number
of elderly is projected to rise from 28% of the working-age
population (aged 20 to 64) in 2000 to 72% in 2050, making it the
second highest in the OECD area (Figure 1.7).

Table 1.3. Population indicators and projections for Japan

                                      Working-age         Fertility
          Total population          population (2)          rate

                     (growth                  (growth
       (millions)   in %) (1)   (millions)   in %) (1)    (TFR) (3)

1990     123.6         0.5         85.9         0.9         1.54
2000     126.9         0.3         86.2         0.0         1.36
2010     127.2         0.0         81.3        -0.6         1.22
2020     122.7        -0.4         73.6        -1.0         1.23
2030     115.2        -0.6         67.4        -0.9         1.24
2040     105.7        -0.9         57.3        -1.6         1.25
2050      95.2        -1.0         49.3        -1.5         1.26

                                              Share of
            Life expectancy     Median age   elderly (4)

            Male     Female

           (years)   (years)    (years)         (%)

1990        75.9      81.9        37.7         12.0
2000        77.7      84.6        41.5         17.3
2010        79.5      86.4        45.1         23.1
2020        80.9      87.7        49.0         29.2
2030        81.9      88.7        53.0         31.8
2040        82.7      89.4        55.4         36.5
2050        83.4      90.1        57.0         39.6

(1.) The average annual growth rate in per cent for the decade.

(2.) Population between the ages of 15 and 64.

(3.) Total Fertility Rate (TFR) is the average number of children
that a woman expects to bear during her lifetime.

(4.) The number of persons over the age of 65 as a percentage of
the total population.

Source: Ministry of Internal Affairs and Communications, Population
Census, and National Institute of Population and Social Security
Research, Population Projection (2006 December version).

The government's population projection is based on a fertility rate
that remains steady around its 2006 level of 1.26, while life
expectancy continues to increase. Any increase in fertility, as
well as greater immigration, could moderate the pace of population
ageing. Nevertheless, it is clear that demographic changes will
have a marked impact on all aspects of the Japanese economy. Rapid
population ageing thus underpins the key challenges addressed in
this Survey: ensuring fiscal sustainability (Chapter 3), reforming
the tax system (Chapter 4), accelerating productivity growth
(Chapter 5) and improving the labour market (Chapter 6).

[FIGURE 1.7. OMITTED]


Ensuring a definitive end to deflation under the new monetary policy framework

As noted above, Japan remains in a state of mild deflation, with the core consumer price index falling in 2007 for the ninth consecutive year (Figure 1.5). The current rate of deflation does not constrain real interest rates at inappropriately high levels--as during the early 2000s--and there is little risk of a deflationary spiral. Nevertheless, deflation is still a concern, both directly, as it may act as a drag on the economy, (8) and because it leaves monetary policy with insufficient margin to respond to shocks that could once again drive the level of real interest rates above that required by economic conditions.

In March 2006, the Bank of Japan ended the quantitative easing policy introduced in 2001 to fight deflation and announced a new framework for monetary policy. (9) As part of this framework, it stated that inflation in the 0 to 2% range is the Policy Board's understanding of price stability. In July 2006, the central bank raised the overnight rate (the policy interest rate which had been fixed at zero since 2001) by 0.25%, followed by a similar hike in February 2007. Despite the interest rate hikes, the real short-term interest rate remains below 1%, raising the question about the appropriate degree of monetary stimulus in the sixth year of an economic expansion. The monetary authorities have made clear their intention to "normalise" interest rates, which it believes "are very low relative to economic activity and price conditions". (10) However, it is difficult to forecast the path of inflation, as there has been little correlation between the output gap and the rate of inflation in recent years.

The decision to raise interest rates by 50 basis points while consumer prices were still falling reflects, in part, the central bank's longer-term perspective that considers risk factors that may significantly impact economic activity and prices. One concern is that an excessively long period of low interest rates relative to economic and price conditions would result in an "inefficient allocation of resources as firms and financial institutions over-extend themselves". (11) There is concern that such an outcome could lead to an asset price bubble, a worry that was reinforced by double-digit increases in commercial land prices in some parts of Tokyo in 2007. In addition to asset prices, the timing and speed of interest rate hikes have important implications for long-term interest rates and hence for the fiscal situation.

Although financial markets expected further increases in the overnight interest rate during 2007, the Bank of Japan has left the rate at 0.5% in the context of slowing economic growth. Moreover, turbulence in international financial markets since the summer of 2007 has raised concern about the risk of slower growth in the world economy and a possible negative impact on Japanese exports. In sum, there is considerable uncertainty about the appropriate path of monetary policy in the context of slower output growth, increased economic uncertainty, persistent deflation despite a sustained economic expansion and the long-term risks of leaving interest rates too low for too long.

Chapter 2 examines monetary policy, focusing on the following issues:

* How can monetary policy help bring a definitive end to a decade of deflation?

* How should the Bank of Japan balance the risk of an early monetary policy tightening, which could undermine the expansion before deflation is definitively ended, with the risk of leaving interest rates too low for too long, creating distortions such as an asset price bubble?

* How could the new policy framework be improved to promote effective monetary policy?

Achieving progress in fiscal consolidation

Government debt has risen to 180% of GDP, the highest ever recorded in the OECD area, making fiscal consolidation an urgent task (Figure 1.8). The run-up in debt has raised concern about the vulnerability of the government's financial position to a rise in the long-term interest rate from its current low level of around 1 1/2 per cent. Japan has made progress in fiscal consolidation, reducing its budget deficit from 8.2% of GDP in 2002 to an estimated 4% (excluding one-off factors) in 2007. About a quarter of the reduction over that period was a result of the economic expansion. The remainder was accomplished through cuts in government spending, primarily in public investment, and measures to boost revenue, including annual hikes in the pension contribution rate and the ending of the temporary personal income tax cut. In addition, corporate tax revenue has been exceptionally buoyant.

The government has set a target of a primary budget surplus for central and local governments combined by FY 2011 as a first step to reducing the government debt ratio in the 2010s. According to OECD estimates, the primary budget deficit (for the general government excluding one-off factors) has fallen by about 1 1/2 per cent of GDP a year since 2002 on a cyclically-adjusted basis, reducing it to 3% of GDP in 2007. Achieving a primary budget balance in 2011 would thus require accelerating the pace of fiscal consolidation to around 3/4 per cent of GDP a year. However, stabilising the government debt ratio by 2011 would likely require a surplus as large as 1% to 2% of GDP. Moreover, achieving the longer-term objective of reducing the government debt ratio would require a still larger surplus.

Japan cut government expenditures from nearly 39% of GDP in 2002 to around 36.5% in 2007. The biggest reduction was in public investment, which fell by about 2% of GDP over that period. However, achieving the medium-term fiscal targets entirely through additional spending cuts would be very difficult. First, population ageing will put continued upward pressure on outlays for pensions, healthcare and long-term nursing care. Second, it will be difficult to achieve further large spending cuts in public investment, as it has already fallen to a level close to the OECD average as a share of GDP. Moreover, the cost of maintaining existing infrastructure, which already accounts for a third of total public investment, limits the scope for future spending reductions. In addition, growing public concern about the regional inequalities is creating pressure to maintain or even increase public investment. Third, realising the government's aim of reducing its wage bill as a share of GDP by half over the next decade is a difficult challenge, given that public employment is already quite low compared to other major OECD countries.

[FIGURE 1.8 OMITTED]

The fall in the budget deficit, excluding one-off factors, is projected to slow to about 1/4 per cent of GDP in both 2008 and 2009 under current policies, highlighting the need for additional fiscal consolidation measures. The Integrated Expenditure and Revenue Reform, announced in July 2006, set out the amount of deficit reduction needed to meet the FY 2011 target, as well as spending cuts in broad areas (social security, personnel expenses, public investment and other). However, the expenditure reductions are not binding on the annual budgeting process. Moreover, details on how the target for public healthcare spending is to be achieved are not spelled out.

The fiscal policy challenges are analysed in Chapter 3, emphasising the following issues:

* What size of primary budget surplus should Japan target to stabilise and then reduce the government debt ratio?

* To what extent can the fiscal goals be accomplished through spending cuts and in what areas can reductions be achieved?

* How can the government strengthen the medium-term plan to maintain confidence in its fiscal consolidation programme and avoid a rise in the risk premium as public debt continues to rise?

Implementing a comprehensive tax reform

Given the pressures for increased expenditure, spending cuts alone cannot achieve the government's fiscal targets, making it necessary to boost tax revenue. There appears to be significant scope to raise revenue as the share of taxes in GDP in Japan is one of the lowest in the OECD area (Figure 1.9). However, there is evidence that higher taxes can reduce the level of GDP per capita, although the extent of the reduction depends on the way in which the tax increase is designed and implemented. With population ageing putting downward pressure on Japan's potential growth (see below), it is important to limit the negative impact of higher taxes on growth. Japan thus faces a number of difficult trade-offs between raising additional revenue and promoting growth. In particular, personal income tax revenue is relatively low in Japan, reflecting the small tax base and the fact that more than half of taxpayers are in the lowest tax bracket of 5%. There is thus significant scope for boosting revenue from personal income taxes, although this may slow growth by weakening work incentives. As for the corporate income tax, the rate is the highest in the OECD area, suggesting that cutting the rate may have a positive impact on growth, although at the risk of reducing tax revenue.

[FIGURE 1.9 OMITTED]

In addition to the trade-off between boosting tax revenue and promoting economic growth, the impact of the tax system on income inequality and relative poverty is another important consideration. Income inequality among the working-age population has risen significantly in recent years, making it the fifth highest in the OECD area in 2000. The relatively high level of inequality reflects the small impact of Japan's tax system on distribution, in part due to large tax exemptions for personal income and weak progressivity in tax rates. However, strengthening the redistributive effect of the tax system by making tax rates more progressive and expanding the role of the personal income tax would tend to have a negative impact on Japan's potential growth rate, as noted above. On the other hand, relying on the consumption tax to generate additional revenue would not contribute to reducing income inequality, although its effect on economic growth would be less negative.

Tax reform should also include measures to improve the local tax system, which is exceptionally complicated, with 23 major taxes. Moreover, the autonomy of local governments in determining tax rates and bases is limited in practice. Fiscal relations between the central and local governments need to be improved in order to maximise the benefits of decentralisation.

Chapter 4 analyses the tax system and proposes the key elements of a comprehensive reform, focusing on a number of questions:

* How can tax reform raise sufficient revenue, while minimising the negative impact on economic growth? Should efforts to raise additional revenue focus on hiking the consumption tax rate or broadening the base of direct taxes?

* Should any broadening of the personal and corporate income tax bases be offset by a revenue-neutral reduction in tax rates in order to promote economic growth?

* Do concerns about income distribution justify strengthening the redistributive impact of the personal income tax even though this may reduce hours worked, with potentially negative effects on economic growth?

* How can the local tax system be improved and simplified, while increasing the autonomy of local governments?

Enhancing the productivity of the service sector

Japan's potential growth rate has fallen from 4% in the 1980s to around 1 1/2 per cent since 2004 and it is projected to remain at that level, the lowest in the OECD area, over the period 2009-13 (Table 1.4). Potential growth has been sustained by an increase in potential labour productivity growth from 1% in the second half of the 1990s to a projected 2.2% over the period 2009-13, above the rate expected for the United States and the euro area. However, a large and growing negative contribution from declining employment, despite a further expected rise in the labour force participation rate, is projected to reduce Japan's potential growth rate to 1.5%, compared to the OECD average of 2.2%. The key factor is the accelerating fall in the working-age population, which lowers the potential growth rate by nearly one percentage point per year during the period 2009 to 2013 (see Box 1.2). Labour utilisation, which was a factor narrowing the per capita income gap with the United States in 2006 (Figure 1.1), will widen the gap instead. Consequently, narrowing, or even maintaining, the size of the income gap with the United States will require faster productivity growth in Japan.

The large labour productivity gap with the United States--30% in 2006--suggests considerable scope for boosting productivity in Japan. Achieving faster productivity growth depends primarily on the service sector, given its dominant share of employment and output. However, productivity growth in services slowed from 3.5% in the 1976-89 period to only 0.9% between 1999 and 2004, with a particularly sharp decline in ICT services. In contrast, in manufacturing, which is more exposed to competition, productivity growth has remained steady at around 4% since the 1970s. Accelerating productivity growth, therefore, depends on reversing the slowdown in the service sector. Productivity growth, in turn, is determined by a number of factors, including the regulatory framework and the strength of competition, which is influenced by international trade and inflows of foreign direct investment.

In addition to the overall deceleration in productivity growth in the service sector, there is concern about the weak performance of key service industries. In particular, the retail sector appears to be relatively inefficient, while prices are high by international comparison for transport industries, notably air transport and harbours, and for network industries, such as electricity. The rapidly growing area of business services appears hampered by pervasive regulations aimed at ensuring adequate quality. Finally, public services, such as health and education, have remained largely closed to market forces.

Chapter 5 discusses how productivity growth in the service sector can be accelerated, focusing on the following issues:

* What are the key factors limiting productivity growth in the service sector?

* How can government initiatives to develop the service sector be improved?

* What measures are needed to strengthen competition? How can competition policy be improved and regulatory reform accelerated?

* What are the major obstacles to productivity growth in key service industries, such as the retail sector, transport, network industries, business services and public services?

Reversing the trend towards dualism in the labour market while increasing labour force participation

Nominal wages resumed falling in 2007 despite the tightening of the labour market noted above. Although wages of regular and non-regular workers, such as part-timers and those with temporary contracts, have been fairly constant (Figure 1.4), the continuing shift to lower-paid non-regular workers is pushing down the overall average wage (Figure 1.10). Firms have an incentive to hire non-regular workers in order to reduce costs. For example, part-time workers (the key component of non-regular workers) are paid only 40% as much on an hourly basis as full-time workers. The total savings to firms is even larger since employees working less than 30 hours a week are exempt from all social insurance charges except employment insurance. In addition, firms use non-regular workers, which include dispatched workers and persons on temporary contracts, to provide greater flexibility than is possible in the case of regular workers.

[FIGURE 1.10 OMITTED]

While the expanded availability of non-regular employment provides job opportunities to some people who would otherwise be unable to find work, the increasing dualism of the labour market poses a number of efficiency and equity concerns. Non-regular workers, who have less education on average than regular workers, (12) tend to be excluded from on-the-job training. Given the important role of firm-based training in Japan, such workers are at risk of being left behind with a low level of human capital. Not surprisingly, the proportion of non-regular workers is the highest in the service sector at 41% of employment - where productivity growth has decelerated sharply. In addition, there are serious equity problems. Although there is little evidence, productivity differences between regular and non-regular workers are likely to be much smaller than the 60% wage gap. The equity concern is magnified by the fact that there is little movement of workers between regular and non-regular jobs, even though around three-quarters of non-regular workers between the ages of 20 and 35 prefer regular employee status. (13) Consequently, a significant portion of the labour force is trapped in a low-wage category from which it is difficult to escape. In sum, a third of the labour force is subject to low wages and reduced social protection, while bearing the brunt of adjustments in employment.

Increased dualism is also a cause of growing inequality. Since the mid-1980s, the Gini coefficient, a broad measure of income inequality, has risen by more than 11% according to Japan's Survey on the Redistribution of Income. In addition, an OECD study that provides an international comparison of income distribution using national data sources found that the Gini coefficient for the working-age population in Japan, which was below the OECD average in the mid-1980s, was the fifth highest in 2000. (14)

Japan is one of only four OECD countries in which the working-age population is already declining. The population in the 15 to 64 age group began to fall in 1996 and the pace of decline has accelerated to an annual rate of close to 1% (see Box 1.2). Although this is partially offset by the upward trend in participation rates, the size of the labour force is shrinking. In addition, the number of hours worked, which remains higher than in most other major countries, may fall further. The accelerating decline in labour inputs will put a growing burden on workers as the population ages. The scope for boosting labour force participation of older workers (ages 55 to 64) is limited, given that it is already the highest in the OECD. On the other hand, there is scope to increase the female participation rate, which is low compared to some other major economies. Moreover, 41% of women who do work are employed part-time, one of the highest in the OECD area. The fact that women account for two-thirds of non-regular employment may discourage their participation in the labour force.

In sum, the key challenges to improving the labour market, which are discussed in Chapter 6, are:

* How can the trend of increasing dualism in the labour market be reversed despite the preference of firms to hire non-regular workers?

* How can the human capital of non-regular workers be increased in an economy that emphasises on-the-job training?

* How can the participation rate be increased, particularly for women and older persons, thereby limiting the pace of the decline in the labour force?

Conclusion

Buoyant business investment supported by progress in corporate restructuring and strong export demand, primarily from Asia, has driven Japan's economic expansion and brought an end to a decade of economic stagnation. Sustaining the upturn is essential to stop deflation and achieve the government's fiscal targets. Achieving these goals requires appropriate monetary and fiscal policies, as well as an overhaul of the tax system that raises the necessary revenue without derailing the expansion. With the working-age population declining by almost 1% a year, further improvements in living standards depend increasingly on productivity, particularly in the service sector, which has experienced a sharp slowdown. Labour market reform is needed to cope with the declining population and to reverse the rising dualism between regular and non-regular workers, which is increasing income inequality. The following chapters analyse the challenges outlined in this chapter and develop specific policy recommendations to meet them.
ANNEX 1.A1

Taking stock of structural reforms

This annex reviews actions taken on the structural policy
recommendations in the 2006 OECD Economic Survey of Japan.
Recommendations made in this Survey are shown in the boxes at the
end of each chapter.

      Recommendations in the             Actions taken or proposed
           2006 Survey                       by the authorities

     A. Maintaining the financial soundness of the banking system

Continue strong prudential           The ratio of NPLs to total credit
supervision over the banks by        for the major banks declined from
requiring them to keep               2.9% in March 2005 to 1.5% in
non-performing loans (NPLs) at       March 2007.
low levels and further
strengthen their capital.

Encourage the regional banks to      The ratio of NPLs to total
further reduce their NPL ratios,     credit for regional banks
which remain higher than in the      declined from 5.5% in March
major banks, and to strengthen       2005 to 4.0% in March 2007.
their capital base.

Avoid moral hazard in government     No action taken.
supervision of regional banks,
which would create additional
non-performing loans.

Follow through on the                The privatisation of Japan Post
privatisation of Japan Post in       has advanced according to its
order to shift the flow of funds     initial plan, as it was split
away from the public sector,         into four companies in October
while ensuring a level playing       2007.
field with private-sector
financial institutions.

Scale back the role of public        The Japan Finance Corp. for
financial institutions,              Municipal Enterprises will be
preferably by closing them, and      closed. The Shoko Chukin Bank and
subject them to clear budget         the Development Bank of Japan are
constraints to reduce the amount     to be privatised. Five other
of government funding.               public financial institutions are
                                     to be combined into the "Japan
                                     Finance Corporation" in 2008 and
                                     their activities will be scaled
                                     back.

Ensure that the new institution      The Law on Administrative Reform
to be created by the merger of       Promotion states that there will
five public financial                be no financial subsidies to the
institutions operates efficiently    Japan Finance Corporation to
to limit the need for government     compensate its losses.
subsidies.

               B. The public expenditure and tax systems

The public expenditure system

Develop a comprehensive plan to      No action taken.
close inefficient public
infrastructure to avoid a
significant rise in renewal and
maintenance costs.

Raise public-sector efficiency,      The government revised the
in part by reforming the             evaluation system for central
employment system, rather than       government workers. A dual
by implementing across the board     career path system and a
cuts in employment.                  reform of the personnel exchange
                                     system with private firms will
                                     be proposed in 2008.

Promote the effective use of         After starting with pilot
market testing to transfer some      projects in three areas in 2005,
government tasks to the private      market testing was expanded to
sector.                              seven sectors in 2007.

Introduce more market mechanisms     No action taken.
into healthcare and nursing care
in order to limit spending
increases.

Policies to improve the efficiency of the tax system

Broaden the personal income tax      No action taken.
base in order to eliminate
distortions.

Introduce a taxpayer                 No action taken.
identification number system to
improve compliance with the tax
system.

Consolidate corporate tax credits    The number of tax expenditures
to broaden the tax base, ensuring    was reduced from 64 in FY 2006
that remaining tax credits are       to 61 in FY 2007, although the
well targeted.                       amount remained unchanged at
                                     about 7% of corporate tax
                                     revenue.

Pursue the plan to sell              The FY 2007 central government
government assets with an aim        budget contains 240 million yen
of increasing efficiency, while      (0.1% of GDP) of revenue from
using the receipts to reduce         the sale of assets, a 26%
gross government debt.               increase from the previous
                                     budget.

                C. Address inequality and relative poverty

Reverse the trend towards increasing labour market dualism
through a comprehensive approach

Reduce employment protection for     No action taken regarding regular
regular workers to reduce the        workers. The Part-time Work Law
incentive for hiring non-regular     was revised, in principle, to
workers to enhance employment        strengthen protection for
flexibility.                         part-time workers. Some employers
                                     have already implemented required
                                     changes.

Expand the coverage of               The revision of the Employees'
non-regular workers by social        Pension Insurance Law, which has
insurance systems based in           been submitted to the Diet, will
workplaces, in part by improving     slightly boost the number of
compliance with current insurance    non-regular workers covered by
systems.                             the employees' pension system.

Increase training to enhance the     Several reforms have been
employability of non-regular         implemented under the Challenge
workers.                             Again Action Plan.

Using social spending and tax reform to address inequality
and relative poverty

Shift the allocation of social       No action taken.
spending to increase the share
received by low-income
households.

Target social spending on            Several reforms aiming at those
vulnerable groups, such as single    groups were implemented under the
parents, while taking care to        Challenge Again Action Plan.
limit the creation of poverty
traps and work disincentives.

Take account of income               No action taken.
distribution in tax reform.

                         D. Encourage innovation

Reform framework conditions to support innovative activities

Promote the development of           Disclosure by firms has been
venture capital markets, while       improved to encourage investment
moving away from public debt         by individual investors in
guarantees and finance.              venture businesses.

Scale back the size of public        See the actions listed in
financial institutions, thereby      Section A.
enhancing the availability of
funds for venture business and
new start-ups.

Enhance the mobility of labour,      The MEXT launched a project to
including researchers, by            promote the diversification of
increasing the portability of        the career path for researchers
pensions and reforming retirement    in FY 2006 and FY 2007.
allowances at public research
institutes.

Expand the use of open               Following the 3rd Basic Plan of
competition in hiring,               Science and Technology (March
performance-based pay and            2006), research institutes and
fixed-term contracts in order        universities are to increase the
to enhance labour mobility and       number of researchers with
reduce "in-breeding" in public       fixed-term contracts.
research institutes and
universities.

Reduce labour practices that         No action taken.
limit the scope for
organisational changes that would
allow firms to benefit more fully
from introducing new technology.

Improve the regulatory framework     The three-year Regulatory Reform
continuously to reflect              Plan included 154 reforms in
technological progress,              healthcare and 79 in social
particularly in the areas of         welfare. In FY 2006, 53 were
medical and social welfare           implemented in healthcare, while
services, while further              32 were implemented in social
strengthening competition policy.    welfare. In competition policy,
                                     four reforms were implemented.

Upgrade the regulatory framework     The guideline for fair trade in
for network industries.              electricity was revised and the
                                     threshold for consumer choice in
                                     the gas sector was lowered from
                                     0.5 to 0.1 million [m.sup.3] in
                                     2007.

Boost productivity in the retail     The CEFP's Program for Enhancing
sector, in part by avoiding          Growth Potential in 2007 included
policies that favour small           strategies for innovation in
stores.                              services. In addition, METI
                                     established the Service Industry
                                     Productivity Council to address
                                     low productivity in services.

Use the special zone initiative      A total of 45 reforms implemented
to quickly advance nationwide        in special zones were expanded
structural reforms and provide       nationwide in FY 2006, followed
greater information on the           by five reforms in FY 2007. A
nationwide implementation of         survey on the economic effects
reforms and their economic           of the special zone policy was
impact.                              issued in September 2006.

Further improve the framework        An action plan to reform the
for evaluating patents to make       patent evaluation system was
the system more efficient.           updated in January 2007.

Promote creativity in education and the diffusion of knowledge

Give more autonomy to local          Local schools are allowed to hire
governments and individual           additional teachers paid by the
schools in setting curriculum,       municipalities. There is to be
hiring teachers and setting          more flexibility in the choice of
wages to increase competition        textbooks and a larger role for
between schools and reverse          municipalities.
declining levels of performance.

Reform the entrance exams for        No action taken.
secondary schools and universities
to test a broader range of
knowledge.

Encourage competition among          A survey on reforms of education
universities by allowing more        at universities was conducted to
flexibility in their management,     facilitate competition by
enhancing transparency in            providing greater information.
evaluating performance and
further reducing regulations,
including those that prevent
foreign universities from
entering Japan.

Enhance vocational training          The Challenge Again Action Plan
by establishing a well               includes several programmes to
functioning system of recognition    enhance vocational training and
and certification of learning        proficiency examinations and
that is co-financed by public and    certificates were strengthened.
private sources.

Upgrade the policy framework to improve innovation-specific
policies

Strengthen links between public      The 3rd Basic Plan of Science and
research institutes and the          Technology promotes co-operation
business sector.                     between business and R&D
                                     organisations through
                                     conferences.

Avoid mixing national innovation     Measures aimed at the
policies with measures to promote    revitalisation of regional
balanced regional development.       economies through R&D investment
                                     were included in the 3rd Basic
                                     Plan in March 2006 and the
                                     Innovation 25 plan in June 2007.

Further increase the share of        The amount of competitive grants
competitive grants in the            rose from 471 billion yen in
allocation of public R&D funds.      FY 2006 to 477 billion yen in
                                     FY 2007, boosting its share in
                                     central government outlays on
                                     science and technology from
                                     12.6% to 13.6%.

Attach greater importance to the     The CEFP's and METI's policies
non-manufacturing sector in the      related to the service sector
allocation of public R&D funds.      noted above focus on increasing
                                     innovation in service.

Maintain flexibility in              The allocation of funds is made
allocating public R&D funds,         based on reviews of past
thereby limiting the risks           policies, opinions from experts
inherent in concentrating R&D        and the mid-term plan.
efforts in the sectors identified
as priority areas.

Focus support for R&D on new         No action taken.
start-ups.

Expand the CSTP's work to include    No action taken.
framework measures to promote
innovation, while strengthening
the link with other councils,
including the CEFP and the
Council for the Promotion of
Regulatory Reform.

             E. Strengthen integration in the world economy

Improve the climate for inflows of foreign direct investment

Use the FDI doubling objective as    A "Program for Acceleration of
a spur to create a more open and     Foreign Direct Investment in
transparent climate for FDI.         Japan" was put forward in 2006
                                     aiming at improving the
                                     investment environment.

Fully open the M&A market to         The necessary policy changes were
foreign firms by allowing them       enacted in the FY 2007 tax
to use their own shares to           reform. Following this reform,
finance M&As and granting them       one "triangular" merger by a
the same tax deferrals that          foreign company has taken place.
are available in the case of
domestic M&As.

Further lift specific                No action taken.
restrictions on FDI, especially
in the service sector and
network industries.

Accelerate regulatory reform in      Demand and supply adjustment in
product markets, such as removing    harbor transport was abolished in
entry barriers for both foreign      all ports in FY 2006 and the
and domestic firms, notably in       permission requirement for
medical care, education,             setting prices was replaced by
transport, electricity and           prior notification for all ports
professional services.               by FY 2006. An Anti-Monopoly Act
                                     guideline for agricultural
                                     co-operatives was issued in FY
                                     2007 to deter unfair trade
                                     practice and to promote new
                                     entry.

Relax employment protection for      No action taken.
regular workers, which tends to
also help encourage foreign
investment.

Remove obstacles to international trade

Pursue the liberalisation of         In addition to its active
trade barriers, giving priority      participation in the Doha Round,
to multilateral trade                Japan signed Economic Partnership
negotiations, complemented by        Agreements (EPA) with the
regional trade agreements, to        Philippines and Chile in FY 2006,
further reduce the level of          and with Thailand, Brunei and
trade restrictions, including        Indonesia in FY 2007.
tariff and non-tariff barriers.
                                     Participation in conformity
                                     assessment bodies of other
                                     countries was permitted in the
                                     field of electrical products and
                                     telecom equipment, based on
                                     mutual recognition agreements.
                                     The list of qualified food
                                     additives was gradually
                                     increased.

Strengthen market forces in the      In order to accelerate the
agricultural sector, in part by      structural reform of agriculture,
reducing market price supports,      the price support for sugar crops
thereby promoting trade              was replaced by a non-product
liberalisation in a multilateral     specific direct payment system
context and broadening the scope     in 2007.
for EPAs.

Allow greater flexibility in the     The recent Economic Partnership
inflow of human resources,           Agreements with the Philippines
including both specialists and       and Indonesia will allow entry
non-specialists, which would also    and temporary stay for
facilitate EPAs.                     individuals who work as nurses
                                     and care workers in Japan once
                                     the agreements enter into force.

Pursue further regulatory reform     The Regulatory Reform Plan has
in product markets in part to        addressed a number of product
improve access for imports.          market regulations.

Encouraging the inflow of human resources to Japan

Improve the immigration control      Preferential measures in the
system to allow more highly          special zone have been expanded
qualified persons to work in         nationwide to give foreign
Japan.                               researchers and data processing
                                     engineers, who work in designated
                                     facilities, residence status and
                                     the maximum period of stay was
                                     extended from 3 to 5 years in
                                     November 2006. Specific dependent
                                     relatives of such foreigners can
                                     also enter Japan under certain
                                     conditions beginning in March
                                     2007.

Expand the range of                  No action taken.
qualifications that permit
foreign personnel to work in
Japan and increase recognition
of qualifications and diplomas
acquired overseas.

Increase the number of               No action taken.
occupational categories where
foreigners are allowed to work
to include non-specialised and
non-technical professions.


Notes

(1.) This is important particularly for small and medium-sized enterprises, which account for almost half of bank loans. Larger companies, in contrast, rely more on internal financing and capital markets.

(2.) Indeed, output fell at a 0.6% annual rate from the third quarter of 2002 to the first quarter of 2003 and was basically unchanged during the final three quarters of 2004.

(3.) Higher tax payments resulted from the phasing out in FY 2006-07 of the temporary income tax reduction introduced in 1999 and a temporary impact from the shift of part of the income tax to the local inhabitant tax in the second quarter of 2007.

(4.) Under this assumption, half of the decline recorded in the level of housing investment in the third quarter of 2007, on a national accounts basis, would be recovered by the end of 2009.

(5.) Indeed, energy prices rose 8.3% in December (year-on-year), accounting for 0.64 percentage point of the 0.7% rise in overall inflation.

(6.) There is also a marked difference between manufacturing and non-manufacturing sectors in their expectations of future growth (Figure 1.2, Panel C), thus dampening capital investment in the latter.

(7.) In its quarterly reports between April 2005 and July 2007, only one region had been downgraded, in contrast to three in the October 2007 report alone. In January 2008, Hokkaido, Tohoku, Hokuriku and Kanto Koshinetsu were downgraded. The assessment of Hokkaido was changed from "flat" to "sluggish".

(8.) See IMF (2003), "Deflation: Determinants, Risks, and Policy Options--Findings of an Interdepartmental Task Force" for a discussion of the costs of deflation. Many economists view inflation at a small positive rate as beneficial for economic growth, as such a rate facilitates adjustments in relative prices and wages. For a discussion of these issues, see Anne-Marie Brook, Ozer Karagedikli and Dean Scrimgeour, "An optimal inflation target for New Zealand: lessons from the literature", Reserve Bank of New Zealand Bulletin, Volume 65, No. 3, September 2002, pp. 5-16.

(9.) This change followed the announcement that the Japanese measure of the core CPI, which excludes only fresh foods, had risen by 0.5% (year-on-year) in January 2006, its third consecutive monthly increase. However, following the revision of the consumer price index in August 2006, the core CPI actually declined by 0.1% in January 2006.

(10.) See the Bank of Japan's October 2007 Outlook for Economic Activity and Prices, page 2.

(11.) See the Bank of Japan's October 2007 Outlook for Economic Activity and Prices, page 6.

(12.) Only 12% of non-regular workers have a university education compared to 31% of regular workers.

(13.) This is based on the "Survey of actual conditions on the attributes of young people" in 2003 by the Cabinet Office. See Chapter 6 for details.

(14.) See Forster and Mira d'Ercole (2005), "Income Distribution and Poverty in OECD Countries in the Second Half of the 1990s', OECD Social, Employment and Migration Working Paper No. 22, OECD, Paris.
Table 1.1. Japan's rebound from a decade of economic stagnation

A. International comparison (annual average percentage change)

                             1992-2002               2002-2007

                                     OECD                     OECD
                         Japan      average    Japan (1)   average (2)

Real GDP                  0.9         2.6         2.1          2.7
Real GDP per capita       0.6         2.0         2.1          2.0
Labour productivity       1.0         1.6         1.9          1.5

B. Components of Japanese growth (annual average percentage change)

                           1992-2002     2002-2007     Change

Private consumption           1.3           1.4          0.1
Government consumption        2.9           1.2         -1.7
Fixed investment             -1.2           1.0          2.2
  Public (3)                 -0.6          -8.1         -7.5
  Residential                -2.2          -1.9          0.3
  Business                   -1.2           5.1          6.3
Final domestic demand         0.9           1.3          0.4
Stockbuilding (4)            -0.1           0.1          0.2
Total domestic demand         0.8           1.4          0.6
Exports                       3.6           9.7          6.1
Imports                       3.9           4.7          0.8
Net exports (4)               0.1           0.7          0.6
GDP                           0.9           2.1          1.3

(1.) The second preliminary estimate of GDP in the fourth quarter
of 2007, which was made on 12 March 2008--after the publication of
Economic Outlook No. 82--was included in the data for 2007.

(2.) OECD estimate for the OECD average in 2007.

(3.) Including public corporations.

(4.) Contribution to GDP growth.

Source: OECD, OECD Economic Outlook, No. 82 (December 2007), OECD,
Paris.

Table 1.2. Short-term economic projections (1)

                                       2006    2007    2008    2009

Demand and output (volumes)
Consumption
  Private                               2.0     1.4     1.1     1.3
  Government                           -0.4     0.8     1.9     1.4
Gross fixed investment                  1.3    -0.3    -0.3     1.8
  Public (2)                           -8.1    -2.2    -4.9    -4.4
  Residential                           0.9    -9.5    -7.6     4.9
  Business                              4.3     2.4     2.4     2.8
Final domestic demand                   1.4     0.9     0.9     1.4
Stockbuilding (3)                       0.2     0.1     0.0     0.0
Total domestic demand                   1.6     1.0     0.9     1.4
Exports of goods and services           9.7     8.8     7.8     7.2
Imports of goods and services           4.2     1.7     4.5     5.5
Net exports (3)                         0.8     1.2     0.7     0.4
GDP                                     2.4     2.1     1.6     1.8
Inflation and capacity utilisation
GDP deflator                           -1.0    -0.8    -0.3     0.3
Private consumption deflator           -0.3    -0.5     0.1     0.3
CPI (4)                                 0.2     0.1     0.3     0.4
Core CPI (4)                           -0.4    -0.2    -0.1     0.3
Unemployment rate                       4.1     3.9     3.7     3.6
Output gap                              0.0     0.2     0.2     0.5
Memorandum items:
Net government lending (5)             -4.9    -4.0    -3.8    -3.4
Net primary balance (5)                -4.1    -3.2    -2.9    -2.3
Gross debt (6)                        179.2   180.3   181.6   183.3
Net debt (6)                           85.6    88.1    90.8    92.4
Current account (6)                     3.9     4.8     4.8     5.2

                                                  2007

                                           1st half   2nd half

Demand and output (volumes)
Consumption
  Private                                    2.4         0.6
  Government                                 0.4         1.5
Gross fixed investment                       0.3        -4.4
  Public (2)                                 8.3        -8.2
  Residential                               -4.9       -27.1
  Business                                  -0.4         2.3
Final domestic demand                        1.5        -0.4
Stockbuilding (3)                            0.1        -0.1
Total domestic demand                        1.6        -0.5
Exports of goods and services                9.3        10.5
Imports of goods and services                2.7         0.8
Net exports (3)                              1.0         1.5
GDP                                          2.7         1.1
Inflation and capacity utilisation
GDP deflator                                -0.6        -1.3
Private consumption deflator                -0.7        -0.1
CPI (4)                                     -0.5         0.8
Core CPI (4)                                -0.2        -0.1
Unemployment rate                            3.9         3.8
Output gap                                   0.7         0.1
Memorandum items:
Net government lending (5)
Net primary balance (5)
Gross debt (6)
Net debt (6)
Current account (6)

                                                  2008

                                           1st half   2nd half

Demand and output (volumes)
Consumption
  Private                                    1.0        1.1
  Government                                 2.3        1.3
Gross fixed investment                       0.3        1.8
  Public (2)                                -3.7       -2.6
  Residential                               -4.6        1.7
  Business                                   2.4        2.9
Final domestic demand                        1.1        1.3
Stockbuilding (3)                            0.0        0.0
Total domestic demand                        1.1        1.3
Exports of goods and services                7.4        7.6
Imports of goods and services                4.8        5.6
Net exports (3)                              0.5        0.4
GDP                                          1.6        1.7
Inflation and capacity utilisation
GDP deflator                                -0.3        0.2
Private consumption deflator                 0.1        0.2
CPI (4)                                      0.2        0.3
Core CPI (4)                                 0.0        0.1
Unemployment rate                            3.8        3.7
Output gap                                   0.2        0.3
Memorandum items:
Net government lending (5)
Net primary balance (5)
Gross debt (6)
Net debt (6)
Current account (6)

                                                  2009

                                           1st half   2nd half

Demand and output (volumes)
Consumption
  Private                                    1.3        1.4
  Government                                 1.4        1.5
Gross fixed investment                       1.7        2.2
  Public (2)                                -5.1       -4.9
  Residential                                6.0        6.0
  Business                                   2.5        3.1
Final domestic demand                        1.4        1.6
Stockbuilding (3)                            0.0        0.0
Total domestic demand                        1.4        1.6
Exports of goods and services                7.2        6.8
Imports of goods and services                5.4        5.5
Net exports (3)                              0.4        0.3
GDP                                          1.8        1.9
Inflation and capacity utilisation
GDP deflator                                 0.3        0.5
Private consumption deflator                 0.3        0.5
CPI (4)                                      0.4        0.5
Core CPI (4)                                 0.3        0.5
Unemployment rate                            3.6        3.5
Output gap                                   0.5        0.6
Memorandum items:
Net government lending (5)
Net primary balance (5)
Gross debt (6)
Net debt (6)
Current account (6)

(1.) Assuming an exchange rate of 109.4 yen to the dollar--the
level on 12 November 2007--and a $90 price for Brent oil in 2008
and 2009. All growth rates are annual rates relative to the
preceding period. Data announced on 12 March 2008--after the
finalisation of Economic Outlook, No. 82--are included in the
historical data for 2006 and 2007. The numbers for 2008 and 2009
are identical to those in Economic Outlook, No. 82.

(2.) Including public corporations.

(3.) Contribution to GDP growth.

(4.) Compared to the same semester of the previous year. The core
CPI is the OECD definition, which excludes both food and energy.

(5.) Per cent of GDP. Excluding one-off factors.

(6.) Per cent of GDP.

Source: OECD, OECD Economic Outlook, No. 82 (December 2007), OECD,
Paris.

Table 1.4. Potential economic growth in OECD countries
Annual averages, percentage points for the total economy

                   Potential GDP     Potential labour     Potential
                      growth           productivity       employment
                                         growth             growth
                                       (output per
                                        employee)

                 2004-08  2009-13   2004-08  2009-13   2004-08  2009-13

Australia          3.2      2.7       1.7      2.0       1.5      0.7
Austria            2.2      1.9       1.7      1.8       0.5      0.1
Belgium            2.1      1.8       1.2      1.6       0.8      0.2
Canada             3.0      2.4       1.4      1.7       1.6      0.7
Denmark            1.7      1.4       1.6      1.7       0.1     -0.2
Finland            3.0      2.1       2.4      2.3       0.6     -0.2
France             1.8      1.9       1.3      1.6       0.6      0.4
Germany            1.5      1.7       1.3      1.6       0.2      0.1
Greece             4.1      3.5       3.2      3.2       0.9      0.3
Iceland            4.4      2.4       2.5      1.7       1.9      0.7
Ireland            5.4      4.6       1.9      2.1       3.4      2.5
Italy              1.3      1.3       0.8      1.5       0.5     -0.2
Japan              1.5      1.5       2.0      2.2      -0.4     -0.7
Korea              4.5      5.0       3.6      4.5       0.7      0.6
Netherlands        1.8      1.7       1.2      1.3       0.6      0.3
New Zealand        2.9      2.3       1.1      1.6       1.8      0.6
Norway (3)         3.3      2.6       2.2      2.3       1.1      0.4
Spain              3.2      2.3       0.3      1.2       2.9      1.1
Sweden             3.1      2.6       2.3      2.4       0.8      0.1
Switzerland        1.7      1.8       0.8      1.0       0.9      0.7
United Kingdom     2.7      2.4       1.8      2.1       0.8      0.3
United States      2.7      2.7       2.0      2.1       0.7      0.6
Euro area          2.0      1.9       1.1      1.6       0.9      0.2
Total OECD         2.3      2.2       1.6      1.9       0.7      0.3

                      Components of potential employment growth (1)

                      Trend            Working-age        Structural
                  participation        population      unemployment (2)
                      rate

                 2004-08  2009-13   2004-08  2009-13   2004-08  2009-13

Australia          0.1      0.0       1.2      0.7       0.1      0.0
Austria            0.1      0.1       0.4      0.1       0.0      0.0
Belgium            0.3      0.1       0.6      0.1       0.0      0.0
Canada             0.3      0.1       1.3      0.6       0.1      0.0
Denmark           -0.2     -0.1       0.2     -0.2       0.1      0.0
Finland            0.3      0.1       0.2     -0.4       0.1      0.0
France            -0.1     -0.2       0.6      0.5       0.0      0.0
Germany            0.4      0.2      -0.3     -0.1       0.1      0.0
Greece             0.7      0.3       0.1     -0.2       0.1      0.1
Iceland            0.0      0.0       1.9      0.7       0.0      0.0
Ireland            1.0      0.8       2.3      1.6       0.2      0.0
Italy              0.5      0.1      -0.1     -0.3       0.2      0.0
Japan              0.2      0.2      -0.7     -0.9       0.0      0.0
Korea              0.2      0.1       0.5      0.3       0.1      0.1
Netherlands        0.5      0.3       0.1      0.0       0.0      0.0
New Zealand        0.3      0.0       1.3      0.6       0.2      0.0
Norway (3)         0.0      0.0       1.1      0.3       0.0      0.0
Spain              0.9      0.2       1.6      0.9       0.5      0.1
Sweden             0.2      0.0       0.7      0.1       0.0      0.0
Switzerland        0.1      0.1       0.8      0.6       0.0      0.0
United Kingdom     0.1      0.1       0.7      0.2       0.0      0.0
United States     -0.5     -0.5       1.2      1.1       0.0      0.0
Euro area          0.5      0.1       0.3      0.2       0.1      0.0
Total OECD        -0.1     -0.3       0.7      0.6       0.1      0.0

(1.) Percentage-point contributions to potential employment growth.

(2.) Estimates of the structural rate of unemployment are based on
the concepts and methods described in "Revised OECD Measures of
Structural Unemployment", OECD Economic Outlook, No. 68 (2000),
OECD, Paris.

(3.) Excluding the oil sector.

Source: OECD, OECD Economic Outlook, No. 81 (June 2007), OECD,
Paris.
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Title Annotation:Chapter 1
Publication:OECD Economic Surveys - Japan
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Date:Apr 1, 2008
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