Japanese Prime Minister Shinzo Abe has unveiled his long-awaited growth strategy – the so-called “third arrow” of what has come to be known as “Abenomics.” A preliminary version of the plan, announced to Japan’s Diet last year, was met with disappointment in international financial markets, which had expected a bolder approach. The new version is far more robust – and has received a far more positive global response.
Over the last 18 months, the first and second arrows of Abenomics – consisting of expansionary monetary and fiscal policies – have achieved considerable success in spurring Japan’s economic renewal. For starters, they have fueled price growth, with the GDP price deflator declining from 3% to nearly zero.
Moreover, the ratio of job openings to applicants, which fell to 0.4 under Japan’s last government, led by the Democratic Party of Japan, is now approaching 1.1. Indeed, Japan is beginning to show signs of a labor shortage.
But the limits of Abenomics’ first two arrows will soon be reached. With employment rising as Japan’s economy moves toward realising potential output, monetary stimulus will create inflationary pressures and public expenditure will yield sharply diminishing returns. At that point, significant growth can be achieved only by increasing the economy’s real productive capacity. That is what Abe’s new growth strategy aims to achieve.
At the strategy’s core is the removal of obstacles to growth for businesses, particularly the elimination or easing of regulatory barriers. Deregulation promises to bolster the ability of Japan’s private sector, which already excels in high-technology industries, to innovate and compete globally. While some officials, who may benefit from business regulations, may resist this initiative, its economic benefits, together with Abe’s determination, are compelling. At the same time, Japan will undergo sweeping labour-market reforms, open designated industries to foreign workers, and create “special economic zones” within which officials will have the authority that they need to reduce red tape in areas like agricultural land management. If concluded, the Trans-Pacific Partnership – a megaregional 12-country free-trade agreement – will provide an additional boost to Japan’s economy.
Perhaps the most promising reform is corporate-tax reduction, which will help Japan boost both foreign and domestic investment. By spurring increased business activity, it will actually increase Japan’s corporate-tax revenue.
By global standards, Japan’s current corporate-tax rate of 35% is quite high. Indeed, while it remains lower than in some US states (California’s rate, for example, stands at 40%), it exceeds the rates applied in Germany (25%), China (24%), South Korea (24%), the United Kingdom (24%), and Singapore (17%).
A quarter-century ago, the UK and Germany had higher corporate-tax rates than Japan. But they have since recognised the value of reduced rates. The UK practically waged a tax war against other countries to attract investment. Both countries’ experiences have demonstrated that substantial reductions over a short period are far more effective than a gradual, drawn-out process. Fortunately, Abe plans to follow suit.
The impact of this approach may be even more pronounced in Japan, where only a small share of firms currently pay corporate tax. One reason for this is the contractionary monetary policy pursued by former Bank of Japan Governor Masaaki Shirakawa, which prevented the economy from reaching its growth potential for more than 15 years, until Haruhiko Kuroda took over the position.
Japan’s so-called “special measures for corporate tax” – ad hoc provisions that reduce or waive certain taxes for firms at particular times – have also contributed to sustaining the economy’s output gap. These measures not only distort resource allocation; they also often lead to collusion between businesses and government officials seeking opportunities to enter the private sector upon retirement. Eliminating them would go a long way toward increasing corporate-tax revenue, without stifling growth.
Abe’s growth strategy has the potential to bring massive benefits to Japan. But it will also demand sacrifices. Consumption-tax hikes will be borne by consumers; the TPP will create new challenges for farmers; and deregulation will run counter to some bureaucrats’ interests. In this context, it is reasonable to expect businesses to relinquish some of their tax exemptions.
The Abe government has presented a set of forward-looking reforms – and appears determined to follow through on implementing them, even if doing so means confronting those with a vested interest in their failure. If the third arrow succeeds in sustaining Japan’s economic revival, there will no longer be any room to doubt the merits of Abenomics.