The post-pandemic recovery is moderating against the backdrop of heightened uncertainty. The strong outcomes of the latest annual spring wage negotiations, the highest in three decades, could signal a turning point for price, growth and income dynamics, a long-standing aim of Japanese policies. Global monetary and financial sector developments and persistent inflation are putting pressure on the monetary policy framework, while interest rate and credit risks in the financial sector warrant close monitoring. Given high public debt, fiscal consolidation to rebuild fiscal buffers, underpinned by a credible medium-term fiscal framework to reduce the primary deficit and put the debt-to-GDP ratio on a clear downward path, is key. Rapid population ageing will drag down trend growth unless productivity gathers speed. It will exacerbate fiscal pressures, which requires policies to contain health and long-term care spending. Increasing the share of basic research in total R&D spending and the share of business-financed R&D performance at universities, strengthening competition and improving access to finance for start-ups would foster business dynamism and innovation. Longer-term sustainability also requires reducing greenhouse gas emissions in line with government targets, calling for green investment and innovation plus carbon pricing.
OECD Economic Surveys: Japan 2024
1. Key policy insights
Abstract
Prior to the pandemic, economic policy, under the heading of “Abenomics”, aimed at overcoming deflation, accelerating economic growth and addressing the impact of demographic headwinds. Thanks to reforms, Abenomics did indeed raise growth and labour market participation, especially of women and older workers, and led to positive, albeit low, inflation. Since 2020, policy has focused more on the near term to protect households and firms against the dual shock of the pandemic and the energy crisis accelerated by Russia’s war of aggression against Ukraine. The pandemic also disrupted the convergence in per capita output growth towards the OECD average (Figure 1.1, Panel A). The post-pandemic rebound, supported by supply-chain improvements, increasing tourist arrivals following the reopening of borders, the release of pent-up demand and accommodative fiscal and monetary policies, has recently lost momentum amidst high uncertainty (Panel B). Furthermore, divergence in monetary policy with other advanced economies, global financial instability, geopolitical tensions, and weaker global growth highlight the importance of enhancing the Japanese economy’s resilience to shocks.
Figure 1.1. The post-pandemic recovery has recently lost momentum
Source: OECD, National Accounts database.
Addressing long-term structural challenges is key to resilient and sustainable growth. The gross public debt-to-GDP ratio reached 245% in 2022 (Figure 1.2, Panel A). Furthermore, demographic pressures will intensify, with the elderly dependency ratio forecast to reach 79% by 2050 (Chapter 2; Panel B). Boosting productivity growth is essential to compensate for the expected decline in the labour force due to population shrinking and ageing (Panel C). Ambitious reforms will also be needed to meet the government’s net-zero emissions target by 2050 (Panel D).
The Kishida administration’s New Form of Capitalism agenda focuses on human capital, innovation, economic security, and digital and green transformations (Box 1.1). The policy priorities are broadly in line with recommendations from past OECD Economic Surveys. To achieve more sustainable and inclusive growth, the government is increasing spending and planning reforms in several areas (human capital, children and families, green) (Government of Japan, 2023a). A Children and Families Agency was established in April 2023, which reflects the government’s priority of addressing the demographic challenge and boosting the fertility rate from its current level of around 1.3.
Against this background, the key messages of this Survey are:
Achieving fiscal sustainability requires a credible and concrete plan to achieve a primary budget surplus and put the government debt ratio on a downward trend by containing ageing-related expenditures and gradually increasing revenues to address post-pandemic challenges. Continued flexibility in the conduct of yield curve control and a gradual modest increase in the short-term policy interest rate is warranted, based on OECD projections of sustained inflation around the 2% target.
Additional productivity-enhancing reforms to improve the innovation framework and incentives to support productive start-ups are key to boosting potential growth and addressing ageing pressures. Strengthening the financial position of young people and policies to support families and children, such as improved parental leave, would help to reverse the downward trend in the fertility rate. Removing obstacles to the employment of women and older persons and making greater use of foreign workers would help counter demographic headwinds.
Meeting the ambitious climate targets requires a comprehensive policy package, including green investment, innovation and carbon pricing, and the preparation of contingency roadmaps towards targets, given the high share of uncertain technologies in emission reduction plans.
Figure 1.2. Long-standing challenges should be tackled
Note: In Panel A, OECD refers to the OECD weighted average. In Panel B, the old age dependency ratio is defined as the population aged 65 and above as a percentage of the population aged 20-64. In Panel D, the dashed line gives the implied linear reductions needed to meet the 2030 target, set at 46% from 2013 levels, and the 2050 target of net zero emissions.
Source: OECD, Economic Outlook No. 114 database; OECD Demography and Population Statistics database; OECD, Productivity database; OECD, Greenhouse Gas Emissions database and OECD calculations.
Box 1.1. New form of capitalism: agenda and recent initiatives
The government’s New Form of Capitalism agenda aims to achieve a “virtuous cycle of growth and distribution” to revive the middle class. This will require collaboration of firms and workers and the public and private sectors. The New Form of Capitalism focuses on investment in four pillars: people, technology and innovation, start-ups, and green and digital initiatives (Government of Japan, 2022a). First, policies will aim to sustain a “virtuous cycle of wages and prices”, building upon recent increases in inflation and the outcomes of the most recent wage negotiations, the highest in the past 30 years. Second, targeted public investment in human capital, digital and green transformations to stimulate further private investment and to attract firms to (re)locate in Japan will boost economic resilience. The November 2023 economic package, besides policies to support households against high prices, includes tax incentives to support wage growth, as well as regulatory reforms to promote start-ups and improve digitalisation, for example in the area of health.
Structural wage increases: The government plans to encourage the pass-through of higher costs to prices by firms, which in turn can support higher wages and fair subcontracting transactions. The public and private sectors will work together to support structural wage increases through three pillars: (i) support for reskilling and upskilling; (ii) introduction of job-based wages according to the actual conditions of individual companies; and (iii) facilitation of the movement of labour to growing fields.
Green transformation (GX): The government will provide support for initial investment (JPY 20 trillion) through “GX Economy Transition Bonds”, introduce carbon pricing, and utilise new financial approaches to facilitate private and public GX investment towards the identified needs of JPY 150 trillion over the next 10 years. Furthermore, Japan will promote the diffusion of technologies and contribute to the realisation of regional and global GX through international cooperation.
Digital transformation (DX): An action plan with tax, subsidy and regulatory reform measures will support domestic and foreign firms in strategic fields, such as semiconductors, batteries, bio-manufacturing, and data centres. The overall environment to promote DX investment will be improved, and the relevant infrastructure (e.g. telecommunications) to realise the Vision for a Digital Garden City Nation, an initiative to revitalise rural areas, will be promoted.
Start-ups: The Five-year Start-up Development Plan, introduced in November 2022, set a goal of increasing start-up investment by more than tenfold (to JPY 10 trillion) by FY2027, and create 100 unicorns (private firms with a valuation of more than JPY 100 billion) and 100 000 start-ups. In the FY2022 supplementary budget, the government allocated JPY 1 trillion to the plan, which includes three pillars to foster start-ups through human resources, funding and open innovation.
1.1. Growth is moderating amidst high uncertainty
High levels of vaccination against COVID-19 (Figure 1.3) and the strengthening of the healthcare system to protect vulnerable groups enabled the lifting of restrictions and the reopening of borders in 2022. The release of pent-up demand, which was also boosted by the government’s subsidies and policies to cushion the price shock, supported the recovery. Real GDP and per capita real output grew 1.0% and 1.4%, respectively, in 2022.
Figure 1.3. Successful vaccination helped overcome COVID-19
Note: The blue and yellow shaded areas show the time under a state of emergency, and quasi-state of emergency, respectively.
Source: Ministry of Health, Labour and Welfare; and OECD calculations based on Our World in Data.
Direct macroeconomic risks from Russia’s war on Ukraine have been limited, as Japan’s trade links with Russia are modest. In 2022, the share of imports from and exports to Russia were 1.7% and 0.6% of the total, respectively. 83% of Japan’s energy comes from fossil fuels, around 90% of which is imported, largely from Australia for coal and natural gas and the Middle East for oil. Dependence on Russia for fossil fuels, which was already low, declined further (coal: 6%, natural gas: 8%, oil: 1% in 2022), with substitution from other major exporters. Japan also depends on Russia for non-ferrous metals (13% of total imports of non-ferrous metals in volume in 2022), including palladium, which is used in catalytic converters for cars. While Japan has some stocks of such metals, whose prices have been more stable recently, persistent higher prices and supply shortages could create bottlenecks. The secondary impact through higher energy and food prices has been more pronounced, leading to sizeable policy support (see below).
Following robust growth in the first half of 2023, real GDP contracted by 0.7% in the third quarter with a decline in domestic demand. High uncertainty and inflation, together with dwindling pent-up demand, moderated private consumption (Figure 1.4). Consumption of durable and non-durable goods dropped in the second and third quarters, while that of services was flat.
In January 2023, headline consumer price inflation and the inflation index excluding fresh food reached their highest level in 41 years at 4.3% and 4.2%, respectively. They remain above target, at 2.8% and 2.5%, respectively, in November (Figure 1.5), with inflation excluding fresh food and energy at 3.8%. The contribution of energy prices to headline inflation has diminished, as has that of import and producer goods prices, while producer services prices are still rising. Consumer service prices were up 2.3% in November, driven by recreational services, including hotel charges (62.9%), reflecting the increase in inbound tourism. Food prices, which increased by 13% between January 2022 and November 2023, remain high.
The pass-through to consumer prices of cost increases led by the past rise in import prices is expected to continue in the near term. The share of price-increasing items in the consumer price inflation basket remains high (Panel C). Going forward, the scaling back of government subsidies for gas and electricity will push up prices, though the timing remains uncertain. Survey-based medium-term inflation expectations have also increased (Panel D), with 60% of firms expecting a price rise of 2% or more in the year ahead and long-term inflation expectations of slightly above 2%. Household inflation expectations have trended up, and average 10.7% for inflation a year from now.
Figure 1.4. The recovery in private consumption has recently moderated
Source: Cabinet Office; and Bank of Japan.
Labour markets have become tighter, with a relatively high jobs-to-applicants ratio (Figure 1.6, Panels A-B). Skill shortages are partly linked to complementarities of intangible investment and skills (Furukawa et al., 2023). Prior to the pandemic, employment rates were steadily increasing, mainly driven by female and elderly people, partly thanks to past structural reforms (Panel C). As the scope for additional labour supply declines with demographic headwinds, structural reforms prioritising employment and skill-enhancing policies will be key (Chapter 2).
Whether inflation will reach the 2% target durably will partly depend on wage growth. The history of stagnant nominal wages in Japan is linked to backward-looking inflation expectations and workers’ focus on job security rather than wage increases and low labour mobility, reflecting Japan’s labour market specificities (2021 and 2019 OECD Economic Surveys; Chapter 2): i) seniority-based wages and long-term employment practices often lead to wage losses of middle-aged and elderly workers upon their job changes; and ii) the rising share of non-regular workers from 32% in 2005 to 37% in 2021 has pushed average wages down.
Wage dynamics are gradually changing, reflecting post-pandemic shifts in labour markets and higher inflation. Key labour unions and employers agreed on increases of 2.1% in base pay and 3.6% in headline wages in the latest Shunto wage negotiations, as against 0.6% and 2.1% a year earlier (Figure 1.7, Panel A). As a result, nominal wage growth has been trending up (Panel B). There were some indications that SMEs facing labour shortages are raising or planning to raise wages (JCCI, 2023), but the spread of wage increases to SMEs has lagged. Nevertheless, the contribution of higher base wages to nominal wage growth of full-time workers, which tended to be driven by overtime earnings and bonuses, is increasing (Panels C-D). In addition, job advertisement data for regular employees suggest a shift towards higher wages, which could boost labour mobility (Furukawa et al., 2023). Going forward, the largest union has stated that it will seek an increase of more than 3% in base pay and more than 5% in headline wages for FY2024 and the latest economic package also includes support for businesses to raise wages. Hence, wage growth is projected to gain momentum in 2024-25.
Figure 1.5. Inflation has become more broad-based
Source: Ministry of Internal Affairs and Communications; Bank of Japan; and OECD calculations.
The recovery of real exports and industrial production has been volatile, reflecting changes in supply-chain conditions and the global outlook. Exports to China, which is a major trading partner (Figure 1.8), have been lagging, while those to Europe have recently declined (Figure 1.9, Panel A). The goods trade balance has been improving due to moderating energy and raw materials prices (Panel B). The total number of inbound tourists was around 2019 levels in November, although the recovery in tourists from China is sluggish at only 34% of pre-pandemic levels (Panel C). The December Tankan survey points to strong enterprise investment plans, but the industrial production outlook has moderated, reflecting the uncertain global outlook (Panel D).
Figure 1.6. Labour markets have become tighter
Note: Panel A: older than15-years old.
Source: Ministry of Internal Affairs and Communications; and Ministry of Health, Labour and Welfare.
In the face of supply chain disruptions, the government passed the Economic Security Promotion Act in May 2022, which includes: (i) securing a stable supply of critical products; (ii) ensuring the stable provision of essential infrastructure services; (iii) supporting the development of specified critical technologies; and (iv) maintaining confidentiality of patent applications for selected security-related inventions. In December 2022, the government designated 11 critical products, including semiconductors, cloud computing, storage batteries, liquefied natural gas, antibacterial substance preparations, fertilisers and permanent magnets. Furthermore, Japan seeks to strengthen rule-based international trading partnerships, such as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, the Regional Comprehensive Economic Partnership Agreement, and more recently the Indo-Pacific Economic Framework, which includes 14 members, representing 40% of global GDP.
GDP growth is projected to slow from 1.9% in 2023 to 1.0% in 2024 and to slightly pick up to 1.1% in 2025, with a shrinking positive contribution from net exports (Table 1.1). Private consumption will be supported by rising wages and the new economic package. Business investment will grow moderately, thanks to government subsidies and high corporate profits. Public investment in large-scale projects will contribute to growth in 2024. The labour market will remain tight, contributing to higher wage growth in 2024-25. Headline consumer price inflation is projected be over 2% by the end of 2025 as government subsidies end, the output gap closes and wage growth gains momentum.
Figure 1.7. Wage growth dynamics are gradually changing
Note: In Panel B, scheduled and non-scheduled cash earnings refer to base and overtime wages, respectively. Special earnings include regular summer and winter bonuses.
Source: Ministry of Health, Labour and Welfare; Japanese Trade Union Confederation; and OECD calculations.
Downside risks include weaker-than-expected external demand, including a sharper slowdown in China, and renewed energy price increases and supply-chain disruptions. A loss of confidence in Japan’s fiscal sustainability and an increase in the sovereign risk premium could destabilise the financial sector and the real economy, with large negative global spillovers. On the upside, growth could be stronger in the event of a faster-than-expected recovery of consumption, especially of services. It would also be boosted by an upward surprise with respect to external demand, including inbound tourism. In addition, other lower probability threats to the outlook could derail the recovery (Table 1.2).
Figure 1.8. China and the United States are Japan’s main trading partners
Note: Data refer to goods trade. Other Regional Comprehensive Economic Partnership (RCEP) includes Australia, Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, New Zealand, the Philippines, Singapore, South Korea, Thailand, and Vietnam. Russia and Ukraine are included in Other Europe.
Source: Ministry of Finance; and OECD calculations.
Table 1.1. Growth is set to moderate
1. Contributions to changes in real GDP, actual amount in the first column.
2. Consumer price index excluding food and energy.
Source: OECD Economic Outlook No.114 database updated to take into account the 8 December 2023 Japanese national accounts release.
Table 1.2. Events that could lead to major changes in the outlook
Figure 1.9. The recovery in exports and industrial production has been volatile
Note: In Panel C, the data are based on monthly averages and for 2023 include the average until November.
Source: Bank of Japan; Ministry of Finance; Japan National Tourism Organisation; Ministry of Economy, Trade and Industry; and OECD calculations.
1.2. Pressures on the monetary policy framework have risen
Monetary policy remains accommodative, with the short-term policy interest rate unchanged at -0.1%, but several adjustments in the conduct of yield curve control were made to improve market functioning. In December 2022, the Bank of Japan (BoJ) modified the conduct of yield curve control, by widening the fluctuation band around the 0% 10-year Japanese Government Bond (JGB) yield target from around ±25 basis points to around ±50 basis points and raising the monthly target of JGB purchases from JPY 7.3 trillion to about JPY 9 trillion. In January, funds-supplying operations were enhanced. In April, the governor announced a broad review of monetary policy (expected to be completed by late 2024) and the BoJ’s forward guidance was changed by dropping the phrase “expects short- and long-term policy interest rates to remain at their present or lower levels”. There are no immediate plans to revise the 2013 accord between the BoJ and the government, which set a goal to achieve a 2% inflation target “at the earliest possible time”. In July 2023, the BoJ announced that the upper and lower bounds of the fluctuation band range will be treated as references, not as rigid limits, in its market operations and offered to buy 10-year JGBs at 1% through fixed-rate operations. In late October, the Bank shifted to regarding an upper bound of 1% of the yield target as a reference, with yields controlled mainly through large-scale JGB purchases and market operations.
Monetary policy divergence between Japan and other advanced economies contributed to substantial yen depreciation (Figure 1.10, Panel A), which triggered foreign exchange interventions with purchases of JPY against USD in September and October 2022 for the first time since 1998, amounting to roughly JPY 9.2 trillion (5% of Japan’s forex reserves). Since then, there have been several episodes of pressures on the exchange rate and the 10-year JGB yield, which spiked at around 0.9% in late October. Pressures subsequently abated somewhat, but could return depending on global developments (Panel B). In September 2023, the BoJ held 54% of outstanding JGBs (excluding T-bills), and its total assets stood at around 126% of GDP (Panels C-D). BoJ purchases of JGBs amounted to a record JPY 23.7 trillion in January 2023 but fell back to JPY 9.3 trillion in October.
The extended use of yield curve control can create challenges, such as lower functionality of the JGB market and market volatility risks at its longer end. Reviews of the Reserve Bank of Australia’s yield target, which ended in November 2021, concluded that future use of such policies should rest on an assessment of the flexibility of yield target to changing circumstances and the associated operational challenges, and that forward guidance weakened when the yield target became inconsistent with policy expectations in 2021 (RBA, 2021; Lucca and Wright, 2022). Despite different circumstances, Japan might face renewed pressures, if markets start speculating about the end of yield curve control. In addition, cross-country evidence suggests that prolonged monetary easing can lead to higher share of “zombie firms” (Jafarov and Minella, 2023; Hong et al., 2022; Acharya et al., 2019).
While acknowledging the potential side effects of prolonged monetary easing and that the likelihood of achieving the price stability target in a sustainable and stable manner has been increasing, the BoJ intends to continue quantitative and qualitive easing with yield curve control. The addition of “accompanied by wage increases” to reaching the price stability target of 2% in a sustainable and stable manner in the April 2023 statement suggests the wish to avoid premature tightening. In October, the BoJ revised its projections of consumer price inflation (excluding fresh food) up to 2.8% in FY2023 and FY2024, and 1.7% in FY2025, citing cost-push factors (BoJ, 2023a). However, according to the summary of opinions of the October 2023 meeting, a few members stated that next year's annual spring wage negotiations and the extent to which wage increases are reflected in prices will be key to confirming that the virtuous cycle between wages and prices is gathering traction.
Figure 1.10. Divergent monetary policy with peers creates pressures
Note: In Panel C, Japanese government bonds do not include T-bills.
Source: Bank of Japan; Cabinet Office; Federal Reserve Board; European Central Bank; Eurostat; and Ministry of Finance.
If inflation remains above target and global yields go up, markets could challenge yield curve control again. Hence, modifications to increase flexibility and lower the risks of abrupt changes later, which could trigger market volatility, should be continued. The options include raising the 10-year JGB yield target, and/or moving to a shorter-term yield target. BoJ assessments suggest that short- and medium-term rates have a greater effect than long-term rates on the output gap. OECD projections of sustained inflation around 2% (Table 1.1), increasing wage growth and a closing of the output gap imply a gradual increase in the policy rate is warranted, starting from early 2024. In this context, potential adverse spillovers on domestic and global financial stability should be considered (IMF, 2023a). Macroprudential policies may help limit exit risks (see below). Communicating the current and future monetary stance clearly and in a timely manner is also key.
The uncertainty surrounding the inflation outlook is exceptionally large. Downside risk factors include long-standing structural barriers to wage growth (see above) and a potential slowdown in the global economy. On the other hand, a tighter labour market may lead to higher-than-projected wage growth. Remaining fiscal support and a renewed rise in energy prices would work in the same direction. In this context, the key challenge facing the BoJ is how to durably achieve its inflation target without significantly overshooting while safeguarding financial stability. If the positive wage-inflation cycle gets underway more slowly than projected by the OECD, the BoJ is likely to wait for longer before raising interest rates.
1.3. Financial stability risks should be monitored closely
The financial system appears to remain resilient in the face of global headwinds. Capital adequacy ratios are well above regulatory requirements, but lower than the OECD average (Figure 1.11). The share of non-performing loans, at 1.2%, remains low. The failure of Silicon Valley Bank highlighted that changes in market interest rates could expose duration risks in banks’ business models, but the impact on Japan’s financial system was limited, with a temporary fall in the prices of bank stocks (BoJ, 2023b). However, rising foreign interest-rate risks and potential credit risks call for close monitoring and vigilance. The enhanced coordination between the BoJ and the Financial Services Agency (FSA), through joint stress tests, data sharing and the establishment of a joint Financial Monitoring Council in June 2021, should be continued.
Figure 1.11. The banking system appears to be sound
Note: 2023Q1 data for the OECD average are calculated using the latest available quarter for OECD countries.
Source: IMF Financial Soundness Indicators database.
A gradual wind-down of COVID-19 relief financial measures is underway. These include the termination of the BoJ’s funds-supplying operations against government-supported loans in December 2022 and non-government-supported loans in March 2023. However, the outstanding loan guarantees remain high at JPY 41 trillion (7.3% of GDP) in FY2022 (Figure 1.12, Panel A). As repayments of interest-free loans start, some micro firms with cash shortages create risks for the exposed banks (BoJ, 2023b). Bankruptcies increased by 35% in the first half of FY2023 from a year earlier, with notably a rebound among SMEs in the food services and retail industries, but remain around pre-pandemic levels (BoJ, 2023c).
Although remaining around the OECD average, the household debt to disposable income ratio, at 121%, has increased, reflecting a higher share of real estate loans (Panel B). While housing loan delinquency rates remain low, increasing no down-payment loans, rising loan-to-income ratios and housing loans with a debt servicing ratio of 25% or above (20% of households), which partly reflect younger households taking larger housing loans, and a high share of floating-rate housing loans (76% of all housing loans in March 2023) warrant close monitoring (Panel C; BoJ, 2023b). The FSA has been considering sector-specific risks, such as real estate lending, while conducting microprudential supervision, which incorporates macroprudential perspectives. However, macroprudential policies can help curb vulnerabilities from growth in housing loans, given the increasing number of households with low resilience to income or interest rate shocks. Including borrower-based macroprudential tools, such as loan-to-value or loan-to-income limits in the supervisory toolkit should be considered to enable speedy deployment, if needed. Furthermore, banks' exposure to domestic and foreign real estate businesses has been expanding, which warrants close monitoring (BoJ, 2023c).
Figure 1.12. Financial stability risks warrant vigilance
Note: In Panel A, data refer to government guarantees of banks’ loans to SMEs at the end of each fiscal year. Data for FY2023 are only partially available until the end of October. In Panel B, data refer to loans by banks, Shinkin banks and trusts.
Source: Japan Federation of Credit Guarantee Corporations; Bank of Japan; and Cabinet Office.
Foreign interest rate, foreign loan and currency funding risks should also be monitored closely. Foreign loans by major banks and foreign bond investments by banks and institutional investors have raised foreign currency interest rate risks (Panel D), although these risks have been declining since early 2023 (BoJ, 2023c). While overall foreign credit risks remain low, the increase in the size and concentration of foreign loans to borrowers with high financial leverage creates vulnerabilities to the exposed banks (BoJ, 2023b). A change in the monetary policy framework, notably a steeper JGB yield curve or an increase in Japan’s short-term policy rate, would also affect the financial system. The JGB holdings by banks (mainly T-bills) increased after the pandemic. While a steeper JGB yield curve can help improve banks’ profitability in the medium term, some financial institutions with high exposures may face an immediate adverse impact (IMF, 2023b). Large banks are addressing these potential vulnerabilities by reducing their duration risks, but smaller banks could face difficulties.
While the sharp increase in interest rates in the UK gilt market and the collapse of the FTX currency exchange in 2022 have highlighted new potential risks, such risks seem contained in Japan. For example, corporate pension funds have refrained from engaging in excessive search for yields, even though the use of leverage transactions by life insurers has increased (Ito et al., 2023). Three legal reforms of the crypto asset regulatory framework since 2016 have strengthened supervision, requiring crypto exchanges, including stablecoin intermediaries (from June 2023), to register with the FSA and obtain a license to operate in Japan. A legal framework that came into effect in June 2023 aims to lower anti-money laundering risks and improve international coordination by including the “travel rule”, which requires crypto exchanges to pass along information to one another for crypto asset (including stablecoins) transfers. These measures are welcome and monitoring of related risks should be continued.
Regional banks’ profitability has been increasing, reflecting BoJ pandemic policy support and the 2020 “Special Deposit Facility”, which aims to strengthen their business foundations. Branch consolidation and digitalisation helped reduce expenses, but further room for cost-cutting remains (Samikawa et al., 2021). The new grant scheme established by the FSA to support mergers is welcome. The authorities should continue to help regional banks upgrade business models, better utilise IT/Fintech, streamline costs, and consolidate, amid structural headwinds of a declining population. Furthermore, some regional banks have not sufficiently ascertained the impact of repayment of principal for effectively interest-free and fully guaranteed loans from the pandemic (BoJ, 2023d). Increasing the effectiveness of their risk management, such as their risk tolerance assessments, including downside scenarios, should be prioritised.
The BoJ has been conducting central bank digital currency experiments since April 2021. Following the completion of a technical feasibility assessment in March 2023, a pilot programme was launched. This will include the integrated configuration of central and intermediary network systems and endpoint devices, and the establishment of a Central Bank Digital Currency Forum to engage private stakeholders. These experiments to ensure ex-ante the coexistence of central bank digital currency with other forms of money are crucial to respond flexibly to future needs of user convenience and universal access. It will be important to carefully consider the impact on financial stability and privacy.
1.4. Addressing short and long-term fiscal policy challenges is key
The measures to protect households and firms against the pandemic and the energy shock compounded medium-term debt sustainability challenges. In 2022-23, the government launched three economic packages, worth JPY 64.7 trillion (11.5% of GDP), including funding for medium-term investment in areas such as economic security (semiconductors and generative AI), the green and digital transformations, education, and measures against the energy shock (Box 1.2), which are projected to keep the deficit high at 5.2% of GDP in 2023. The November 2023 economic package includes stronger tax incentives for businesses to achieve structural wage increases, regulatory reforms and R&D financing to generate new frontiers of growth in space and oceans. The measures to moderate the impact of high prices, in a context of falling real wages, include cash handouts to low-income households (additional JPY 70 thousand per household) and temporary cuts to income and residential taxes (JPY 40 thousand per person), which will cost JPY 1.1 trillion (0.2% of GDP) and about JPY 4 trillion, respectively.
Box 1.2. Main policy responses against the increase in energy and food prices
Several economic packages have been utilised to moderate the price surge and support vulnerable households and businesses (JPY 14 trillion, 2.4% of GDP) in 2022-23. The energy price subsidy for capping prices of petroleum products started in January 2022, with JPY 80 billion financed from the FY2021 supplementary budget. The September 2022 measures (JPY 3.5 trillion) included the extension of the subsidy for petroleum products, the freezing of the government selling price of imported wheat at the April level, a one-off special cash benefit to low-income households, and a special grant to local governments to help them support vulnerable households and businesses. The latter may be targeted but its criteria depend on each municipality. The second economic policy package and supplementary budget for 2022 further extended the subsidies for petroleum products until September 2023 and introduced new schemes to reduce electricity and city gas bills from January to September 2023 (JPY 6.1 trillion). In March, the government decided to use JPY 2.2 trillion from the contingency reserve fund to enhance the support and reduced the renewable energy levy on electricity from April. The extension of the subsidy programme aimed at lowering gasoline prices until the end of the year was announced in August 2023. Measures to reduce electricity and city gas bills were also extended, with the subsidy rates halved in September. The November economic package extended the current subsidies to cushion the impact of higher fuel oil, electricity and city gas prices until April 2024 (additional JPY 0.8 trillion), with those for electricity and city gas to continue with reduced rates in May 2024. It also included additional grants to local governments (JPY 1.6 trillion) to fund measures, including one-off cash benefits for low-income households. The broader package of reforms to deal with the energy crisis and with energy security also includes plans to accelerate the use of nuclear energy (see below).
The main support measures have been sizeable and predominantly untargeted. Prolonged energy price caps exacerbate fiscal sustainability challenges and can reduce incentives to shift to renewables and lower energy demand by distorting market signals. Some OECD countries have already terminated untargeted VAT reductions on energy (e.g. the Netherlands) and remaining measures are set to expire in Autumn or Winter 2023 (Hemmerlé et al., 2023). As the recovery continues, policy normalisation should commence, with the phase-out of remaining measures. Any additional public support to income, if warranted by renewed energy price shocks, should focus only on the most vulnerable, who are not adequately protected by the general social protection system.
Persistent and sizeable fiscal deficits can undermine confidence in Japan’s debt servicing capacity, which has been a concern for some time (Hoshi and Ito, 2014). Japan lacks a credible medium-term fiscal consolidation strategy to put public debt on a downward path and build fiscal buffers to increase resilience to shocks, which should include both revenue and expenditure measures (Figure 1.13, Panel A). Expenditures should move from demand creation towards boosting the supply side, guided by spending reviews (see below), while tax reforms should ensure a tax mix which limits the negative impact on growth and equity and does not undermine other objectives of the government. Net interest payments on outstanding debt are low at 0.47%, but the potential increase in the debt servicing burden if interest rates rise should be included in the consolidation scenarios. The plans to increase defence spending (JPY 43 trillion over the next five years) and the budget for children and families (JPY 3.5 trillion per year over the next three years; Chapter 2) may exacerbate these trends, as concrete offsetting revenue measures are yet to be decided.
Adopting assumptions in line with historical trends can improve fiscal policy credibility. The policy response to the dual shock worsened the fiscal situation, but the commitment to reaching primary surplus by FY2025 remains unchanged. The government produces different scenarios for medium-term fiscal projections (baseline, high growth and reference), which is welcome (Panel B; Cabinet Office, 2023a). In the high growth and reference scenarios, which assume that TFP growth rises to 1.4% and 1.1%, respectively, in the next five years, the government achieves a primary surplus in FY2025, with expenditure reforms, but these scenarios could be difficult to achieve. The primary deficit remains under the baseline scenario where the economy grows around potential, with TFP growth of 0.5%, which is around the average for the period between 2012 and 2020. Hence, a clear and credible roadmap to achieve a primary surplus also at lower growth rates, underpinned by specific measures, and putting the government debt ratio on a downward trend, is needed.
Figure 1.13. Fiscal consolidation efforts should include expenditure and tax measures
Note: In Panel B, the economy grows around potential, with TFP growth of 0.5% under the baseline scenario, while the reference and the high growth scenarios assume TFP growth of 1.1% and 1.4%, respectively, with higher labour force participation rates. The primary balance is central and local governments on a fiscal year basis. See Cabinet Office (2023), Economic and Fiscal Projections for Medium to Long Term Analysis for details.
Source: OECD, Economic Outlook No. 114 database; and Cabinet Office.
1.4.1. Assessing debt sustainability
The government projects that with ageing, social security spending will rise from 21.5% of GDP in 2018 to around 24% by 2040. Without corrective action, this would substantially worsen long-term fiscal sustainability. Building on the framework in the 2021 Economic Survey, updated OECD debt sustainability analysis incorporates projections by the Cabinet Office until FY2032, the latest population projections (IPSS, 2023; Cabinet Office, 2023a) and additional spending to advance the green transformation. In the baseline scenario, where fiscal policy parameters are kept constant with annual real GDP growth of around 0.5%, the primary deficit of central and local governments will widen sharply after 2030 as spending pressures intensify due to rising age-related social security expenditures and a rapidly declining labour force, with the outstanding debt to GDP ratio rising rapidly to around 310% by 2060 (Figure 1.14).
In the fiscal reform scenario, where consumption and carbon taxes gradually increase after 2025 and half of their revenues are recycled to moderate their economic impact, the budgetary position improves for a while, before underlying spending pressures lead to increases in debt levels. The same happens albeit later in the productivity-enhancing reforms scenario, where potential annual growth rises to around 1% and improvements in public spending efficiency lower spending by 10% compared to the baseline. To keep fiscal policy sustainable, fiscal reforms need to be combined with structural reforms to promote productivity growth. The projections rest on various simplifying assumptions, notably with respect to interest rates, and are sensitive to population and labour dynamics (Box 1.3). The possible impacts of some of the fiscal measures are outlined in Box 1.4.
Figure 1.14. Reforms are needed to ensure long-term fiscal sustainability
Note: The horizontal axis shows fiscal years. The primary balance and outstanding debt are based on the Cabinet Office definition (implying a somewhat lower debt ratio than the national accounts definition), and projections up to 2032 are based on the baseline Cabinet Office projection. The OECD assumes further spending related to the green transformation (GX) of around JPY 2 trillion per year from 2023 to 2050, and revenues from the forthcoming carbon pricing are assumed to be around JPY 1 trillion by 2050. After 2033, the long-term interest rate equals nominal GDP growth plus term and risk premia of around 0.2-0.3 percentage point. The baseline scenario takes into account rising spending pressure stemming from ageing and holds current fiscal policy settings constant. The fiscal reform scenario assumes the consumption tax (value-added tax) rate is gradually increased from 10% to 20% and the carbon tax from JPY 289/tCO2 to JPY 4 000 over ten years beginning in 2025. Half of the additional revenues are recycled to offset the economic shock. The real GDP growth rates of the baseline and the fiscal reform scenario are almost identical due to the assumption of recycling revenues to mitigate the shock. In addition, the fiscal reform scenario includes raising the pension eligibility age by one year every three years, starting from 2031, towards age 70, which is assumed to affect labour force participation rates in age groups 60-64, 65-69 and 70-74 in 2030 and 2045, which by 2030 are the same as those in the baseline for five-year younger groups in 2045. Those who thus retire later are assumed to receive higher benefits by 4.2% per year of delay, corresponding to half of the currently applicable 8.4%. The productivity-enhancing reform scenario assumes a higher total factor productivity growth rate by 0.3 percentage point (Saruyama and Tahara, 2020) and higher labour participation, taken from the high growth scenario of the Cabinet Office projections, with a constant capital equipment ratio. Government spending is assumed to grow less robustly such that spending relative to baseline is 10% lower after 30 years. The combined reforms scenario reflects the joint effect of the fiscal reform and productivity-enhancing reform scenarios.
Source: Cabinet Office (2023a); OECD (2021a); MHLW (2019); and OECD calculations.
Box 1.3. Sensitivity analyses of long-term projections
Interest rate assumptions are critical to fiscal projections, given high levels of debt. The difference between long-term interest rates and nominal GDP growth rates after mid-2030 is around 0.2%-0.3%, which is low compared to historical experience on average over long periods. Uncertainty regarding interest rates has been rising. Additional simulations assuming that the interest rate-growth differential is higher or lower by one percentage point show that in the baseline scenario, the debt-to GDP ratio in 2060 would be around 70 percentage points more in the higher interest rate scenario (Table 1.3).
Table 1.3. Higher interest rates create risks for long-term fiscal sustainability
Outstanding gross debt as a per cent of GDP in 2060
Note: Assumed changes to interest rates are gradually phased in after 2030 over five years.
Source: OECD calculations.
A second set of sensitivity analyses concerns population projections, with the fertility rate higher or lower by 0.5 than the current rate of 1.3. For the higher (lower) fertility rate case, total population in 2060 will be around 9% larger (smaller) than in the baseline, affecting GDP growth and cost pressures. Reforms to reverse the declining trend in fertility rates, discussed in depth in Chapter 2, can improve debt sustainability (Figure 1.15).
Figure 1.15. Fiscal projections are sensitive to population assumptions
Note: The fertility rate will gradually increase (decrease) from 1.3 over the next ten years. The other economic assumptions, such as labour force participation rates, remain the same.
Source: OECD calculations.
Box 1.4. Illustrative fiscal impact of proposed reform measures
The illustrative budgetary impact of some of the reforms proposed in this Survey, to the extent it can be quantified, is reported in Table 1.4.
Table 1.4. Illustrative impact of selected proposed reforms on the budget balance
Per cent of GDP
Note: The impacts reported are on the fiscal balance of central and local governments.
Source: Ministry of Internal Affairs and Communications; Ministry of Health, Labour and Welfare; Cabinet Office; and OECD calculations.
1.4.2. Improving the fiscal framework
Overreliance on supplementary budgets and contingency reserve funds lowers the reliability and transparency of fiscal projections and targets. There have been 18 supplementary budgets since 2012, and seven since the pandemic, while contingency reserves have increased tenfold compared to their pre-pandemic average (Figure 1.16). While allowing a swift and effective policy response to shocks, the use of large and frequent supplementary budgets makes expenditure ceilings non-binding and lowers the consistency of annual budgets and medium-term fiscal sustainability. Notwithstanding the recent response to the large shocks, supplementary budgets across OECD countries tend to be small and are typically used for technical adjustments rather than new policy. Furthermore, revised budget increases can be offset by reducing budgets for other agencies by a corresponding amount or by borrowing from next year’s appropriation (OECD, 2023a).
Recently, in Japan, parts of unused voted funds have been carried over to other purposes. For example, part of the unused voted funds, including contingency reserves, will serve to finance part of the increased defence spending. However, the use of supplementary budgets and contingency funds should be limited to large macroeconomic shocks with a more concrete definition under which circumstances they can be used. For example, the government could be obliged to declare a crisis or emergency formally to use supplementary budgets over a certain threshold. In addition, the use of the funds should be more targeted, for example towards supporting vulnerable groups against shocks and evaluated ex post to strengthen the fiscal framework and increase the effectiveness of macro policy support. To ensure that off-cycle budget spending is indeed used to respond to crises, whether or not off-budget spending is urgently warranted as a crisis response could be assessed in real time externally, for example by an independent fiscal institution.
Figure 1.16. The use of supplementary budgets and contingency reserve funds has increased
Note: Horizontal axes show fiscal years. In Panel B, contingency reserve funds include funds for general and special purposes.
Source: Ministry of Finance.
Establishing an independent fiscal institution can help achieve fiscal targets and evaluate fiscal projections. Such bodies, which exist in most OECD countries, are associated with increased fiscal rule compliance, more accurate forecasts, and less pro-cyclical fiscal policy (Rawdanowicz et al., 2021). Their functions include monitoring compliance with fiscal rules, assessing long-term fiscal sustainability, analysing budgets and medium-term fiscal plans and endorsing or producing economic and fiscal forecasts (Box 1.5). In Japan, the Council on Economic and Fiscal Policy provides analysis and evaluation of long-term fiscal forecasts and fiscal targets since 2001. Headed by the Prime Minister, the Council includes five ministers, the BoJ governor, and two academic experts. More recently, the appointment of eight new experts for the advisory panel to the Council on Economic and Fiscal Policy and the enrichment of fiscal projections, reflecting the discussions of the Council, through additional scenarios and extended evaluation of risks via sensitivity and fan chart analysis, are steps in the right direction. However, establishing an independent fiscal institution would support the Japanese fiscal framework further. The main mandate should be to assess the government’s macroeconomic and fiscal plans and projections, and could also include providing timely and transparent ex-ante evaluation of selected policies (e.g. pension and tax reform scenarios, targeting of temporary support measures) as in other OECD countries. For example, the Spanish and Belgian independent fiscal institutions regularly estimate ageing costs and simulate the fiscal effect of different pension reform proposals, which improves the transparency of such costs. The Irish Fiscal Advisory Board provided independent scrutiny of recent emergency spending programmes (i.e., pandemic-related and cost-of-living packages), including by quantifying the share of targeted measures (OECD, 2020a; IFAC, 2022). Independent monitoring by the Swedish Fiscal Policy Council, together with budget policy targets, a disciplined central government budget process and rules to secure openness and clarity, is an important element of the Swedish fiscal framework.
Spending reviews can support public finance sustainability through systematic analysis of existing expenditures with a view to prioritise and reallocate expenditures. Japan conducts annual spending reviews, which are then linked to the annual budget process, but they do not feed into multi-annual programmes. In addition, Japan applies Evidence-Based Policy Making (EBPM) methodology to evaluate the effectiveness of policies and projects ex-post. The use of both in the context of multi-year programmes and budgets could be enhanced further. For example, in Denmark, spending reviews inform decisions on multi-annual budget agreements to improve links with the medium-term fiscal framework (Tryggvadottir, 2022). There is also room to improve resources in terms of capacity (skilled experts) and time and the availability of performance data to effectively implement spending reviews and EBPM methodology (OECD, 2020b; RIETI, 2022). For example, Latvia established a specialised unit for spending reviews to build capacity and scale up the use of spending reviews. Increased use of digital technologies to connect related databases and data sharing across different government levels and bodies can help identify spending efficiency gains in areas such as health and long-term care (see below).
Box 1.5. Independent fiscal institutions: international experience
According to the OECD Principles for Independent Fiscal Institutions (IFIs), their leadership’s term should optimally be independent of the electoral cycle; IFIs should be precluded from any normative policy-making responsibilities; and the leadership should be selected strictly on the basis of merit and technical competence (OECD, 2014). Experiences of OECD countries with IFIs have been varied. For example, in the United Kingdom, the IFI was created due to sharp increases in public debt and concerns over excessively optimistic fiscal forecasts (Chote and Wren-Lewis, 2013).
The Irish case is a good example of how IFIs can raise public awareness of long-term fiscal challenges and strengthen fiscal management (OECD, 2017). Established in 2012, the Irish Fiscal Advisory Council (IFAC) is mandated to independently assess the government’s fiscal stance and budgetary forecasts, endorse the official macroeconomic forecasts prepared by the Department of Finance and monitor compliance with budgetary rules. The Council is made up of five members – including its Chair – appointed by the Minister of Finance among recognised domestic and international experts in macroeconomic and fiscal matters. The Council, whose members’ four-year mandate is renewable up to three consecutive terms, has an annual budget of around EUR 0.8 million, and a six-person full-time Secretariat. Over the years, IFAC has become central to the national debate on public finances, particularly by stressing the need to ensure fiscal sustainability in the face of systemic challenges, such as population ageing, climate change and the digital transition. IFAC’s reports and recommendations have gradually made inroads in the policy sphere. The authorities adopted a spending rule in 2021 and enhanced transparency via the adoption of strengthened medium- and long-term budgetary frameworks.
1.4.3. Addressing ageing-related costs
Population ageing will increase fiscal pressures, with national projections pointing to an increase of around JPY 17 trillion (2.7% of projected GDP in 2025) in health, long-term care and pension expenditures between FY2025 and 2040 (Figure 1.17, Panel A). Recent reforms to contain expenditures include an increase in co-payments of medical costs and a drug price revision. A roadmap for social security reforms is being discussed, which would include adjusting contributions of the elderly to medical and long-term care insurance, boosting the productivity and efficiency of health care, including via the digitalisation of health services, reforming social security insurance to reduce gaps across different types of workers and extending healthy life expectancy (Committee on Social Security System Oriented to All Generations, 2023). Since 2022, pension amounts are recalculated once a year even when a beneficiary is still working to reflect the contributions based on working after age 65 in pension benefits before the time of termination of employment or the age of 70, and the threshold of income beyond which earnings-related pensions are reduced for people aged 60 to 64 has been increased. Depending on the results of the next financial verification of the sustainability of the pension system (conducted every five years), scheduled for 2024, the authorities may consider further pension reform.
Ensuring a sustainable pension system
Pension reforms should carefully balance adequacy and sustainability concerns. Strong employment growth, including through longer careers, has partly offset the demographic impact on pension expenditures. However, the future net replacement rate of 39% for full-career average-wage workers is well below the 62% OECD average (Panel B), and could increase relative old-age poverty, which at 20% is already higher than the 13% OECD average. Lack of income security from the basic pension (National Pension Scheme) for some elderly also puts pressure on the tax-financed public assistance system. Public assistance was designed to provide emergency relief to those unable to maintain a minimum income level, but has started to function as a supplementary pension. Around half of recipients are aged 65 and over (2.8% of the elderly population), compared to 36% in 2000 (Panel C), which can crowd out assistance for low-income households of working age (Oshio, 2018).
Japan and Korea are the only OECD countries where the mandatory retirement age applies to private‑sector workers from age 60, while in nine other countries it applies only from age 65 or higher (OECD, 2021b). Future retirement ages (i.e. for those entering the labour market at age 22 in 2020) are set to increase in a number of OECD countries, for example to 67 in Norway and 68 in Finland, but no changes are planned in Japan. The reform with the biggest impact would be to raise the pension eligibility age above 65 in line with life expectancy and abolish mandatory retirement, which was set at age 60 by 72.3% of firms in 2022, even though many of them have extension and/or re-employment schemes (Chapter 2). This would strengthen work incentives, reduce poverty among the elderly, improve intergenerational equity and promote the sustainability of the pension system. Furthermore, it would be desirable to accelerate the increase in women’s eligibility age for Employee Pension Insurance, which is set to reach 65 by 2030 (Chapter 2). Another reform option could be to extend the contribution period for a full basic pension from 40 to 45 years.
Macroeconomic indexation, introduced in 2004, which applies a correction both to price indexation of mandatory basic and earnings-related pensions in payment and, for new pensions, to the uprating of past wages, will help cope with spending pressures. However, the application is delayed in times of negative price or wage growth. A carry-over mechanism, introduced in 2016, in principle corrects for the delayed adjustment in following years, but the correction will be suspended if the replacement rate falls below a certain threshold (50% based on the Japanese method for calculating the rate). The failure to revise the income-related benefits in line with indexation plans resulted in the overpayment of benefits in the past. To ensure the long-term sustainability of the pension system, indexation should be fully applied, even in the event of deflation.
Reforms to expand employee insurance coverage of non-regular workers should be continued. The self-employed are covered by the basic pension but are not mandatorily covered by earnings-related schemes. The firm size threshold that applies to mandatory coverage for part-time workers declined from 500 full-time employees to 100 in 2022 and will decrease to 50 in 2024, but about 30% of part-time employees in Japan work at firms with less than 50 full-time employees. To the extent that about one-third of women tend to be part-time workers, such reforms can also help lower the gender pension gap, as the relative pension income difference between men and women at 47% is much higher than the OECD average of 26% (OECD, 2021b). Removing obstacles to the creation of full-time and regular jobs, notably by reducing employment protection for regular workers, and continuing with Work Style reforms, as recommended in previous Economic Surveys, would also help (Chapter 2).
Figure 1.17. Population ageing exacerbates fiscal sustainability challenges
Note: Panel A shows national projections of health, long-term-care and pension expenditures under baseline economic scenarios with medium birth and death rates. Horizontal axes show fiscal years. In Panel B, OECD calculations based on the pension model, using pension entitlements on current legislation and pension system parameters reflecting the situation from 2020 onwards. The calculations show the pension benefits of a worker who enters the system that year at age 22 and retires after a full career. In Panel C, the protection rate refers to the share receiving the Basic Livelihood Protection Programme.
Source: Ministry of Health, Labour and Welfare; OECD, Pensions at a Glance 2021; Ministry of Internal Affairs and Communications and OECD calculations.
Containing health and long-term care spending
Several indicators, such as the high number of hospital beds, long length of hospital stays and the high number of medical consultations, point to room for efficiency gains in health and long-term care spending (Table 1.5). The share of public health expenditures in total expenditures is comparatively high, out-of-pocket payments are low, especially for certain segments of the population, and doctors are predominantly paid on a fee-for-services basis. Improving spending efficiency is key as population ageing will increase such pressures and costs. For example, dementia prevalence in Japan, which was the highest in the OECD at 26.7 people per 1 000 population in 2021 (compared to the 15.7 OECD average), is expected to increase to 44.7 by 2050 (OECD, 2021c). Besides the fiscal costs of dementia, the productivity costs for family and informal caregivers are also high (Ikeda et al., 2021).
Out-of-pocket expenditures as a share of current health expenditure at 15.1% are below the OECD average of 24.1%. The level of co-payment depends primarily on age, rather than income, with reduced rates on co-payments for those aged 70 and over (Figure 1.18, Panel A). The burden on the working population will increase as the population ages. Hence, the increase in the co-payment ratio from 10% to 20% for those aged 75 and over, whose income surpasses a certain threshold, since October 2022 (as against a 30% standard rate), is welcome. Further raising the co-payment ratio or lowering the income threshold could be considered, given the large wealth of the elderly on average. The reduced co-payments should be means-dependent for all adults and limited to low-income households.
Figure 1.18. There is room to reduce the fiscal cost of health and long-term care
Note: Panel B: OECD aggregate shows the average for 30 jurisdictions in the OECD. Low, moderate and severe needs correspond to 6.5, 22.5 and 41.25 hours of care per week, respectively. The costs of institutional care include the provision of food and accommodation, so are overestimated relative to home care. The OECD average is computed across jurisdictions’ latest available observations (from 2018 to 2022). The reference year is 2022 for Japan.
Source: Ministry of Health, Labour and Welfare; OECD Health at a Glance 2021; and OECD analyses based on the Long-Term Care Social Protection questionnaire and the OECD Income Distribution Database.
Table 1.5. International comparison of selected health and long-term care settings
Note: 1. In days. 2. Per 1 000 population aged 65 years and older. 3. In hospitals.
Source: OECD, Health Statistics database.
Japan mostly uses fee-for-service payments for both primary care and outpatient specialists, which is the case amongst half of the OECD countries. This type of payment can result in excessive expenditure growth due to incentives for the overprovision of care, if not combined with strict budgeting mechanisms (Lindner and Lorenzoni, 2023). As recommended in the 2019 Economic Survey, gradually increasing the use of a pay-for-performance system, in which providers are given financial incentives to meet performance standards, could help reduce the number of doctor consultations and improve spending efficiency in Japan. In this context, some OECD countries are testing new payment models (based on value rather than volume) more aligned with the objectives of improving quality of care, better co-ordinating and integrating care delivery across settings and services, containing health expenditures and rewarding health promotion and disease prevention, which could also be considered.
Patients can access secondary and tertiary care facilities directly without a referral from a primary care physician (Kato et al., 2019) even though additional out-of-pocket payments were introduced in 2016 on visits to tertiary care hospitals without referral. Such payments for direct access to hospitals were increased in 2022, which is welcome. Requiring primary care referral for secondary care can lower costs further. Well-integrated medical records can also improve the efficiency of primary care and connection between inpatient and outpatient primary care, but an enhanced data infrastructure and management is needed. The proportion of primary care physician offices using electronic medical records has increased from 15% in 2012 to 42% in 2021 but remains far below the 93% OECD average (OECD, 2021c). Further use of digital technologies to connect related databases, as recommended in the 2021 Economic Survey, is also key. Systematic analysis of such data can create spending efficiency gains and improve quality of care. For example, Ireland is planning to set up an independent central authority to reap the benefits of data integration. In Japan, Fukuoka City is centralising and analysing relevant data to improve the effectiveness of its long-term care policies (Box 1.6).
Box 1.6. Fukuoka City: creating a healthy social model
Fukuoka is a dynamic city, with a favourable business environment, and reasonable costs of living and doing business. Designated a National Strategic Special Zone for Global Startups and Job Creation in 2014, Fukuoka City has a Startup Support Hub, which offers integrated startup support services, a startup visa programme and special corporate tax reductions for startups. Fukuoka City has also successfully delayed the demographic transition, with a relatively young population. Nevertheless, it is preparing for the future when the effects of population ageing will kick in (the “era of 100-year life”) through the Fukuoka 100 project, which started in July 2017 and includes a number of initiatives. First, information on the 1.64 million Fukuoka City residents, regarding births, health, nursing care and deaths, has been centralised and analysed to identify the main reasons for needing long-term care. This analysis then serves to create mechanisms and devices that make people want to be active by utilising roads and parks, and prepare preventive measures, for example, to keep oral health for the entire lifetime. Second, to create a “dementia-friendly city”, where people with dementia can live in a community that they are accustomed with in a familiar environment, the city holds lectures on dementia care techniques for different groups, such as local residents, elementary and junior high school students, and paramedics.
Source: Fukuoka City Government (2017), Fukuoka 100.
Moving long-term care away from hospitals can create savings and enhance patient well-being, complementing the existing focus on community-based comprehensive care delivery. The number of long-term care beds in hospitals is 2.5 times the OECD average (Table 1.5), and many acute care hospital beds are used for long-term care (Jones, 2022). The large hospital capacity is one reason behind the provision of long-term care in hospitals, with “social hospitalisation” contributing to long average hospital stays. Using hospitals for long-term care is inefficient, as it costs more than twice as much as beds in long-term care facilities, reflecting regulations on the number of medical staff and equipment in hospitals (Jones, 2022). In addition, costs of home-based long-term care for over-65-year-olds with mild and moderate needs as a share of their disposable income tend to be significantly lower than in the case of institutional long-term care (Figure 1.18, Panel B). Hence, moving long-term care away from hospitals, prioritising home-based care, including the provision of help through formal caregivers, and assigning only those with severe needs to institutional care would be most cost-effective. It will be important to ensure that the shift to home-based care does not lead to unintended consequences, such as women dropping out of the labour force to care for elderly relatives. Ensuring an adequate supply of paid nurses or formal helpers, which could include foreign long-term caregivers, and increasing awareness of the 2017 Child Care and Family Care Leave Act, which offers flexibility to allow workers to provide some long-term care and remain in the labour force, to workers and firms, are key (Chapter 2).
1.4.4. Reforming the tax system
Boosting government revenues should be an integral part of a strategy to achieve fiscal sustainability. Japan’s tax revenues as a share of GDP are close to the OECD average (Figure 1.19, Panel A), although they are above the non-EU OECD average. However, the share of consumption and personal income taxes is relatively low (Panel B). In contrast, the shares of social security contributions and corporate income taxes are above the OECD average. The government is considering raising social security contribution rates further, which can lower employment incentives, and corporate income taxes to finance higher defence spending. The former already make up 36% of general government revenues. Given population ageing, eliminating distortions in the tax system that discourage employment, while enhancing its redistributive function to achieve an optimal tax mix is key.
Despite steadily increasing to 10% by October 2019, the consumption tax (standard value-added tax) rate remains among the lowest in the OECD and consumption tax revenues at 5% of GDP are relatively low (Panel C). Consumption taxes have relatively low distortionary effects on labour, savings and investment, distribute the tax burden equitably across generations and can be a relatively stable revenue source. Among the policy options, a continuous and gradual increase of consumption taxes would yield relatively high fiscal revenues, with relatively small adverse effects on long-run GDP and welfare (OECD, 2021a; McGrattan et al., 2018). As recommended in previous OECD Economic Surveys of Japan, the consumption tax rate should be raised gradually, following a regular medium-term schedule enshrined in legislation, to limit the economic impact and minimise policy uncertainty, and could be complemented with well-targeted cash transfers to low-income households.
Several deductions to personal income taxes erode the tax base (Table 1.6). Reforming deductions benefiting high-income households would increase tax progressivity and revenues. Despite a top statutory rate of 55%, personal tax revenues are relatively low. Reducing the wage income deduction, the largest deduction at 28.5% of gross personal income before taxes, which exceeds the costs faced by employees (such as commuting), can broaden the tax base. Currently, the earned income deduction, which aims to serve as a deduction for estimated service costs and adjust the tax burden on employees with that of other incomes, starts at JPY 550 000 of gross employment income and is capped at JPY 1.95 million. The need to adjust the burden of employee incomes against other incomes could be reduced by improved tax compliance by self-employed workers through an effective use of the national personal ID (My Number) system to increase transparency of their income. Likewise, deductions for pension income apply even to very wealthy pensioners, with a ceiling of JPY 1.95 million. Tax reforms in FY2018 cut the deduction and lowered the ceiling in both cases. However, there is room to further lower the ceilings, accompanied by targeted support measures for low-income households. Reforming the social security insurance and tax treatment of second earners would boost female employment and tax revenues (Chapter 2). The deduction for dependent children who are older than 16 years under certain conditions could also be reassessed if the eligibility for the child allowance, currently ending on 31 March after the child reaches the age of 15, is extended to 31 March after turning 18, as discussed in the government’s Children’s Future Strategy Policy (Government of Japan, 2023b).
Figure 1.19. The share of consumption and personal income taxes is relatively low
Note: In Panel A, data for Japan and Australia refer to 2020. For Japan, data are presented in fiscal years. Tax revenues include social security contributions according to the OECD Revenue Statistics methodology. In Panel D, statutory corporate income tax rate refers to the combined central and sub-central (statutory) corporate income tax rates.
Source: OECD, Revenue Statistics database.
Table 1.6. Personal income tax deductions
Per cent of gross income before taxes in 20211
1. For a married household with two children with one worker earning the average wage. 2. Work-related expenses.
Source: OECD (2022), Taxing Wages, 2022.
Japan’s corporate income taxes yield high revenues, with a relatively high corporate tax rate (Panel D). However, a targeted reduced rate (15%) applies to an annual taxable income below JPY 8 million for SMEs, compared to the standard 23.2% rate for large companies. Such size-contingent policies may discourage firm growth (Benedek et al., 2017). The corporate tax system is further complicated by local taxes, which vary with company size. Hence, in the medium term, simplifying the system and abolishing the lower tax rate for SMEs could increase revenues. Raising taxes on capital gains and dividends could also boost revenues and could enhance the progressivity of the tax system. Marginal effective tax rates on bank deposits, dividends and capital gains in Japan are lower than the OECD average, especially for high-income earners (OECD, 2018). Capital gains and dividends are subject to a flat rate of 20%, with some exemptions to promote households’ financial investments through Nippon Individual Savings Accounts. As higher-income earners have more capital, which is taxed at a flat lower rate than the top tax rate for labour income, the tax burden declines for annual income exceeding about JPY 100 million (Kumakura and Kojima, 2018).
Table 1.7. Past OECD recommendations on macroeconomic policies and actions taken
1.5. Productivity-enhancing reforms should be prioritised
Raising productivity growth, which has been muted in recent decades, is key to address the demographic headwinds. Improving the innovation framework and incentives, boosting regulation and increasing access to finance can help lower the productivity gap between SMEs and large firms and boost intangible investment.
1.5.1. Reviving the R&D engine
At 3.3% of GDP, Japan’s spending on research and development (R&D) was among the highest in the OECD in 2021 (Figure 1.20, Panel A). However, since 2000, R&D outlays have risen at an average annual rate of only 1.2% in real terms, the third weakest outturn in the OECD area. Furthermore, domestic innovation activities exhibit weak integration with global innovation networks, with foreign sources funding only 0.6% of total R&D in 2021. Private businesses performed around 80% of total R&D, but just about 6% was linked to SMEs, way below the OECD average of 40% (Panel B; OECD, 2022a). In this context, the large concentration of business R&D in manufacturing activities, which account for about 80% of the total, limits the resources earmarked for more innovative services. R&D investment in the ICT sector, for instance, amounted to less than 3% of all business R&D in 2020, an OECD-low.
While Japan is a global leader in the number of patents, these are largely driven by incremental innovation, as most filings relate to narrow improvements of existing technologies (Jones, 2022), while many are not used in follow-on research (Bahar and Strauss, 2020). Moreover, a number of patents are actually thickets of intellectual property rights set up by incumbents, which may deter the commercialisation of new inventions or innovative products (OECD, 2021a). This is a potentially important issue for the digital transformation with the development of new products and processes spanning several intellectual property domains. To better support open innovation, the Japan Patent Office has thus set up model contracts helping R&D start-ups and business companies to improve their communication and successfully navigate the legal and negotiating hurdles of joint research and licence agreements. However, competition authorities may need to monitor whether improper strategic use of patenting is hindering digital transformation.
Figure 1.20. High levels of R&D spending are mostly sustained by large enterprises
1. Includes higher education and private non-profit sectors.
Source: OECD, Research and Development Statistics database.
Enhancing R&D incentives
Public support to business R&D is below the OECD average and has decreased markedly in recent years, decoupling from business R&D expenditures. The support is largely tax based, with direct grants accounting for less than one fifth of the total (Figure 1.21, Panel A). The policy mix is broadly consistent with empirical evidence that tax incentives generate more benefits than costs (Lester and Warda, 2020) and are relatively effective in promoting R&D spending (Hall and van Reenen, 2000), even if potentially open to risks of deadweight losses. Direct subsidies are frequently associated with “picking winners” risks, which can, however, be limited through well-designed competitive processes (Jones and Kim, 2015; Giebe et al., 2006). Hence, increased use of direct grants targeting specific objectives, such as reducing the financing gap in intangibles, which affects innovative start-ups (OECD, 2021d; Appelt et al., 2016), could be considered. However, it is important to evaluate the effectiveness of direct subsidies, which increased during the pandemic, to prevent the creation of zombie firms (Hashimoto and Hirasawa, 2021).
The design of the R&D tax incentives implies slightly negative marginal tax subsidy rates for loss-making firms, below the OECD average (Panel B). While this is independent of firm size, the impact on smaller firms could be higher. Although accounting for 71% of all recipients, SMEs received just 7% of overall R&D tax subsidies in 2019, whereas they attracted about one fifth of direct funding (OECD, 2021e). The non-refundable nature of the tax credit and the lack of carry-forward provisions, abolished in 2015, stifle the investment incentives of new and smaller firms, which generally lack sufficient tax liability and are more likely to be credit-constrained. Making the credit refundable or reinstating the tax carry-over would enhance investment incentives of innovative start-ups and SMEs.
Figure 1.21. Public support of R&D spending is largely tax based
1. In the case of Canada, Japan, and Hungary, subnational tax support for BERD is included in tax support for BERD.
2. Implied marginal R&D tax subsidy rates, customarily derived as 1 minus the B-Index, specify the notional level of subsidy (before tax) on one additional unit of R&D outlay. See OECD, Definition, interpretation and calculation of the B index for further details.
Source: OECD R&D Tax Incentives database; R&D Tax Incentives in Japan, INNOTAX, Tax Incentives for R&D and Innovation.
Boosting the innovation potential of universities
The strong commercial orientation of Japan’s R&D system restricts the scope for basic research, largely performed in universities and public research institutes (Figure 1.22). Basic research helps generate new knowledge that, even if without any immediately foreseeable application or use, lays the foundation for further technological innovation. However, interactions between business and university R&D are limited, with only 0.5% of business-financed R&D performed at universities, despite a relatively generous tax credit allowing companies to deduct 30% of R&D expenses from their tax liabilities, when incurred in joint research projects with universities or acknowledged national public research institutions (METI, 2022a). Hence, enhancing the role of universities and public research institutions by strengthening their links with businesses, especially SMEs, could help fulfil the government’s objective to boost creative innovation (Government of Japan, 2021).
The limited mobility of researchers across institutions remains a barrier to the diffusion of innovative ideas. While researchers’ mobility is relatively strong within the business sector, university researchers or experts rarely avail of the possibility, introduced in 2014, to hold cross-appointments with multiple universities, research centres and private companies (METI, 2020a). Hence, the plans to include cross-organisational experiences among the evaluation criteria for permanent research jobs in universities and researchers’ career progression should be followed through. Likewise, Japan’s net inflows of scientific authors remained steadily negative in recent years (OECD, 2023b), despite government pledges to attract more foreign talent to enhance universities’ internationalisation (Government of Japan, 2015). Enabling incoming foreign scientists and researchers to progress their career within their host departments and universities would maximise the impact of new skills and concepts on local operational and organisational processes.
Fulfilling the Science, Technology and Innovation Basic Plan’s objective to make universities the engine of a revamped national innovation circuit, built on a strong public-led basic research system, warrants considerable investment. Having acquired the status of national university corporations in 2004, following partial privatisation, national universities were pressured to broaden their sources of revenues and their operational support funds were cut by 1% per year (Kikuchi, 2021). In 2019, general government funding of university-performed R&D was only about 4% above its 2000 level, in real terms, compared to a 61% increase in the United States, although it grew in line with nominal GDP over the same period (OECD, 2022a).
Figure 1.22. Engagement in basic research projects is weak
As a percentage of total R&D expenditures, 2021 or latest year available
Source: OECD Research and Development Statistics database.
The University Endowment Fund, launched in March 2022 and with a current allocation of about JPY 10 trillion (1.8% of GDP), is set to use the gains from the investment of the fund’s assets to provide selected universities with stable long-term funding to upgrade their research infrastructure, and support university start-ups and higher personnel expenses to attract top researchers. The Fund is managed by the national research funding body, the Japan Science and Technology Agency, based on a set of guidelines drafted by the Ministry of Education to ensure investment with a long-term perspective (Council for Science, Technology and Innovation, 2021).
Access to the scheme is based on an assessment of the candidate institutions’ plans for institutional reform, capacity to generate internationally outstanding research, possession of highly effective business and financial strategies, and autonomous and responsible governance systems (Government of Japan, 2022b). Eligibility criteria for the scheme should be clearly outlined and transparent, particularly as regards assessing universities’ vision and commitment to future reform, while ensuring limited scope for government intervention. This would support competition and reduce the risk of stifling innovation by concentrating investments into “preferred” technologies.
The potential of the Fund to boost innovation intensity is large, but adverse incentives should be avoided. A priori, selected universities will enjoy full flexibility on how to use the allocated funds, without facing specific requirements on research areas and type of projects, which can enable academia to foster research that would not be viable in the private sector (Aghion et al., 2008). It will be important to ensure that not only research projects leading to relatively quicker commercial returns are conducted. Hence, the impact of the Fund on boosting theoretical basic research should be regularly assessed and monitored.
Declining research time of scientists can restrict universities’ innovation capacity. Increased staff shortages, driven by steady reductions in block funding since 2004, have increased the involvement of researchers in administrative work and university management. Stricter separation between research functions and academic administrative responsibilities, assuming availability of adequate funding, would boost innovation outcomes. Empirical evidence suggests mostly an inverted U-shape relationship between researchers’ productivity and age (Costas et al., 2010), although high individual ability may help offset the adverse effects of age on the quality of scientific contributions (Yu et al., 2022). Hence, easing seniority rules in project management by increasing the cap on the annual amount of project funding attributable to young researchers, independently from their affiliations with associate or full professors, may encourage more creative thinking.
Reviving the interest for scientific professions
Japan’s capacity to regain excellence in broad-based innovation will hinge on a highly skilled workforce, but the share of science, technology, engineering, or mathematics (STEM) graduates remains relatively low at 19% in 2021, compared to 24% OECD-wide. At 7%, the share of female STEM graduates is the lowest in the OECD. Moreover, the rate of advancement to doctoral programmes fell to less than 10% in 2021 from 17% in 2000 (Government of Japan, 2022b), which is potentially driven by stagnant wages and the perspective of slow career progression, amidst increasing non-standard employment contracts, with only 22% of university professors younger than 40 in 2021 (Figure 1.23, Panel A).
Figure 1.23. The age and gender diversity of university professors remains low
1. Unweighted average across countries with available data.
Source: OECD, Education at a Glance database.
Mirroring broader gender gaps within Japan’s socioeconomic context, discussed in Chapter 2, women’s participation in academia and STEM tertiary education programmes is relatively low, although increasing. The share of female university professors at 30% in 2021 was the lowest in the OECD (Panel B), while female students made up 17% and 20% of new enrolments in STEM tertiary education and doctoral programmes, respectively. The government has committed to launch a large-scale survey and factor analysis of the reasons behind gender-specific approaches to education and careers in natural sciences by 2023-24. The STEM pipeline can be strengthened by the promotion of mentoring to promote STEM vocations among female students in secondary and in early university years, which has proven successful when provided by female mentors (Wu et al., 2022), or events showcasing female STEM role models (Guenaga et al., 2022). Easing the burden of childcare for young couples and lone parents can also help in this context, as well as reducing employment and wage gender gaps of 11.7% and 22.1%, respectively (compared to the OECD averages of 10.2% and 11.9%) (Chapter 2).
Ongoing reforms to increase the attractiveness of research careers are welcome. The government plans to triple the number of doctoral students receiving a payment for living expenses (JPY 1.8 million per year) by 2025. Forthcoming regulations allowing universities to finance salary increases for some staff, e.g., research assistants, through external funds, could also help (Government of Japan, 2021; Cabinet Office, 2022). Bringing forward the implementation of some planned reforms, such as lowering the ratio of clerical-to-teaching work to less than 10% and changing the criteria for evaluating the performance of senior university managers to incentivise them to improve gender and age diversity of the academic staff, should be considered.
1.5.2. Strengthening resource allocation
Business dynamism is relatively modest in Japan, with low firm entry rates and growth of start-ups, reflecting the difficulties faced by more innovative start-ups in accessing finance and scaling up (OECD, 2021a). Traditionally bank-based, business financing still relies heavily on real estate collateral and personal guarantees, which are ill-suited for intangible-intensive new businesses. Moreover, effective resource allocation is constrained by generous – and weakly targeted – public support to SMEs, which prevents the exit of unproductive firms. Stronger incentives for equity financing, including venture capital and merger and acquisition deals, could ease these distortions and boost business dynamism.
Reforming public support to businesses
In FY2021, government-guaranteed loans accounted for about 14% of total outstanding loans to SMEs and 7.9% of GDP, up from 4% of GDP in 2018 (Figure 1.24). Loan coverage rates have been declining to 80% from 100%, but remain relatively high. Likewise, upstream Credit Guarantee Corporations, which cover the credit risk of private banks, avail of a rather generous credit insurance provided by the publicly-owned Japan Finance Corporation, with coverage rates of around 70-80%. Furthermore, public financial institutions provided direct loans to SMEs worth 5.2% of GDP (OECD, 2022b). While some European countries offered similar coverage rates on subsidised business loans during the pandemic (Albertazzi et al., 2020), others provided more targeted support, with France and Spain differentiating coverage rates based on firms’ turnover, applying lower basic rates to larger SMEs (Altavilla et al., 2021).
The type of generous public support to SMEs provided in Japan can lower resource reallocation and firm exit, delay restructuring, and reduce the entry and investment opportunities of more innovative firms. Furthermore, it tends to favour firms that have established relationships with credit institutions and reduces financial institutions’ risks and incentives to establish effective credit evaluation for SME lending, hindering the development of market-based financing (Jones, 2022). Hence, the government should further lower the coverage rates of government guaranteed loans to strengthen banks’ credit risk management.
Bank preferences for real estate collateral and personal guarantees weigh on business creation and firm growth, as any additional expansion-oriented financing requires the redefinition of collateral (Financial Council, 2023a). As recommended in the 2021 Economic Survey, exempting the family home from personal professional bankruptcies (like in many Canadian provinces and France) could help. Recent measures, such as Japan Patent Office’s guidelines on intellectual property business valuation in SME settings, have helped develop lending based on immaterial assets, and increase the share of private banks’ loans not associated with managers’ guarantees from 12% in FY2015 to 33% in FY2022 (METI, 2023a).
Figure 1.24. Government guarantees for SME loans have surged further with the pandemic
As a percentage of GDP¹
1. Government guarantees available to banks and other financial institutions.
2. As of the end of the fiscal year (March) for Japan.
Source: OECD Secretariat calculations based on OECD (2022), Financing SMEs and Entrepreneurs 2022: An OECD Scoreboard.
Government plans to reform the collateral system, which will improve financing conditions for start-ups with growth potential, are welcome. Allowing for new lending to be underpinned by a security interest established over the entirety of the business’ assets and its future receivables will remove the need for personal guarantees and collateral by reducing information asymmetries between lenders and borrowers (Financial Council, 2023a). A new credit guarantee system will also free start-ups younger than five years from the need to provide personal guarantees. The effectiveness of the scheme will depend on clearly defining collateralised assets to ensure legal stability and on ensuring that the scheme does not deteriorate the relative position of stakeholders, especially workers (Financial Council, 2023b). The government aims to submit new legislation to introduce the possibility – when negotiating a loan – to incorporate intangible assets into collateral, which is not foreseen under the current Civil Code. Rapid approval and enactment of the reform will be key to help domestic innovative start-ups fulfil their potential.
Improving conditions for innovation capital
Well-functioning venture capital (VC) markets are important drivers of innovation and productivity growth. VC eases information asymmetries involved in the valuation of intangibles, allows funding for radical innovations, and increases the probability of co-financing by institutional investors (Jeppson, 2018). In 2021, domestic VC firms accounted for one third of total investment in Japanese start-ups, whose value had sextupled since 2014 to reach an overall worth of JPY 1.1 trillion (METI, 2022b). Nevertheless, Japan’s VC market remains undersized (Figure 1.25) and is mostly concentrated in seed and early-stage investments. The Government Pension Investment Fund has recently started investing in private equity and venture capital funds, which can support start-up creation and development and provide an important boost to innovation funding, like in the United States.
The five-year plan for start-up development includes a wide array of measures, including substantive financial support, regulatory changes, and greater openness to foreign risk-capital investors (Cabinet Secretariat, 2022). Some prioritisation of the measures, frontloading those to attract innovative foreign investors, including by ensuring streamlined administrative and regulatory requirements, full mobility of skilled labour, enhanced information sharing and greater integration of domestic actors in global innovation networks and hubs, would support its effectiveness. Planned measures include the expansion of funding by JPY 120 billion to boost limited liability capital investment in domestic and foreign VC funds by 2027 and the strengthening of tax incentives and deductions for VC firms and individual business angels. Targeted tax measures should be appropriately designed and continuously monitored to ensure they are cost effective and do not create equity issues.
Figure 1.25. The venture capital market is undersized
As a percentage of GDP
Source: OECD Venture Capital Investments database.
Reliance on mergers and acquisitions (M&A), to overcome size-related barriers to growth, featured in less than 25% of Japan’s start-up exits in FY2020 (METI, 2022c), compared to 90% and 67% in the United States and the European Union, respectively. M&As provide start-ups, particularly VC-backed ones, with a flexible approach to quickly scale up through the acquisition of new products, technologies, or talent. Planned tax reforms, set to become effective in 2023-24, and allowing, under certain conditions, companies to deduct 25% of the value of an equity investment in a start-up from their corporate taxable income, and the easing of tax rules applied to business spin-offs, can strengthen large corporations’ incentives to invest in innovation. Reducing or removing limitations on the carry-forward of net operating losses in the case of corporate ownership changes could support these welcome reforms.
While regulatory barriers to foreign direct investment (FDI) are close to the OECD average (OECD, 2023c), Japan’s inward FDI stock as a share of GDP is very low in international perspective (OECD, 2023d). In April 2023, the government announced a new action plan to reach the target of increasing the inward FDI stock from JPY 46.2 trillion at the end of 2022 to JPY 100 trillion by 2030 (Council for Promotion of Foreign Direct Investment in Japan, 2023). The plan highlights the need for further efforts to lower barriers, such as easing procedures, providing multi-lingual support and improving the business environment. Reducing explicit restrictions, focusing on those affecting the service sector, would promote FDI inflows. Japan is also a minor player in cross-border M&As, which increasingly drive FDI, so activating the market for M&As, as recommended in the 2017 OECD Economic Survey, would help as well (Jones, 2022).
M&A deals generate benefits but should be monitored closely. First, they can enhance quality in management and organisational processes and enable fairer valuations of firms’ growth potential. Second, M&As can offer profitable firms led by older managers a wider range of alternatives to closing the business due to a lack of suitable successors. Despite subsidised loans, tax incentives, advisory and matching services, in 2022, 55% of the 49 600 business closures due to succession-related issues referred to profitable firms (TSR, 2023). Conversely, M&As can lower competition if used by large incumbent companies to ‘internalise’ innovations created by smaller competitors or new potential entrants (OECD, 2021a). The Japan Fair Trade Commission has stepped up its ability to identify anti-competitive mergers (Yagami et al., 2022), but the increased complexity of underlying trades warrants more flexible merger control frameworks. Having a stronger reliance on ex-post reviews and requiring dominant incumbents to prove that nascent acquisitions of start-ups do not have anticompetitive effects, in line with OECD recommendations (OECD, 2020c), would support competition enforcement and preserve consumer rights.
Boosting regulation and governmental digital transformation
A more competition-friendly regulatory framework would boost business dynamism and productivity growth. According to the OECD product market regulation indicators, licensing requirements are relatively low, thanks to an on-line one-stop shop and “silence is consent” rules, but the complexity of regulations, such as the high number of procedures involved in the registration of start-ups, can be reduced. Such reforms have the potential to boost GDP growth in the medium and long run (Box 1.7). The regulatory framework in the service and network sectors (except e-communications) is competition friendly and the regulatory environment for trade in services is the most open in the OECD. However, limitations on foreign entry and movement of people restrict legal and telecommunication services (OECD, 2022c). Relaxing the requirement for foreign service providers to be registered in Japan would help. There is also room to improve the regulatory framework for public procurement which does not guarantee a level playing field for all potential bidders.
Government use of digital technologies is lagging but progressing, as recommended in the 2021 Economic Survey, with a target of having 98% of administrative procedures online by 2025. Online medical consultations and drug administration guidance were enhanced during the COVID-19 pandemic. Technological development may create new framework conditions, which requires the adoption of new rules or the revision of existing ones. Hence, the ongoing review of the regulations on software medical devices, including AI diagnostic imaging, to ease their development and market launch, is welcome. Japan has also been promoting smart cities, which rarely go beyond feasibility studies, due to marketability and legal barriers. However, National Strategic Special Zones, designated regions in which exclusive regulatory and system reforms are implemented, can help, as can the ongoing “Super City Initiatives” in Osaka and Tsukuba since 2022 (Cabinet Office, 2023b). Complementary policies to prevent digital exclusion, due to Japan’s large cohorts of older people with limited or no digital literacy, are key.
Following a slow uptake since its introduction in 2016, the number of people with a My Number (national personal ID) card, which aims to facilitate the linking of data to the provision of public services, reached 72.7% of the population in October 2023, driven by the pandemic and the provision of more incentives by the government. Full uptake as soon as feasible should be aimed for. Following some recent cases of errors linked to the use of the cards, the government committed to a review of the system in June 2023. Ensuring data protection and privacy and improving user-friendliness, for example by simplifying the use of PIN numbers, will be key to build public trust in the wider use of the system. The application of the card as a health insurance card is being rolled out and the plans to further link it to the provision of public and private services should be prioritised. Using the My Number system to complete administrative procedures, track the income of the self-employed and ensure data sharing across different government levels, as recommended in the 2021 Economic Survey, and to improve the administrative efficiency of targeting subsidies to vulnerable households following shocks, would help better reap the benefits of digitalisation.
Box 1.7. Quantification of the impact of structural reforms
Table 1.8 presents the growth impact of some key structural reforms proposed in this Survey. These estimates are illustrative. The impact on GDP per capita is estimated using historical relationships between reforms and growth in OECD countries. The model does not capture policy-induced changes in deep-rooted preferences like risk aversion and their subsequent effects on economic variables.
Table 1.8. Potential impact of selected proposed reforms on per capita GDP
Note: Regulatory environment refers to improving Japan’s OECD product market regulation score by two decimal points from its current 1.4, to bring it within the range of the top third performers in the OECD. The assumed rise in R&D spending to support start-ups equals 0.8% of GDP. Active labour market spending per unemployed in per cent of GDP per capita (12% in 2019), is assumed to increase by 15 percentage points, bringing Japan closer to the median of OECD countries.
Source: OECD calculations based on Guillemette and Turner (2021).
Strengthening public integrity
Government integrity and transparency is key for public-sector efficiency and productivity growth, via safer investment environments. It also conditions trust in public institutions, which, according to recent survey data, is weaker than the OECD average, in particular for the national government and legislatures (OECD, 2022d). Overall, levels of perceived corruption are below the OECD average (Figure 1.26, Panels A-C). Similarly, Japan is largely compliant with OECD best practices with respect to exchange of information with tax authorities, as assessed by the Global Forum on Transparency and Exchange of Information for Tax Purposes. However, there is room to improve anti-money laundering regulation, via more effective preventive measures, supervision, investigation and prosecution proceedings (Panel D). Enhanced guidelines on the identification and quantification of foreign bribery’s proceeds for confiscation purposes could be of further help (OECD, 2021g).
Public service ethics laws are rather stringent, and several measures to strengthen the control of corruption have been adopted in recent years. However, some areas of public officials’ interaction with the corporate sector remain a potential source of collusive behaviour (OECD, 2021a). Japanese companies’ practice of hiring former, or freshly retired, senior government staff heightens the risk of bid-rigging incidents in public procurement (kansei dango) or of illicit lobbying activities. With respect to bid-rigging risks, the Japan Fair Trade Commission (JFTC) has been increasingly focusing its efforts on advocacy activities, to prompt companies to pre-emptively modify potentially illicit behaviours (Ae et al., 2023). Recent revisions to the leniency programme, ensuring applicant firms might avail of additional reductions in the administrative fines for bid-rigging, according to firms’ degree of cooperation with case investigations, have enhanced JFTC’s ability to enforce the law and deter its violations. Making use of algorithm-driven collusion-detection models in public procurement auctions might help improve enforcement of competition policies (García-Rodríguez et al., 2022). Moreover, extending the rules requiring external audits and greater transparency in dealings with bidding companies, adopted by METI for its own larger procurement transactions in 2020, to other spheres of central government would boost integrity in public procurement and public spending efficiency.
Figure 1.26. Levels of perceived corruption are relatively low
1. Panel B shows the point estimate and the margin of error; Panel C shows sector-based subcomponents of the “Control of Corruption” indicator by the Varieties of Democracy Project; Panel D shows ratings from the FATF peer reviews of each member to assess levels of implementation of the FATF Recommendations. The ratings reflect the extent to which a country's measures are effective against 11 immediate outcomes.
2. Refers to money laundering.
3. Refers to terrorist financing.
Source: Panel A: Transparency International; Panel B: World Bank, Worldwide Governance Indicators; Panel C: Varieties of Democracy Project, V-Dem Dataset v12; and Panel D: OECD, Financial Action Task Force (FATF).
Japan has no specific law or disclosure requirement for government interactions with interest groups, despite indirect regulation through the Act on Public Service Ethics. Requiring public officials to disclose information on their interaction with lobbyists through publicly available registries or open agendas, as in most OECD countries (OECD, 2021f), would support more inclusive policymaking. Similarly, centralising and consolidating reports on lawmakers’ political fund income and expenditures, currently submitted to the Ministry of Internal Affairs and prefectural election administration commissions (Noguchi, 2021), to make them available in electronic format and in a timely way, would be welcome.
Despite ongoing progress, the implementation of the OECD Anti-Bribery Convention remains incomplete. Increased efforts are needed to strengthen enforcement of foreign bribery cases, set up a proper framework enabling private sector legal, auditing, and accounting professionals to detect and report suspicious acts, and consider revisions of export credit agencies’ staff guidelines for recently established internal reporting procedures (OECD, 2021g). In June 2023, the Diet approved legislation to increase sanctions for foreign bribery to the highest level among Japan’s economic crimes, extend the statute of limitations and expand jurisdiction. The impact of these reforms will need to be assessed as they are implemented. Amendments to the 2004 Whistleblower Protection Act, which came into force in mid-2022, considerably enhanced insiders’ incentives to report criminal and administrative offences, but failed to introduce penalties for firms retaliating against whistleblowers (OECD, 2021g). Such penalties, combined with the adoption of specific reward programmes, may encourage disclosure activities, improving effective enforcement of anti-corruption policies.
Table 1.9. Past OECD recommendations on productivity and digitalisation and actions taken
1.6. Achieving net-zero emissions by 2050 will require major efforts
1.6.1. Emission reduction targets and plans
Japan has ambitious targets of reducing greenhouse gas emissions by 46% from 2013 levels by 2030 and achieving net-zero emissions by 2050. After peaking in 2013, emissions have been declining (Figure 1.2 above), driven by a decline in energy intensity and an increase in the share of renewables (Figure 1.27, Panels A-B). Energy remains the largest source of emissions, followed by manufacturing and transport (Panel C). The government aims to lower the share of total energy supply from fossil fuels from 84% in FY2022 to 67% in FY2030 (Panel D). In addition, the Green Growth Strategy noted an energy mix of 50-60% renewables, 30-40% nuclear and thermal with carbon capture utilisation and storage and 10% hydrogen and ammonia in 2050 as a reference point for discussion (METI, 2020b). However, an official breakdown for the energy mix in 2050 does not exist given high uncertainty, including for different technologies, and the possibility of multiple scenarios towards achieving 2050 targets (METI, 2021).
Figure 1.27. Bold reforms are needed to reach ambitious targets
Source: IEA (2021), IEA World Energy Statistics and Balances database; OECD, National Accounts database; Environment Database - Greenhouse gas emissions; and Ministry of Economy, Trade and Industry.
Japan’s renewed impetus towards reducing emissions, outlined in the recent Basic Plan for Green Transformation (GX) Policy (Government of Japan, 2023c; Box 1.8), by a mix of innovation, green investment, transition finance, regulations, international collaboration, and carbon pricing, is welcome. The government plans to raise JPY 20 trillion through GX Economy Transition Bonds to kick off private and public investment of around JPY 150 trillion over the next 10 years, and has outlined a breakdown of investment needs in different areas (Figure 1.28). The funds will likely be used for investment in existing technologies and those still in development. The 5-year and 10-year bonds (JPY around 800 billion each) are to be issued in February 2024 as “Japan Climate Transition Bonds”, with international third party certification. The complete redemption of the bonds is intended for 2050 and to be financed with revenues from the forthcoming carbon pricing measures.
While Japan has strong climate change coping capacity (INFORM, 2023), it is also highly exposed to climate change risk (IEA, 2021) as an island state located in a region with increasing typhoon intensity. About 40% of the population (and business facilities) are exposed to the risk of floods, which, for example, entailed damages worth JPY 2.1 trillion in 2019. Besides their impact on human lives, such natural disasters involve large economic costs that may weigh on the real economy, including on land prices and financial institutions, especially regional banks (Ashizawa, 2022). The National Adaptation Plan, launched in 2021 and formulated based on the climate-related risks identified in a five-yearly impact assessment report, outlines the planned government measures for disaster prevention and control across sectors (NIES, 2023). As of September 2023, all prefectures have formulated Local Climate Change Adaptation Plans based on the Climate Change Adaptation Act, and municipalities are also progressively formulating plans. 41 prefectures have completed the establishment of Local Climate Change Adaptation Centres (NIES, 2023). Ensuring information is efficiently shared among all policymaking levels is key to scale preventive adaptation action at the local level, while measures supporting the availability and take-up of insurance against natural hazards may also be considered. Integrating policies and measures for climate resilience into long-term energy and climate plans to make the energy sector more resilient to climate hazards should be continued.
Box 1.8. Basic Plan for Green Transformation Policy
The Basic Plan for Green Transformation (GX) Policy outlines a ten-year roadmap towards decarbonisation targets, based on four key areas, First, pro-growth carbon pricing will include upfront investment support via GX Economy Transition Bonds to expand non-fossil fuel energy sources and facilitate R&D in new and green technologies, a GX surcharge (on fossil fuel supply) and an emission trading scheme to be gradually phased in over the next ten years (see below). Second, regulatory support, such as expanding offshore wind power generation sites to exclusive economic zones, will stimulate private investment via long-term assistance and R&D support. Strengthening regulations, such as building efficiency standards, will help achieve the target of net-zero energy consumption for newly constructed buildings and houses by 2030 and all buildings and houses by 2050. Third, new financing methods to support companies will be promoted through international rule making and investment support for transition technologies, such as ammonia. Fourth, Japan will focus on supporting global and regional decarbonisation plans. For example, Asia Zero Emissions Community, a cooperation platform to help partner countries in Asia achieve energy transition through policy coordination and integrated support on technology, finance and human resources, was formed. Furthermore, the Joint Crediting Mechanism, a bilateral offset crediting mechanism to incentivise leading decarbonising technologies in partner countries, will be extended.
Figure 1.28. Investment needs towards decarbonisation are large
Source: METI (2023b), Realising and Implementing Pro-Growth Carbon Pricing Initiative Related to the Draft of Basic Policy for Realising GX.
1.6.2. Moving away from fossil fuels
Forthcoming measures to restart as many existing nuclear reactors as possible, prolong those still in operation beyond the current 60-year limit, with regular reviews by the regulator, and construct "next-generation” reactors, can boost the share of nuclear power in electricity supply. Of Japan’s 33 operational reactors, 10 have restarted and 7 had passed the Nuclear Regulation Authority review as of May 2023. The recovery of Japan’s nuclear plants requires an independent technical review by the regulator to satisfy enhanced safety standards, and work with local communities to regain social acceptance. Since the Fukushima Daiichi Plant accident in 2011, safety standards have been tightened, and according to a February 2023 Asahi Shimbun poll, 51% of the population support restarting reactors, the highest share in a decade, partly reflecting the energy price crisis. Nevertheless, relatively long inspection and restart times create uncertainties.
Hydrogen, ammonia, and carbon capture, utilisation, and storage (CCUS) are expected to play a key role in meeting net-zero emissions by 2050. The government has revised its Hydrogen Strategy and is working to introduce co-firing of ammonia in coal-fired plants to reduce CO2 emissions during combustion. Increasing power generation by hydrogen and ammonia will depend on reducing production, transport and storage costs, and R&D outcomes in this area. Japan should also continue to lead efforts to develop international supply chains for hydrogen and ammonia, which remain limited, and promote international knowledge sharing. Given the high share of public R&D on these technologies, conducting systematic evaluations to make timely adjustments will be key.
Plans to reach the 2030 target of reducing the share of coal-fired power in the energy mix to 19% include efficiency improvements, the phase-out of inefficient coal-fired power plants, and the development of “CCUS-ready” coal plants and co-firing of ammonia in coal-fired plants. However, reconciling continued reliance on coal and the commitment to achieve net-zero emissions by 2050 will be challenging. Given the high average lifespan of 40 years of coal plants, a clear plan to phase out inefficient coal-fired power plants is key to avoid the risk of “stranded assets”, while expanding alternative power generation capacity, such as nuclear power and renewable energy, in order to promote energy security and economic efficiency. Japan plans to build “CCUS-ready” coal and gas plants, but uncertainty about the scope for scaling up carbon capture, utilisation, and storage in a cost-effective manner remains high. Hence, major investment in new coal-fired capacity should be contingent on progress in developing new decarbonisation technologies and cost-benefit analysis.
High carbon content of energy used (e.g., coal) also leads to high emissions in the residential sector, despite comparatively low energy consumption per capita (Hoeller et al., 2023). Japan is among the 16 OECD countries with explicit climate targets and commitments for the building sector, with an aim to promote zero-energy buildings and houses (buildings or houses with zero net primary energy consumption annually) for newly constructed buildings by 2030 and in the average of all building stocks by 2050 (MLIT, 2022). The plans to streamline building standards and the revised Building Energy Conservation Act, which entered into force in June 2022, mandating all new buildings from 2025 to comply with energy efficiency standards, are welcome. The ongoing efforts to help decarbonise existing buildings, such as financial support for renovations to improve energy efficiency and the promotion of the use of renewable energy in buildings, should be continued.
Expanding the use of renewables can help meet climate goals, increase energy security and improve affordability. Japan has a high potential for power generation from offshore wind and tidal power (world’s sixth-longest coastline and widest exclusive economic zone), and geothermal resources (third-largest and equivalent to 10 nuclear power plants). However, their share in electricity supply and targets remains modest, and the deployment of renewables could be accelerated. The installation costs of renewables are relatively high in Japan because of the limited availability of cheap land, high labour costs and special safety requirements for equipment against natural disasters. However, there is potential for reducing costs, especially through increased competition (IEA, 2021). Improving social acceptance (e.g. for offshore wind) and complementary investment in network infrastructure coupled with demand-side management and targeted R&D support will also be key.
Across the OECD, R&D funding, streamlined planning processes, and subsidies have contributed to significant reductions in the costs of renewables and increases in private investment in clean energy technologies. For example, government policies have contributed to development of offshore wind energy in Denmark and the United Kingdom (Box 1.9). Given the scale of investment needed, an efficient permits and licensing system should complement existing measures, such as technology support to innovation and subsidies. Hence, measures, such as the increase in seabed lease duration from 2-3 years to 30 years for offshore projects in 2019, should be continued.
Uncertainty in some emission reduction pathways due to technologies that are not yet cost effective, or may face lack of public acceptance, requires contingency planning. Given changing technologies, regularly assessing whether existing strategies, policies and instruments need to be revised, and mapping out energy scenarios and roadmaps considering different futures for the development of energy sources is key.
The ongoing efforts to boost the contribution of renewables to electricity supply are partly constrained by limited integration of regional electricity grids. The fragmentation of the electricity network into regional grids, with two different frequencies and limited interconnector capacity, constrains the transmission and distribution network (OECD, 2021a; IEA, 2021). A renewable feed-in-premium was introduced in April 2022. By paying generators a subsidy based on the wholesale market price, plus a marginal rate, the feed-in-premium links the revenue the generator receives with the market price and provides more incentives to increase supply during peak demand hours. The government is also reforming its battery energy storage system regulations to lower grid constraints. The Organisation for Cross-regional Coordination of Transmission Operators recently revised a long-term plan for wide interconnected systems by FY2050, with investment estimated at around JPY 7 trillion (OCCTO, 2023). Three regional interconnectors are set to start operation in FY2027, as recommended in the 2021 Economic Survey.
There is room to improve competition in electricity markets. In 2020, the legal unbundling of transmission and distribution segments from generation and retail segments of ten vertically integrated electricity companies was completed. However, recent cases of customer data mismanagement, i.e., sharing of customer information by transmission and distribution companies with retail ones, have raised competition concerns (The Mainichi, 2023). Low penalties for non-compliance could be a factor. The Electricity and Gas Market Surveillance Commission (EGC), created in 2015 for monitoring competition, can investigate and make recommendations, but has no formal power to regulate markets (IEA, 2021). Increasing EGC’s powers in ensuring incumbents’ compliance with laws and regulations, for example by enabling it to decide on enforcement actions rather than make recommendations to the minister, would boost competition and investment.
Box 1.9. Offshore wind energy in the United Kingdom
The United Kingdom is the largest offshore wind energy market in the OECD, with a total commissioned capacity currently close to 14 gigawatts (GW), following average annual capacity additions of 1.2 GW since 2015. Hornsea 2, the world’s largest offshore windfarm (1.3 GW), located 89 km off the Yorkshire Coast, became operational in August 2022 and will provide low-cost energy to 1.4 million homes.
Public policies have played a key role in the development of the United Kingdom’s offshore wind industry. The government’s move to protect renewable generation investors from volatility in wholesale electricity prices via long-term private law contracts reduced uncertainty. Furthermore, an offshore wind acceleration task force was established to streamline planning and permitting processes, while the frequency of seabed leasing rounds was gradually increased. Offshore wind projects are also set to benefit from the economy-wide generous capital allowances introduced in Budget 2023 to support investment in plants and machinery and plans to reduce the approval time for new offshore wind farms from four years to one.
Source: IEA (2023), Renewable Energy Market Update, June; UK Department for Business and Trade (2023), Offshore Wind; and Ørsted.
Electric and fuel cell vehicles could make a key contribution to emission reductions for transport. Reaching the 2035 target of 100% for the sale of new “electrified passenger vehicles”, which includes non-plug-in, plug-in hybrid and hydrogen-based vehicles, requires further investment, improved regulations and sufficient electricity supply and smart grids. Investigating the extent of the effect of the increased share of EVs on electricity demand and grid integration, careful planning of electricity infrastructure, peak load management, and smart charging will be critical. The number of EVs per charging station increased from 6.3 in 2016 to 13.9 in 2022 (the OECD average being 20). The 2030 target of 150 000 charging stations, including 30 000 fast chargers, is welcome in light of the government’s ambition to strongly increase the sale of EVs. Evidence from Norway suggests that public investment in charging stations in large cities and major highways can trigger private investment in such infrastructure (D’Arcangelo et al., 2022). Reducing private car ownership and boosting alternative modes of transport via street redesign, spatial planning that is focused on increasing proximity, and support for shared mobility, can also help decarbonisation of the transport sector (OECD, 2022e).
Japan has been a pioneer in electric, hybrid and hydrogen-based cars using fuel cells, but full EVs represented only 2% of new passenger car sales in FY2022, despite support through subsidies and tax incentives. The rising global demand for full EVs and regulations in Japan’s export markets, which exclude hybrids from zero emission vehicles, can create risks for the automobile industry, which has concentrated on hybrids until recently. In addition, production capacity for hydrogen-powered vehicles remains small. It will be important to monitor international developments and periodically assess government support policies for different technologies and their contributions to emission reductions to guide investment towards the most cost-efficient technologies in this field.
1.6.3. Implementing planned carbon pricing measures effectively
Countries have a wide range of policy mixes to reach their net zero emissions. Carbon pricing in Japan has been limited so far, with a tax on fossil fuels introduced in 2012 and voluntary cap-and-trade emissions trading systems (ETS) in Tokyo Metropolitan City and Saitama Prefectures (ICAP, 2022a and 2022b), which are relatively limited in scope. However, the gradual introduction of an ETS in three phases from FY2023 and of a GX surcharge (on fossil fuel supply) from FY2028, is planned to complement increases in infrastructure investment and improved regulations.
While the introduction of an ETS, as recommended in past Economic Surveys, is welcome, the long phase-in period will limit its contribution to meet 2030 targets and should be reconsidered. The first phase of Japan’s ETS (a voluntary baseline-and-credit system) started in April 2023 through the GX League, an initiative launched in 2022 to facilitate public-private-academia cooperation towards decarbonisation (METI, 2023c). Each firm in the League will set its own GHG emissions targets, disclose its efforts and investments and implement voluntary emissions trading. As of July 2023, 564 firms, from various industries, such as manufacturing, finance and ICT, accounting for around 40% of total emissions (including electricity supply to households), are participating. From FY2026, participation and compliance will shift towards a mandatory system, which will include targets based on government guidelines and approval by private third parties and a stronger regulatory system, but details are not yet known. From FY2033, a transition from a benchmark-based free allocation to auctioning of CO2 emissions in the power generation sector is planned. Annual performance assessments of the first phase should be conducted to adjust the system at an early stage, if needed, and clarify the design of the next phases.
Policy certainty is crucial to incentivising green investment and behavioural change (Berestycki et al., 2022). The lack of caps on emissions, voluntary participation and goal setting as well as free allocation of emission allowances by the government makes the first phase different from traditional schemes and does not generate revenues. Hence, it will be important to follow through with the transition to the second phase of mandatory compliance and allocation of emission allowances by the regulator, based on firms’ historic emissions or capacity. The necessary legislative measures for the implementation of the second phase of the ETS are set to be introduced within two years. This should include the announcement of which emission-intensive industries will be required to participate well in advance of their phase-in dates. Introducing a minimum allowance price, as in California, could also be useful. Hence, it is welcome that the authorities plan to review the case for the introduction of minimum and maximum prices.
While free allocation might help safeguard competitiveness and prevent carbon leakage initially, gradually winding it down in favour of auctioning can help correct potential market distributional distortions, such as penalising new entrants, generate revenue and increase the mitigation effectiveness of ETS. Free allocation of permits drives a wedge between marginal and average carbon prices, similar to tax allowances (OECD, 2021h; IEA, 2020). Hence, the plans for introducing auctions from 2033 should be followed through. International experience, such as in the European Union and British Columbia, suggests that well-designed ETS do not adversely affect employment and firm profits (OECD, 2021i; Yamazaki, 2017). For example, recycling of revenues to particularly impacted firms can help smooth the transition.
There is considerable room to improve carbon pricing (Figure 1.29, Panel A). The current tax, at JPY 289 (USD 1.78) per tonne CO2, is one of the lowest in the OECD. The effective CO2 price is particularly low in industry and power generation (Panel B). The plan to introduce a GX surcharge (on fossil fuel supply) from FY2028 is welcome, but the scope and coverage of the surcharge are yet to be decided. The late phase-in and likely low initial level may limit its contribution to meet 2030 targets and should be reconsidered. The level and scope of the surcharge should provide sufficient incentives and equalise marginal costs. Japan’s specific features, such as a large industrial base and high end-user prices for electricity and natural gas, can increase the impact of higher carbon prices on households and firms. A significant percentage of financially weaker firms in high-emission sectors and those in downstream industries could be adversely impacted (IMF, 2023b; Makoto, 2021). Hence, measures to prepare high-emission sectors through clear signals and transition finance support could help.
Figure 1.29. Carbon pricing is underutilised
Source: OECD (2022), Pricing Greenhouse Gas Emissions: Turning Climate Targets into Climate Action, Paris.
Japan should also use revenues from carbon prices to mitigate the impact on low-income households, which can help boost public acceptance. According to a recent OECD survey of more than 1900 representative respondents across Japan, 89% agree that climate change is an important problem and 85% that Japan should take measures to fight climate change (Dechezleprêtre et al., 2022). Policies that are perceived to be more effective and progressive, such as subsidies for low-carbon technologies and regulations including insulation of buildings, receive more support. The use of revenues matters substantially for policy support for carbon taxes. Public support for carbon pricing at USD45/tCO2 is higher when the revenues are used to fund green infrastructure and clean-technology adoption, lower income taxes or fund cash transfers to the poorest households. In contrast, taxes on fossil fuels without earmarking of revenues are among the least popular policies (Figure 1.30). Information campaigns explaining the effectiveness and distributional effects of climate policies can significantly increase support.
Figure 1.30. Public support for climate change policies varies across measures and countries
Source: Dechezleprêtre, A. et al. (2022), “Fighting climate change: International attitudes toward climate policies”, OECD Economics Department Working Paper, No. 1714.
Table 1.10. Past OECD recommendations on environmental policy and actions taken
Recommendations on macroeconomic and structural policies
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