Ensuring a definitive end to deflation. After raising the policy interest rate twice under the new monetary policy framework introduced in 2006, the Bank of Japan has appropriately left the rate unchanged since early 2007. Further hikes would not be warranted until inflation is firmly positive and the risk of renewed deflation is negligible, hence avoiding the risk of derailing the expansion. Given the need for an adequate buffer against deflation, the Bank’s Policy Board should raise the lower bound of its understanding of price stability, which is now set at zero.
Achieving progress in fiscal consolidation. Japan has reduced its fiscal deficit from 8.2% of GDP in 2002 to around 4% in 2007 (excluding one-off factors). But government debt has continued to rise, reaching around 180% of GDP in 2007. It is essential to achieve the target of a primary surplus for central and local governments combined by FY 2011 as a first step towards reducing the government debt ratio in the 2010s. While the first priority is to further cut spending, measures to raise revenue are also needed.
Implementing a comprehensive tax reform. Tax reform should aim at promoting growth, addressing the widening of income inequality and improving the local tax system, in addition to raising additional revenue. Meeting these goals will require wide-ranging reforms, including an increase in the consumption tax rate and the broadening of the direct tax bases. With only a third of firms paying taxes and more than half of wage income exempted from taxes, there is significant scope for base broadening. Base broadening would facilitate a cut in the corporate tax rate to promote economic growth. Aspects of the tax system that discourage labour force participation and distort the allocation of capital should be removed, thereby accelerating growth. An Earned Income Tax Credit could be introduced to improve income distribution. The complicated local tax system should be simplified.
Enhancing the productivity of the service sector. Labour productivity in Japan is 30% below the US level. Closing this gap largely depends on reversing the significant slowdown in productivity growth in the service sector in recent years. This requires a comprehensive strategy aimed at promoting competition by accelerating regulatory reform, strengthening competition policy and increasing international openness to trade and inflows of foreign direct investment. The special zone initiative should also be revitalised with more focus on nationwide regulatory reform. It is also essential to address regulatory problems in key service industries, such as the retail sector, energy, transport and business services.
Tackling growing dualism in the labour market while promoting higher labour force participation. The share of non-regular workers has reached about a third of employees, raising serious equity and efficiency concerns. Increasing dualism is creating a large segment of the population with lower wages, short-term job experience and limited opportunities to enhance their human capital. A broad strategy is required, including enhancing employment flexibility for regular workers and expanding social security coverage and training programmes for non-regular workers. Encouraging female labour participation is essential in the face of a rapidly ageing population.
