The economic expansion, the longest in Japan’s post-war history, continued through 2007, although at a slower pace of around 2%. This protracted upturn has reversed a decade of economic stagnation that reduced Japan’s rank in per capita income from the fifth highest in the OECD area in 1992 to nineteenth in 2002. Business investment and exports have been the main drivers of growth, accounting for about three-quarters of increased output since 2002. Corporate restructuring to reduce excessive levels of debt, production capacity and employment laid the foundation for a rebound in business investment, while buoyant export growth boosted corporate profitability and demand for additional capacity. Closer trade links with Asia, which now accounts for one-half of Japanese exports, have sustained export growth during this expansion. In 2007, exports expanded almost 9% despite weak demand from the United States. With exports growing strongly and corporate profits at record levels, the expansion is projected to continue through 2009, with growth rates of between 1½ and 2%.

The economic expansion, the longest in Japan’s post-war history, remains on track, though at a slower pace. The upturn is driven by business investment and exports, while other components of demand remain sluggish. Although growth is projected to continue at a 1½ to 2% rate through 2009, Japan must address a number of problems to sustain the expansion over the medium term. This chapter identifies five key challenges: i) ensuring a definitive end to deflation under the new monetary policy framework; ii) achieving progress in fiscal consolidation in the context of high public debt and rapid population ageing; iii) implementing a comprehensive tax reform to increase government revenue, while promoting economic growth, addressing rising income inequality and improving the local government tax system; iv) enhancing productivity growth in the service sector; and v) reforming the labour market to reverse rising dualism and boosting labour force participation to offset demographic trends.

With the end of quantitative easing in 2006, the Bank of Japan introduced a new monetary policy framework that includes an understanding of price stability as 0 to 2% inflation and raised interest rates from zero to 0.5%, although most measures of inflation have remained negative. Given remaining deflationary pressures, slower economic growth in 2007 and increased uncertainty about the outlook for growth, the central bank should not raise the short-term policy rate further until inflation is firmly positive and the risk of renewed deflation becomes negligible. In addition, the lower end of the inflation range should be increased to provide an adequate buffer against deflation.

With gross debt of 180% of GDP, further measures to reduce the large budget deficit are increasingly urgent. An improvement in the budget balance of between 4% and 5% of GDP (on a primary budget basis) is needed just to stabilise the government debt to GDP ratio, a first step towards the government’s goal of lowering the ratio in the 2010s. The first priority is to further cut government spending, which has fallen by 2½ percentage points as a share of GDP during the past five years, focusing on public investment and the government wage bill. Expenditure reductions should be accompanied by reforms to improve efficiency in the public sector. In addition, policies to limit the increase in social spending, in the context of rapid population ageing, are essential for fiscal consolidation. However, expenditure cuts alone are insufficient to achieve Japan’s fiscal objectives, making it necessary to raise additional revenue.

Tax reform is an urgent priority, as Japan needs as much as 5% to 6% of GDP of additional government revenue just to stabilise public debt, which has risen to 180% of GDP. In addition to raising revenue, tax reform should promote economic growth, address the deterioration in income distribution and improve the local tax system. Additional revenue should be obtained primarily by increasing the consumption tax rate, currently the lowest in the OECD area, while broadening the personal and corporate income tax bases. The corporate tax rate, now the highest in the OECD area, should be cut to promote growth, while eliminating aspects of the tax system which discourage labour supply and distort the allocation of capital. Japan should also consider introducing an Earned Income Tax Credit to promote equity. The local tax system should be simplified, increasing reliance on existing taxes on property, income and consumption.

Labour productivity growth in the service sector, which accounts for 70% of Japan’s economic output and employment, has slowed markedly in recent years in contrast to manufacturing. The disappointing performance is associated with weak competition in the service sector resulting from strict product market regulation and the low level of import penetration and inflows of foreign direct investment (FDI). Reversing the deceleration in productivity growth in the service sector is essential to raise Japan’s growth potential. The key is to eliminate entry barriers, accelerate regulatory reform, upgrade competition policy and reduce barriers to trade and inflows of FDI. Special attention should be given to factors limiting productivity growth in services characterised by either low productivity or high growth potential, such as retail, transport, energy and business services. Finally, it is essential to increase competition in public services, such as health and education, where market forces have been weak

The proportion of non-regular workers has risen to one-third of total employment. While non-regular employment provides flexibility and cost reductions for firms, it also creates equity and efficiency concerns. A comprehensive approach that includes relaxing the high degree of employment protection for regular workers and expanding the coverage of non-regular workers by the social security system would help to reverse dualism. Given that non-regular workers receive less firm-based training, it is necessary to expand training outside of firms to support Japan’s growth potential, while enhancing the employment prospects of non-regular workers. Reversing the upward trend in non-regular employment may also encourage greater female labour force participation, which is essential given rapid population ageing that is already reducing Japan’s working-age population by almost 1% each year. Expanding childcare facilities and paying more attention to work-life balance would also boost female employment, while also raising Japan’s exceptionally low birth rate.