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The "Appropriate Level" for the Labor Share and a New Method for the Allocation of Added Value
— Issues to be considered in the 2007 shunto wage negotiations if Japan is to achieve sustainable growth —

January 31, 2007

Summary

The labor share, which rose sharply during the 1990s, has been falling and, in recent years, has fallen to its "appropriate level" or even lower. The labor share has been following a downward trendas global competition has intensified, but as the shunto wage negotiations have become little more than a formality, it has become still more prone to fall below the trend line.

With the gap in business performance between enterprises widening, the arguments for raising the labor share by means of a uniform wage increase lack force. On the other hand, an excessively low labor share is a problem in that it increases the risk of over-investment or, worse still, may cause a fall in the "quality of labor" as a result of reduced incentive to develop labor skills and reduced spending on training.

Japan needs to develop a new approach to the allocation of added value based on three key elements — the creation of new and more flexible "performance-related" wage systems that take account of the "Human Resourse developing " role of wages, the fair and equal treatment between regular and non-regular employees, and the establishment of labor markets and market rates of pay for different occupations — and take steps to optimize and stabilize the labor share.

Overview

Although the Japanese economy is enjoying its longest growth phase since the Second World War, the benefits of the strong business performance of the corporate sector have been slow to filter through to the household sector. One reason for this problem is the "decline of the labor share", and with the 2007 shunto wage negotiations approaching, the method by which added value is allocated has become a bone of contention.

Although the labor share rose sharply after the collapse of the bubble economy, it has been falling since the beginning of the 2000s. From fiscal 2001 into fiscal 2003, enterprises adopted a tougher approach to the reduction of personnel costs, and because personnel costs were cut faster than the rate of decline in added value, the labor share has fallen, in recent years, to its "appropriate level" or even lower.

An examination of the reasons for which the labor share has declined since the beginning of the 2000s reveals that personnel costs are exerting downward pressure on the labor share to an unprecedented degree. In particular, the fact that personnel costs were cut so sharply in fiscal 2002 and 2003 resulted in a fall in the labor ratio in spite of the lack of any significant recovery in added value. The main reason for the sharp fall in personnel costs was the substantial cuts in wages, and the tendency to curb wages continued in fiscal 2004 and thereafter.

One of the main factors for the lack of growth in wages is the intensification of competition at the global level, and this is why the labor share was set to decline in the medium term in the first place. However, the fact that the shunto wage negotiations, which helped to raise the level of wages to an appropriate level during the 1970s and 1980s have become little more than a formality, has made the labor share even more prone to fall below the trend line.

From the early 1990s onwards, the rise in the ratio of "non-regular employees" lent momentum to the hollowing-out of the shunto wage negotiations. During the first half of the decade, enterprises implemented set annual pay rises and base wage increases but, in order to offset the rise in personnel costs, which exerted an upward pressure on the labor share, took steps to increase the ratio of non-regular staff they employed. Moreover, the response to calls for the unification of base wage increases having been postponed, and 2001 and 2002 actually saw the average scheduled wages of general workers fall on a macro basis. The reasons behind this fall include the discontinuation of set annual pay rises and the reduction in scale of wage increases, and some enterprises actually went so far as to cut wages, but the impact of moves to reduce the number of workers promoted to higher grades cannot be overlooked.

In fiscal 2004, the recovery in the rate of economic growth alleviated the pressure to cut wages and an increasing number of enterprises adopted an approach to the allocation of added value that involved keeping basic salaries at their current level and redistributing added value by means of bonuses. In this way, the weight of bonuses within the allocation of added value increased. This approach has been praised by some observers as enhancing the flexibility of wages, but it has also made the labor share more prone to a downward bias.

With business performance gaps between enterprises widening, the arguments for flat-rate pay rises across the board as a means of increasing the labor share lack force. On the other hand, an excessively low labor share is a problem in that it will lead to a rise in the volume of funds procured at zero cost proportional to the restriction of the labor share and may cause a decline in capital efficiency.

Excessive zeal in curbing personnel expenses can also lead to problems on the supply side, in terms of a fall in the "quality of labor". Restricting the size of pay rises or stopping them altogether undermines workers' morale for work and dampens their enthusiasm for developing their skills. Cutting spending on education and training also has a negative impact on the development of human resources.

Moreover, because enterprises have boosted the ratio of non-regular staff they employ in an effort to reduce personnel expenses, a large proportion of younger workers — those between the ages of 25 and 34 — are in non-regular employment. This is a serious problem, as it means that sufficient human resources are not being developed among the generations that will support Japan's society in the future.
In the United States, the labor share has been relatively stable as compared to Japan, but this has been achieved largely through employment adjustments. Moreover, wages have grown more flexible in recent years, and a virtuous circle of strong business performance and wage growth has formed, with enterprises rebuilding their business portfolios for greater flexibility by adjusting employment and differentiating remuneration with a view to securing talented human resources and motivating workers.

Now that the problem of excessive personnel expenses has largely been resolved, if Japan is to maintain its international competitiveness and at the same time optimize and stabilize its labor share so as to encourage workers to develop their skills, it must develop a new approach to the allocation of added value based on the following three key elements:

(i) Establishment of new mechanisms for the setting of wages
While the emphasis on bonuses in the allocation of added value should be maintained, the excessive emphasis on short-term results must be corrected.
Japan needs to establish new "performance-based" wage systems that take account of the "Human Resource developing" role of wages while allowing for flexibility. Specific measures should include the adjustment of wage tables and promotion rates to give workers a greater incentive to develop their skills, a substantial increase in incentives paid to high performers, and the rebuilding and strengthening of human resource development systems.

(ii) Fair and equal treatment between regular and non-regular employees
All employees, including non-regular staff, should be regarded as entities creating added value, and, in addition to providing opportunities for non-regular employees to develop their skills, Japan must move towards "equal pay for equal value of work".

(iii) Establishment of labor markets focused on occupation
Japan should establish mechanisms to ensure that the labor share is set at an appropriate level by establishing markets to help optimize the distribution of labor throughout the economy and establishing market rates for the remuneration based on occupations, which would create conditions that would have an impact on reviews of basic wages.

For more information on the content of this report, please contact Hisashi Yamada , the Japan Research Institute, Limited.

Tel: 03-3288-4245
E-mail:yamada.hisashi@jri.co.jp

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