Volume 1, no. 4, September 2013
Author: Masayuki Morikawa, RIETI
Political stability and economic growth
In the House of Councillors election on July 21, the ruling coalition of the Liberal Democratic Party (LDP) and New Komeito won 76 seats, securing the majority in the upper chamber of the Diet. This put an end to the divided Diet for the first time in the three years since the previous House of Councillors election in 2010. Positive appreciation of ‘Abenomics’, a set of economic policies of Prime Minister Shinzo Abe’s government, as well as an expectation of political stability are thought to be reflected in the election outcome. What is particularly important is that the ruling coalition’s dominance in both chambers is likely to continue for the next three years.
“The economic impact of political stability is quantitatively massive, far exceeding those of major growth policies such as trade liberalisation and corporate income tax cuts.”
When the two chambers of the parliament are controlled by different parties or when the opposition controls the legislature under the presidential system, decision making on important policies is bound to be stalled or postponed, whether it is in Japan, the United States, or any European country. As I have written elsewhere, a series of empirical studies have shown that political instability and frequent change of government have a negative impact on the national economy. According to these studies, the economic impact of political stability is quantitatively massive, far exceeding those of major growth policies such as trade liberalisation and corporate income tax cuts. This means there is a good possibility that the outcome of the House of Councillors election per se will serve as a significant driver of economic expansion and growth.
However, many hurdles remain. In addition to ensuring the successful implementation of the “three arrows” of Abenomics (bold monetary easing; flexible fiscal spending; and a growth strategy), the government is faced with difficult policy decisions on a range of issues on which there are conflicts of interest among the Japanese people. In particular, it must lay out a clear path toward fiscal sustainability which includes a final decision regarding whether or not to go ahead with the planned consumption tax hike, reform the social security system and clarify its stance on the negotiation of the Trans-Pacific Partnership (TPP) and other economic partnership agreements (EPAs). Will the end to the divided Diet dispel the uncertainty over the future course of government economic policies and regulations? The answer to this question is a key determinant of the success or failure of the government’s efforts to motivate companies to take positive action.
Policy uncertainty and corporate behaviour
Various research attempts have been made to examine the economic impact of uncertainty (e.g., Bloom 2009, Carrière-Swallow and Céspedes 2013). In particular, it has been found that in addition to the macroeconomic environment, policy uncertainty has a substantial negative impact on the real economy such as the gross domestic product (GDP), equipment investment, and employment (Baker et al. 2013).
“In other words, even where the government has chosen the right policy, it would not lead to actual long-term business investment if corporate managers believe that it may be changed in a year or two.”
Uncertainty about future economic policy and regulations prompts households to increase precautionary savings and affects their behaviour in terms of participation in the labour force, investment in education, decisions about having children, and so forth. For instance, it has often been pointed out that anxiety about the future of the social security system may discourage consumption. The degree of certainty about the future course of economic policy also has a significant influence on corporate management decisions with respect to medium-to long-term investment in equipment, research and development, business expansion overseas, human capital, and so forth. For instance, a country’s corporate taxation and monetary policy (i.e., interest rates) affect the cost of capital, a key element in determining the profitability of investment. Labour market regulations—such as those for employment protection, agency workers, and workers hired on fixed-term contracts—affect the cost of employment. The social security system, which involves costs to companies in the form of employers’ contributions, has a similar impact. Meanwhile, the government’s policy for the TPP and other trade issues results in changes in the costs of international trade and direct investment, thereby affecting corporate decisions regarding business expansion in the global market. Since such investment is irreversible in nature and involves substantial adjustment costs, a wait-and-see strategy could be a rational choice for companies if the future course of policy is uncertain. Therefore, greater uncertainty about the future has a detrimental effect on investment and employment.
In other words, even where the government has chosen the right policy, it would not lead to actual long-term business investment if corporate managers believe that it may be changed in a year or two. In order to have a positive impact on the real economy, it is important to ensure that political stability leads to the sustainability of individual government policies and regulations without being limited to the stability of the political power per se.
Problematic types of policy uncertainty from the viewpoint of business
Photo credit: Image by hi-tlz on Flickr
However, most studies conducted to date primarily analyse the impact of macroeconomic uncertainty, and research delving into individual government policies and regulations has been scarce. In response to this gap in the research, we conducted an original survey of publicly listed Japanese companies to find out which specific policies have created uncertainty , the impact such uncertainty has on management decisions, the types of management decisions that are strongly affected by uncertainty and so forth. In what follows, I would like to outline the key points of our findings.
First, we asked respondents to indicate the degree of uncertainty they feel about the future course of various types of government policies and regulations—such as tax policy, social security system, labour market regulations, corporate law and regulations, and international trade policy—by selecting from the following three options: ‘high degree of uncertainty’, ‘moderate degree of uncertainty’, and ‘no significant degree of uncertainty’. The results show that international trade policy poses the greatest uncertainty to Japanese companies, followed sequentially by the social security system, environmental regulations, tax policy, and labour market regulations.
We found that uncertainty about tax policy has the greatest impact on corporate management decisions with nearly half of the respondents indicating that their management decisions are ‘significantly affected’ by it.
Second, we asked to what extent their management decisions are affected by such uncertainty. For each type of government policy and regulation, respondents were asked to select from the following three options: ‘significantly affected’, ‘somewhat affected’ and ‘hardly affected’. As a result, we found that uncertainty about tax policy has the greatest impact on corporate management decisions with nearly half of the respondents indicating that their management decisions are ‘significantly affected’ by it. International trade policy and environmental regulations followed with the ratio of those ‘significantly affected’ by their uncertainty at around 30%, and subsequently labour market regulations, corporate law and regulations, and social security system at around 20%. Meanwhile, a comparison between manufacturers and non-manufacturers shows that the percentage of those significantly affected by uncertainty about international trade policy and environmental regulations is substantially higher in the former whereas the percentage of those significantly affected by uncertainty about land use and zoning restrictions as well as consumer protection law and regulations is conspicuously higher in the latter.
Uncertainty could affect corporate behaviour in a broad range of activities including equipment investment, innovation, mergers and acquisitions, and the hiring of new employees. Thus, we asked what type of management decisions are significantly affected by policy uncertainty. Cited by roughly two-thirds of the respondents, equipment investment is found to be most affected by uncertainty, followed by decisions regarding entry into or withdrawal from overseas markets cited by nearly half of the respondents, and then decisions on the hiring of permanent full-time employees and those on organizational restructuring. These findings suggest that the predictability of government economic policies and regulations is a critical factor in making long-term investment decisions.
The government has pledged to push forward tax incentives to encourage private-sector investment in equipment. Our findings reflect the expectations pinned on such supportive tax policies in activating forward-looking business investment and boosting the growth potential of the Japanese economy. At the same time, they also suggest that improving the predictability of cross-industry policies and regulations—i.e., international trade policy, social security system, labour market regulations—would significantly help revitalise the economy.
This article has focused on the impact of uncertainty on corporate behaviour. However, a greater predictability of the future would have just as much positive impact on household behaviour. Japan is being faced with an array of policy issues that require difficult political decisions amid conflicting interests, including inter alia fiscal consolidation and social security reform. Against this difficult backdrop, it is hoped that greater political stability will lead to the improved performance of the Japanese economy, putting an end to prolonged stagnation.
This is a revised version of the article Seiji no antei to kigyōkōdō – nejire kaishō no keizai kōka originally published on the Research Institute of Economics, Trade and Industry (RIETI) website.
Baker, Scott R., Nicholas Bloom, and Steven J. Davis (2013), “Measuring Economic Policy Uncertainty,” unpublished manuscript.
Bloom, Nicholas (2009), “The Impact of Uncertainty Shocks,” Econometrica, Vol. 77, No. 3, pp. 623-685.
Carrière-Swallow, Yan and Luis Felipe Céspedes (2013), “The Impact of Uncertainty Shocks in Emerging Economies,” Journal of International Economics, Vol. 90, No. 2, pp. 316-325.
Morikawa, Masayuki (2013), “Policy Uncertainty and Business,” RIETI Discussion Paper, 13-J-043. (in Japanese).
About the author
Masayuki Morikawa is the Vice Chairman and Vice President of the Research Institute of Economics, Trade and Industry (RIETI), which is a collaborating institution of the AJRC. In 1999 he was posted to Australia as Counsellor (Economic) at the Embassy of Japan and after returning to Japan has worked at the Ministry of Economics, Trade and Industry including as Deputy Director-General in 2008.