Japanese Economy Update

By Jun Saito
Senior Research Fellow
Japan Center for Economic Research

Equity, Growth, and the Size of the Government:Trilemma facing Japan

(April 9, 2018)

In last December's column entitled "Widening of Inequality in Japan: Its Implications," I discussed the special features of the widening of inequality in Japan and the direction of policies that they suggest. In this month's column, I would like to develop the argument a little further.

Widening of Inequality in Japan

The main points of the discussion made in last December's column (see can be summarized as follows.

"Inequality in Japan is widening. However, compared to the United States and major European economies, the increase in share of the top one percent income earners is limited, and inequality in the working generation has not widened significantly.

The reason behind this seems to lie in the fact that technological changes and globalization (inward globalization, in particular) in Japan have not taken place as much as in other developed economies.

If that is the case, it implies that Japan has chosen to cap the widening of inequality by sacrificing the growth opportunities that technological changes and globalization may have provided.

In face of the aging and shrinking of the population that Japan faces and its need to grow, it seems inappropriate and impossible to maintain the current set of policies. In order to enhance the growth potential, technological change and globalization have to be pursued and accelerated. However, it raises the concern that inequality may widen in exchange.

In order to overcome such a trade-off, opportunities for accumulating human capital regardless of age through enhancing education and training need to provided, and institutional arrangements to match labor demand and supply need to be improved."

I would like to develop the above argument and shed new light on it from the point of view of a trilemma between equity, growth, and the size of the government.

Trilemma between equity, growth, and the size of the government

When I say a trilemma between equity, growth, and the size of the government, I have in mind the following relationship that emerges from the point of view of policy options (Figure 1):

Figure 1: Trilemma between Equity, Growth, and the Size of the Government

It shows that, when a national economy has three policy objectives, "egalitarian society," "globalization/innovation," and "small government," it is impossible to achieve all three, but has to choose two among the three and sacrifice the remaining one.

The idea of expressing the problem in terms of a trilemma comes from the "impossible trinity theorem" in international finance, and from the more recent discussion of a "political trilemma of the world economy" by Dani Rodrik (2011). Please note that if the national economy is not a democratic nation, it may be able to achieve all three, at least for a short period of time. I am assuming that we are talking about a democratic nation.

My discussion in December's column can be understood as a situation where Japan is pursuing an egalitarian society and a small government, thereby sacrificing globalization and innovation. The fact that Japan has been pursuing a small government can be confirmed by the small contribution made by redistribution polices in reducing Gini-coefficient, an important indicator of inequality, among the OECD countries (Figure 2).

Figure 2: Contribution of Redistribution Policies in Reducing Inequality
(OECD Countries, 2014)

In contrast, the United States seems to have chosen globalization/innovation and a small government, leaving equity to deteriorate (i.e. widening of inequality).

Policy choice of the Nordic countries

The Nordic countries, on the other hand, seem to have chosen "egalitarian society" and "globalization/innovation" and give up "small government." The Welfare State is what has been realized, as we all know.

Let us confirm the situation of the Nordic countries from the relevant aspects.

First, globalization of the Nordic countries can be seen in their relationship with the European Union (EU). Denmark, Finland and Sweden are members of the EU, and Finland is a member of the Euro Zone as well.

While Iceland and Norway are not members of the EU, they participate in European Economic Area (EEA) as members of European Free Trade Association (EFTA), and form a part of the single market. The two countries also participate in the Schengen acquis, removing border control for free movement of people between the EU countries.

Second, inequality in Nordic countries have not widened as much as in the other countries. Compared to the Gini-coefficients in other OECD countries, those of the Nordic countries are in the lowest group (Figure 3).

Figure 3: Gini-Coefficients
(OECD Countries, Disposal Income, 2014)

Similarly, relative poverty rate is also limited in the Nordic countries. Relative poverty rates in other OECD countries are much higher than those in the Nordic countries (Figure 4).

Figure 4: Relative Poverty Rate
(OECD Countries, Disposal Income, 2014)

Third, the size of the government has expanded in return. Tax and social security contribution relative to GDP in the Nordic counties are among the highest in the OECD countries.

Figure 5: Tax and Social Security Contributions

Policy option facing Japan

The situation of the Nordic countries provides Japan with important suggestions as to which direction policies should head for. If Japan chooses to pursue globalization/innovation as well as to achieve an egalitarian society, Japan needs to make a shift from a small government towards a larger government.

More specifically, it means that, in addition to the improvement of the education, training, and matching systems, Japan needs to reform its redistribution policy so as to strengthen redistribution among the working generation and among the aged, rather than promoting redistribution from the working generation to the aged. In this sense, a major reform in the tax, welfare, and social security systems is required.

What has been mentioned is already a huge task, but Japan needs to be aware of another big change that needs to be made. Accelerating globalization means that, in addition to promoting agricultural imports and inward foreign direct investment, it needs to accept more immigrants.

Nordic countries have been facing the risk of aging and shrinking of the population, just like Japan. But they have overcome this challenge by large inflow of immigrants. The share of foreign born in total population is high in Sweden and Norway (Figure 6). The share in Denmark and Finland is smaller than the two countries, but still much larger than Japan (which does not show up in the figure).

Figure 6: Share of the Foreign-Born in Total Population

Japan at a critical crossroad

Japan is facing rapid aging and shrinking of the population. If we are to maintain the living standard and to secure sustainability of the fiscal and social security systems, we need to grow, not only in terms of per capita GDP, but also in terms of total GDP. Accelerating globalization and innovation is essential in realizing these objectives.

But, as we have discussed, the policy choice raises the risk of widening inequality. In order to prevent this from happening, we need to engage in wide range of reforms, in the area of redistribution and labor market policies in particular, that would only be achieved by a larger government.

Japan has to make an important policy choice in view of the fact that, from a long-term point of view, we are at a critical crossroad.

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Jun Saito is a Senior Research Fellow in Japan Center for Economic Research (JCER).
After receiving Bachelor and Master of Economics degrees from the University of Tokyo, he joined the Economic Planning Agency in 1978. He held a number of senior positions in the Government before serving as the Director-General of the Cabinet Office's Economic Research Bureau between 2007 and 2012. He also has spent some time outside the Government; studying at the University of Oxford, and working as economists in the International Monetary Fund (IMF) and the JCER. He is currently a Visiting Professor at the International Christian University (ICU), and also teaches at Aoyama Gakuin, Keio, and Tokyo Universities. He assumed the current position at the JCER in 2012.

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