Japan's taxing time

The tail does not wag the dog, but the bad start to yesterday's equity trading in Tokyo did not help the rest of the world's share markets. Tokyo had a pretty dreadful day, with the Nikkei index off 556 points to 17,385, a 3.5 per cent fall that ranks as the second-sharpest this year. This is not good in itself but worse for what it says about Japanese business sentiment.

Until a few weeks ago the mainstream view in Japan was accepted by, and reflected in, the financial markets. This view, which is still quite widely held, is that though there will be no growth this year there should be a modest recovery next. No one believes the official forecasts, for these have been spectacularly wrong, having wholly failed to predict any recession.

But while the private research institutes, which do carry more credibility, have been revising down their forecasts for this year they still on balance predict a recovery in the second half of 1994.

There is, however, a seriously pessimistic analysis, which some more thoughtful commentators are now articulating and which is starting to be reflected in share market prices. It runs like this.

There are three reasons why the performance of the Japanese economy in 1994 will be even worse than in 1993 - excess capacity, excess employment and excess inventory.

The capacity problem results from a combination of excessive investment in the late 1980s and the need to shift production overseas to cope with the effects of the high yen. There is nothing that can be done about excess factory capacity, for the plants have been built, and - given the size of the current account deficit - not much that can be done about the present value of the yen.

Industry has already tried to cut fixed costs by trimming inessentials, in particular entertainment, transport and advertising, known as the 'three Ks' - kosai, kotsu and kokoku. But this has not been enough and, faced with falling demand, productivity has declined since the third quarter of 1991.

The next stage of the contraction will be driven by falling payrolls. In the early stages of contraction Japanese firms were able to keep full-time staff on by sacking part-timers. Employment in manufacturing started to fall only at the beginning of this year, whereas production turned down at the end of 1991.

It is still high by international standards at just below 25 per cent of the workforce but one Japanese forecaster, Nakamae International Economic Research, expects this to come down to 20 or even 15 per cent if the yen remains strong.

This fall in manufacturing employment is taking place in all advanced industrial economies, but in most of these the service sector is able to take up the slack. Not so in Japan, for the service industries are already overstaffed in comparison with manufacturing and in any case are trying to reduce their own costs.

The official unemployment figures, showing 2.6 per cent of the labour force out of work, do not take into account people who have withdrawn from the labour market and those who are still carried on corporate payrolls but are without a proper job. Allowing for these, true unemployment is already about 5 per cent of the labour force and this is before the recession has taken full effect.

The third problem is inventory. The optimistic scenario for this year assumed that by now the inevntory adjustment would be complete, that stocks would be sufficiently run down so that production could bounce up. This has not proved the case. People tend to ignore stock adjustments, but in the short term they are enormously important, particularly for businesses. More than any other single factor, this appreciation that stocks were still too high has led to the latest collapse of commercial confidence and hence to the further falls of share prices.

Once these three adjustments have beeen worked through it will be possible for the economy to recover. But this could take another couple of years, which has not been factored fully into Japanese industrial planning, at least until recently. Faced with this, the question for the government is whether it can do anything to speed up the adjustment.

The only obvious weapon is tax cuts. Cutting interest rates further is at best to push on a string, for rates are so low already that they are unlikely to stimulate investment by going yet lower. Indeed, the effect might be perverse, for falling rates would cut savers' incomes and so reduce demand.

The trumpeted public spending packages are ineffective. Implementation lags far behind the announcement, and they do not affect the motor, electronics and machinery industries, which face the most serious adjustment problems. Taxes, though, are high.

Or, rather, specific taxes are high. The top rate of personal income tax, allowing for social security contributions, is 70 per cent, while the effective corporation tax is around 50 per cent. Small firms are also heavily taxed.

To get its economy moving Japan needs something akin to the Reagan tax cuts of 1981 - a thought that is now just beginning to make itself felt in Tokyo.