@ 2018 Annunziata + Desai Advisors, LLC

  • Marco Annunziata

Japan's wager


Policymakers in advanced economies are disappointed with the slow pace of wage growth. Even as the global economy accelerates and labor markets continue to tighten, wage gains remain meager


US wage growth averaged 2.6% in the past six months. In part this reflects composition effects: experienced high-wage workers retire and are replaced by younger, lower-paid ones. The Atlanta Fed tracks wages of continuously employed workers: they registered a 3.3% average pace of growth over the same period. But even this seems modest given the strong drop in unemployment.


I could make a cynical argument that slow wage growth should neither surprise nor concern: even 2.6% is more than enough to cover the slow increase in cost of living (US CPI inflation at around 2%) and reward the near-zero pace of productivity growth.

There are three good reasons to wish for faster wage growth, however:


1. Save the scapegoats. Most people today see slow wage growth as bad. They look for scapegoats: foreigners and robots. Slow wage growth becomes a weapon for protectionists and luddites.


2. Reduce inequality. The spectacular boom in asset prices of the last several years has benefited asset-holders — who tend to be wealthy. Wage earners have been left behind. This exacerbates income inequality, which undermines social cohesion and can have a negative impact on economic growth (IMF, 2015).


3. Bring central banks back on familiar ground. Fears of deflation — which I always found…overinflated — have receded. But inflation remains oddly low for this phase of the cycle. Technology plays a role, but faster wage growth would help bring back the good old inflation challenge that central banks feel more comfortable with.


The press has devoted a lot of attention to recent announcements of wage increases by U.S. companies on the heels of the corporate income tax cut. Some call it a PR exercise; some see it as a quid-pro-quo with a new business friendly Administration. I see a bit of both, together with a natural response to a tighter, more competitive labor market (as noted in John Cochrane’s blog.)


Less talked about, but more interesting, is Japan’s proposal of a tax incentive targeted to accelerate wage growth. More than any other country, Japan really wants — and needs — higher inflation; and two decades of efforts have nurtured a creative and innovative approach to the challenge.


The proposed scheme works as follows: companies that raise wages of existing workers by 3% or more will be allowed to deduct 15–20% of the increase in the wage bill from their corporate taxes, up to 20% of the total tax bill. This could reduce the effective tax rate to 25% from close to 30%. SMEs can benefit from a similar tax break kicking in at lower wage increases. The proposal grants an additional corporate tax break for investments in Internet of Things technologies (which could reduce the tax rate to 20%). The tax incentive would remain in force for three years.


When I read about it, my initial reaction was horror. In a capitalist economy like Japan, market forces are supposed to set wages to balance labor demand and supply and compensate workers for their marginal productivity. The government should never try to set the price of labor. Never. Right?


Though…


The same economic logic says governments should not distort firm behavior, period. Yet, most governments distort corporate decisions in a variety of ways: Taxing corporate profits influences investment. Taxing dividends and interest payments at different rates distorts the choice between debt and equity financing. More to the point, governments utilize targeted tax breaks to spur R&D investment — with the blessing of economists.


A company’s R&D investment partly benefits other companies and consumers by advancing innovation. Since the individual company does not capture these spillover benefits, it will underinvest in R&D — compared to what would be optimal from a social perspective. A targeted tax break raises the after-tax return on R&D investment for the individual company and generates higher R&D spending, raising a country’s productivity and economic growth.


But wouldn’t wage increases today provide similar externalities? They would support consumption, confidence and reflation. They would “deflate” the protectionist and anti-technology backlash. They would help reduce income inequality. The individual company, however, only benefits from the increased motivation and loyalty of its workforce. By granting a tax break, the government increases the after-tax return to “investing” in higher wages.


Will Japan’s scheme work? Most likely yes. Japan’s labor market is tight, with unemployment at 2.8%. Companies will eventually need to raise wages. Targeted tax breaks provide a powerful incentive to do it sooner rather than later. There is also a social and political dimension. The Abe administration has explicitly targeted a 3% increase in wages, and Japan’s confederation of large businesses Keidanren has endorsed the goal. With this tax incentive the government shows it’s serious about the wage growth target, and offers companies an added incentive to play ball.


Japan’s new tax incentive scheme could actually be a brilliant initiative.Faster wage growth would today bring positive externalities that cannot factor into individual companies’ decisions. To the contrary, I fear that financial markets impose a relentless pressure on corporates to reduce costs, often with a short-term perspective. And as innovation powers ahead, and robotics and artificial intelligence reshape the workplace, under-investing in the workforce will become even costlier and more dangerous from a national and global perspective. Investment in human capital deserves and justifies policy action as much as investment in R&D. Japan might be showing the way.