Heterogeneity in Japanese TFP, Part 2: Regulation, Capital Allocation, and TFP in Japan

In the first essay of our examination of Japanese total factor productivity, “Why Overcoming Deflation Alone Will Not Solve Japan’s Structural Problems,” we examined the role of relative deflation of capital goods in an exogenous model of productivity. In this study we gather empirical evidence on sector-specific characteristics of total factor productivity with the latter as an endogenous variable. Using panel regressions of industry-specific total factor productivity (both adjusted and unadjusted for labor and capital utilization) segmented by sector we discover a positive relationship between industry-wide measures of deregulation and total factor productivity in the services sector. However, the coefficient reverses in the manufacturing sector – a drop in already-deregulated manufacturing is consistent with a decline in total factor productivity. Although the direction of causality is indeterminate, an optimal level of regulation across industries in terms of total factor productivity growth appears to lie somewhere between the manufacturing and non-manufacturing sectors. Separately, we find strong evidence that the share of innovative capital scaled by firms’ output correlates positively with TFP growth, across most industry sectors. The sum of our findings provide a specific policy argument: to prioritize deregulation in services over manufacturing, moreover that the target of such policy adjustments should be at once to incentivize innovation in not only IT-relevant but also non-IT sectors and to dispose of “dead weight” capital in non-IT related Services industries in particular. We supplement the latter claim with empirical evidence of stagnation in the aggregate quality of capital in non-IT versus IT- related industries and, to a lesser extent, in Services versus Manufacturing