Annual Report on the Japanese

Economy and Public Finance


- No Gains Without Reforms IV -

July 2004

Cabinet Office

Government of Japan

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Section 3 Promotion of Economic Partnership

    The economic development of Japan was achieved through the advancement of multilateral liberalization centered on the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO). In recent years, the global initiatives for liberalization of trade and investments have witnessed vigorous moves towards establishing free trade agreements (FTA) among specified countries and regions. Japan concluded the Japan-Singapore Economic Agreement for a New Age Partnership in 2002, and largely reached an economic partnership agreement (EPA) with Mexico in March 2004. Japan is also proactively carrying forward consultations on conclusion of bilateral agreements with the ROK, Thailand, Philippines, and Malaysia and on establishment of an economic partnership with the entire Association of Southeast Asian Nations (ASEAN).
    In this section the significance of FTA for the Japanese economy is outlined with some caution with regard to FTA.

1. Initiatives for Economic Partnership

Marked increase in FTA from the 1990s onwards

    An FTA is a form of regional trade liberalization: agreements based on elimination of tariffs among the participating countries. Since FTA result in liberalization within a limited area, the characteristics of FTA include an exception from the most favored nation (MFN) principle, as well as an advancement of liberalization by eliminating tariffs within the specified area.
    In line with these characteristics of FTA, the WTO imposes the following conditions for concluding FTA and other regional trade agreements: (i) liberalization should be implemented practically for all trades; (ii) liberalization should be implemented within 10 years; and (iii) tariffs, etc. after the conclusion of FTA must not be more complicated or more restrictive than those prior to the conclusion. In other words, while the WTO promotes the principle of indiscriminate liberalization of global trade, it admits as an exception of the principle, FTA as a framework for liberalization among specified regions that will eventually lead to liberalization of global trade, as long as the FTA promote advanced liberalization.
    There has been a marked increase in the number of such FTA since the 1990s (Figure 3-3-1). A total of 150 (effective) economic partnerships have been reported to the WTO. Less than 10 FTA went into effect in the 1980s, 31 in the first half and 60 in the second half of the 1990s, and further 40 since 2000, with the most marked increase taking place from the end of the 1990s onwards. FTA initiatives gained speed in the 1990s, starting with efforts by the advanced American and European countries (NAFTA, EU), but in particular, an increasing number of developing countries or trans-regional groups of countries have concluded FTA in recent years. In the past few years an increasing number of FTA initiatives have been implemented in Asia and the Asia-Pacific region as well, and 12 FTA have been concluded.
    The recent WTO activities are next examined in order to understand the reasons behind the increase in the number of FTA.
Expansion, enhancement and stagnation of WTO
    The principle of trade liberalization was first introduced after World War II by the GATT, which was later superseded by the WTO as the system that took the initiative in establishing basic rules, such as the principle of non-discrimination in trade (the MFN principle and the principle of national treatment), etc. However, negotiations under the WTO have grown somewhat stagnant in recent years. A typical example of this trend is the collapse of the Fifth WTO Ministerial Conference held in Cancun (September 2003). The conference's goal was to carry forward the negotiations of the Doha Round (the Fourth WTO Ministerial Conference in Doha), but because the participating countries could not reach a consensus on the range of the main negotiation issues, the adoption of a Ministerial Declaration was postponed. The following developments, which have occurred since the completion of the Uruguay Round in 1993, explain the current stagnation in negotiations.
Figure 3-3-1 Number of FTA that Went Into Effect Around the World by Year and Region
    First is the expansion of membership. In the establishment of the GATT system, the number of participating countries increased from 62 in the Kennedy Round to 102 in the Tokyo Round and to 123 in the Uruguay Round. Particularly marked was the increase in participation among the developing countries. In the Doha Round from 2001 onwards, number of participating countries and regions increased further to 147. As a result, the maintaining common interests among the participating countries became very complicated and made it difficult for them to achieve consensus in the negotiations.
    Second is the expansion of liberalization issues. Following the development of the global economy, the scope of negotiations was enhanced to incorporate liberalization not only in trade of goods, but also in trade of services and in investment as well. Furthermore, the Uruguay Round established the Agreement on Agriculture in the agricultural sector, which was excluded from the areas to which the basic principles of liberalization applied under the GATT system as well, enabling liberalization in agriculture based on the above-mentioned principles. Thus the range of liberalization has expanded. Furthermore, rulemaking initiatives for a multilateral free trade system have also advanced not only through border measures, including tariffs and import restrictions, but also through domestic measures that impact trade and investment, such as competition policies and intellectual property protection. As the scope of negotiations under the WTO keeps expanding, the advancement of the rounds becomes slower.
    Therefore, in order to further promote trade liberalization, the WTO must deal with the pending issues taking into consideration the factors outlined above. At the Doha Round, the issues of the new round were summarized in the "Doha Development Agenda," in a clear indication that the expansion of membership among the developing countries requires negotiations that fully take into consideration the development issues. At the same time, negotiations should be advanced in a manner that will not betray the expectations placed on the WTO, keeping in mind the fact that as the scope of negotiations expands, a wider range of issues is brought up and negotiations tend to get prolonged.

Expansion and enhancement of liberalization through FTA
    The following factors can be identified as reasons behind the sharp increase in FTA from the second half of the 1990s onwards: (i) as noted above, the widespread awareness that swift consensus-building within the WTO has become difficult; (ii) the emergence of a trend for countries with a common interest to go a step ahead and establish bilateral relationships to take advantage of the benefits of liberalization; and (iii) the motivation to promote FTA as part of a country's international political strategy.
    Most recently, the areas for application of FTA have expanded from the traditional trade liberalization (elimination of tariffs, etc.) to include investment, competition policies, intellectual property, government procurement, smooth movement of human resources, e-commerce, environment and harmonization of labor-related systems, etc. These areas are new even for the WTO itself. That is why the most recent agreements (those that include, apart from tariffs, the above-mentioned wide range of areas) are called economic partnership agreements (EPA) in order to distinguish them from the traditional free trade agreements (agreements that stipulate tariff elimination among the member-countries).
    The enhancement of economic partnerships and the establishment of rules for the new areas on a bilateral basis first have the following advantages: (i) they can swiftly respond to the growing needs for advancement of liberalization and facilitation of economic activities which go beyond the trade of goods and cover a wide range of areas on a regional basis; (ii) they can facilitate the accumulation of know-how and experience with regard to system creation in the areas of application, and utilize them as materials for consensus-building at multifaceted negotiation fora; and (iii) they can be expected to exercise leadership in the process of rule creation for the new areas in multilateral negotiations. If these expected effects are realized, they could contribute to the negotiations under the WTO as well.
    However, FTA cannot be positive without reserve, and economists bring up various issues with regard to this aspect of FTA. The most important question is whether the WTO principles can be maintained, in other words, whether (i) the initiatives towards conclusion of FTA will sustain and reinforce efforts for multifaceted liberalization centered on the WTO, and (ii) FTA will emphasize the principles of liberalization in many new areas other than the traditional liberalization of trade that the WTO is currently introducing.
    Also, rules of origin will be required for the operation of FTA, but if different rules are applied for each FTA, then the complex entanglement of rules of origin (the spaghetti bowl phenomenon) will cause excessive administrative costs. It is pointed out that such problems should be avoided.
    Therefore, in advancement of FTA, it is necessary to pay sufficient consideration to promotion of multilateral liberalization through the WTO.

2. Economic Effect of Economic Partnership

Deepening relations with the East Asian economies
    Currently, Japan is proactively advancing efforts for conclusion of FTA with East Asian countries (Appended Table 3-1). In addition to the geographical closeness, these countries actually are deepening economic relations with Japan, so it is expected that conclusion of FTA will have significant positive effects on the economy.
    Looking at Japan's trade structure, the share of exports for Asia has increased from around 30% in 1990 to more than 40% in 2003. As seen in Chapter 2, such relations also reflect the advancement of Japanese companies in Asia.
    Also, the tariff ratio in the Asian countries is generally high compared with developed countries, so tariff elimination through liberalization will bring significant benefits to both Japan and its Asian counterparts. Furthermore, it can be thought that the Asian countries draw significant benefits from liberalization of trade relations with Japan, particularly through transfer of technologies, etc.
    Thus, of the three regions, Asia, North America and Europe, further liberalization of relations with Asia is expected to bring additional benefits to Japan. If, on the contrary, Asian countries conclude FTA with countries other than Japan, and Japan fails to conclude FTA with the Asian countries, then it is highly likely that Japan will risk suffering a negative economic impact.

Economic effects of trade liberalization
    Theoretically, trade liberalization through conclusion of FTA has both static and dynamic effects. Both are explained below.
    One of the direct and positive static effects of trade liberalization is creation of trade between the countries concluding an FTA due to elimination of tariffs between them (trade creation effect). In other words, liberalization gives consumers in the importing country the opportunity to purchase low-price imported products, which they have not had before the conclusion of an FTA. Also, trade liberalization is believed to promote diversification of consumers' choices.
    Based on the principle of comparative advantage, trade liberalization also realizes a shift of economic activities to highly-productive sectors in both countries. However, if productivity in relatively weaker industries does not improve, these industries might shrink.
    On the other hand, FTA have some negative static effects as well. As a result of elimination of tariffs only between countries that conclude an FTA, goods that previously have been subject to transactions with a country, which carries out efficient production but is not party to the FTA, could be replaced by the low-price goods of a country, whose production is inefficient but which is party to the FTA (trade diversion effect). However, it is believed that if a larger number of countries conclude FTA, then there will be less room for emergence of the trade diversion effect.
    Below, the effect on the Japanese economy of a complete elimination of tariffs between Japan and the East Asian countries is examined by using an applied general equilibrium model(30).
    Here the economic effects in the event that Japan concludes FTA with the East Asian countries (China, ROK and ASEAN in particular) were measured on the premise that the implementation of FTA will simply reduce tariffs to zero. Also, in order to compare the effects of FTA with the East Asian countries, the effect of the case that all countries throughout the world including Japan (WTO-based liberalization) eliminate tariffs was estimated.
    According to the estimation, the increase in benefits for consumers as direct effects of trade liberalization will be as follows (Figure 3-3-2).
Figure 3-3-2 Impact of Elimination of Tariffs on Japan's Economy
   1) Maximum benefits can be drawn from liberalization on a global scale. The increase in consumers' surplus, which measures benefits for consumers (benefits that occur as a result of the ability to consume more low-priced goods)(31), to the GDP is calculated at about 0.6%.
   2) The benefits of conclusion of FTA with the East Asian countries are relatively small compared with FTA on a global scale, but they have some positive effects.
   3) In the event that Japan does not participate in FTA by China, ROK and ASEAN, trade diversion effect will occur, and Japan's consumer surplus will become negative.
    The results of this estimation demonstrate the significance of conclusion of FTA between Japan and the East Asian countries.
    From the perspective of the overall economy, it can be concluded that the benefits for consumers will increase, but the impact of liberalization on each sector will differ depending on the comparative advantage and the content of the FTA, resulting in expenses for industrial adjustments. Therefore, it is important to work towards minimizing FTA-related expenses by improving productivity through structural reforms, and to address the issues outlined above.

Expected dynamic effects
    The applied general equilibrium model measures the static effects of FTA on trade. However, it cannot measure the significant dynamic effects of FTA, which in reality will have an impact on domestic industries and the overall macro economy through improvement of productivity and accumulation of capital.
    First is the "scale merit," or in other words, the improvement in productivity that accompanies the realization of an economy of scale, as a result of the elimination of regional trade and investment barriers and integration of markets. In IT-related producer goods, for instance, since fixed costs are significant, it is believed that economic effects due to the economy of scale could easily be experienced.
    The second effect is the increase of productivity due to competitiveness and transfer of technology. The inflow of low-priced goods and services, the participation of foreign companies and the entrance in Japan of foreign managers and engineers stimulate competition, which in turn triggers a rise in productivity based on the diffusion of outstanding management know-how and skills.
    Third are the effects of reform of domestic systems. Effective policies, regulations, etc. are shared by or transferred between the countries that conclude FTA through the negotiations towards the conclusion of FTA or the consultations and other initiatives after their conclusion.
    In addition to borderline measures, it is expected that the improvement of the business environment will be facilitated and a system that will promote trade and investment will be established, by establishment and standardization of investment rules such as the elimination of restrictions on investment, simplification and clarification of procedures, as well as improvement of conflict-resolution procedures, etc., or through the liberalization in the fields of services and investment.
    Furthermore, the rise in productivity caused by the effects mentioned above, is believed to have a positive impact on the long-term growth rate of the countries concluding an FTA from a macroeconomic perspective, as the countries will accumulate capital through the increase in domestic investment and inward direct investment due to the improved expected rate of return in the partner countries and the reduced uncertainty over their economic future, etc.

3. Future Initiatives

Promotion integrated with domestic structural reform
    As observed above, establishment of economic partnerships with the East Asian countries is expected to produce versatile economic effects, and it is important to strengthen initiatives for economic partnership under the following basic principles.
    Firstly, from the perspective of contributing to the global economy and supplementing and promoting the WTO, initiatives for economic partnership need to be implemented along with efforts to promote negotiations under the WTO New Round. As previously mentioned, maximum economic benefits can be drawn from liberalization on a global scale, and from this point of view it is necessary, first, to include forward-looking initiatives that will be useful as reference in future liberalization efforts carried out under the WTO, and to aim at raising the level of Asia in new areas, particularly investment rules, competition policies and intellectual property rights; and second, in concluding FTA, it is necessary to maintain consistency with relevant regulations under the WTO.
    Secondly, Japan must exercise its leadership as a developed Asian country. Towards this end, Japan should, first, place emphasis on promoting the development of its partners from the perspective that Asia's advancement and stability will benefit Japan over the long term, and, second, take into consideration the possibility for creation of an even greater free trade zone in the future through integration of FTA with other regional economic partnerships that cover China, ASEAN countries and others.
    Thirdly, such initiatives should be promoted in an integrated manner with domestic structural reforms. Towards this end, Japan needs to accelerate structural reforms with the following objectives: First, to take advantage of new business chances derived through liberalization of trade and investment, and to smoothly advance creation of new industries and employment; and, second, to reform the regulations, etc. that restrict vitalization in less-competitive industries from the perspective that competition triggered by liberalization might result in activation in those industries.
    In its current initiatives for establishment of economic partnerships, Japan needs to comprehensively examine the promotion of movement of people, including acceptance of foreign workers in areas such as nursing, long-term care and others. Also, swift advancement of agricultural policy reform with the aim of improving the efficiency of agricultural production is important from the perspective of promoting economic partnerships.
    Furthermore, in the event that Japan's partners in negotiations for the establishment of an economic partnership face the bottlenecks in the fields of technologies, development of human resources, domestic legal systems (government procurement, protection of intellectual property rights, competition policies, etc.), telecommunications and transportation infrastructure and others which might slow down or obstruct the liberalization, it is important that Japan provides support for solving such issues through the utilization of official development assistance (ODA) and other cooperation tools.

Cooperation on taxation
    Another initiative for stimulation of regional trade and investment, similar to FTA, is the movement for revision of tax treaties. Tax treaties are concluded to avoid double taxation through adjustment of taxation rights between two countries and support international flow of investment by companies and investors. Japan has so far conducted 45 tax treaties, which are being applied in its relations with 55 countries, but some of them have been in force for so many years, that they can no longer adequately respond to the recent economic situations, including the sharp increase in overseas operations of companies.
    Against this backdrop, the US-Japan Tax Treaty was revised for the first time in about 30 years under the new tax treaty basic principles (reduction of the ceiling tax rate on income from investment and introduction of measures for avoidance of evasion of taxation), and was ratified and entered into force in March 2004. In order to promote investment exchange, the new US-Japan Tax Treaty generally stipulates substantial reduction in taxes withheld at source (the investment destination), and thus significantly lowers the risk of double taxation in cross-border transactions between Japanese and US companies. Also, the expansion in exemption from taxes withheld at source (the investment destination) will result in an increase in the share occupied by taxes withheld in the country of residence, thus sparing investors the trouble of completing tax procedures. Such measures are expected to further stimulate investment and trade between Japan and the US.
    On the other hand, against the background of the deepening economic closeness between Japan and the East Asian countries, it is important in the East Asian region to stimulate trade and investment with Japan, and at the same time secure stable economic growth over the long term. From this perspective, revising the taxation treaties with the East Asian countries in line with the basic principles adopted in the new US-Japan Tax Treaty, will promote FTA along with stimulating further trade and investment between Japan and the East Asian countries. Also, it is believed that a revision of taxation treaties will contribute to the economic growth of the East Asian region, as it will bring into circulation not speculative short-term funds, but long-term private funds aiming for stable investment in this region.

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