Annual Report on

The Japanese Economy and Public Finance


- No Gains Without Reforms V -

Cabinet Office

Government of Japan

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Section 4 The Source of Innovation and the Challenge to Improve Competitiveness

    The "Demographic Wave" to strike Japan in 2007 is likely to have a significant impact on Japan's growth potential through a decline in the labor force. As discussed in Section 1, it is essential to respond to this labor force decline by improving productivity through innovation and thereby maintain per-capita income. In addition, as population factors work to contract the domestic market, companies must enhance their competitiveness through high value-added technological creativity.
    This section first presents an overview of the changes in competitiveness as recognized by companies and the background of these changes. It then examines the state of innovation by Japanese companies and factors spurring this innovation, and analyzes the impact that innovative activities is having on companies' productivity. In connection with the view that regardless of the amount of research and development in Japan, companies have yet to secure a matching level of productivity, this section shows that innovative activities by companies and improving productivity does not necessarily depend on the amount of research and development investment but rather hinges on the creativity and inventiveness of research and technical personnel at the worksite and on how management utilizes research and development in the organization.
    The second half of this section outlines the current state of innovation in the service sector, which is a key issue in improving productivity in Japan, and discusses the challenge of securing the scientific, technical and research personnel to undertake the next generation of innovative activities as population restrictions strengthen, particularly in the younger age groups.

 The power of innovation to influence corporate competitiveness
    The following is a brief discussion of the changes in competitiveness as recognized by companies and the background of these changes based on a company-level opinion survey concerning innovation (hereafter, "company survey")(58) In particular, the company survey examined companies' evaluations of how their competitiveness had changed over the past three years in terms of the relative strength of the products and services they provide. Considerable variation among the companies surveyed was found, with 31% of companies stating that their competitiveness had strengthened and 33% stating that it had weakened (Figure 3-4-1). In a breakdown by industry sector, the company survey revealed that the proportion of companies which stated that their competitiveness had increased was relatively high in the materials industry, which enjoys continued strong profits and in the financial sector, which has made progress in the disposal of non-performing loans.
Figure 3-4-1 Changes in competitiveness and factors behind it
    Asked to identify the factors responsible for their stronger competitiveness, companies mentioned the quality, capabilities and categories of their products and services, as well as their capacity to develop products and services. On the other hand, factors identified as causing a decline in competitiveness included, most prominently, development capacity, confirming that strength in developing products and services with high added value, or in other words, the ability to innovate, had a major impact on companies' competitiveness.

 R&D investment is strong but how effective?
    Research and development investment is one of the factors that determines a company's ability to develop products and services. To shed light on this relationship, the discussion will now focus on the current state and efficiency of R&D investment in Japan. Since the 1970s, Japan has aimed to expand enterprise value by embodying science and technology in products through research and development. As a result of this effort, the amount of R&D investment in Japan reached 3.12% of GDP in FY2002, the largest percentage among the major industrialized countries (Appended Figure 3-31). One of the chief characteristics of R&D investment in Japan is the relatively low weight of investment by the government sector compared with other countries, with more than 70% of investment borne by the private sector.
    Although active R&D investment has been pursued in Japan, especially in the private sector, population constraints, as seen in Section 1, will strengthen from now, and to maintain Japan's economic strength, it is singularly important that innovations spawned by R&D activities lead to improvements in productivity. However, despite the finding that total factor productivity (TFP), and R&D investment in the industrialized countries have a moderately positive relationship, increases in the ratio of R&D investment to GDP in Japan since the 1990s have been accompanied by a decline in the growth of TFP. Although changes in TFP cannot be attributed solely to innovation,(59) this trend indicates the possibility that improvements in productivity commensurate with the amount of R&D investment have not been realized (Appended Figure 3-32).
    These facts probably indicate that the efficiency of R&D investment in Japan including that by the private sector is low. An index that measures the efficiency of R&D investment calculated by dividing cumulative operating profit over five years by cumulative R&D costs over five years displays an immediate, albeit small, rise upon the recovery of corporate profits due to the economic recovery, but the long-term trend is downward (Figure 3-4-2). From these statistical patterns, it could be concluded that the efficiency of research and development by Japanese companies is declining in comparison with the past.
Figure 3-4-2 Trends in the efficiency of research and development (manufacturing industries)

 Current status of Japanese companies' innovative activities
    Next, the discussion will consider the factors behind the decrease in the efficiency of research and development by examining the present status of innovative activities by Japanese companies. In this analysis, companies' innovative activities are treated as a factor ("output") that links the "input" of R&D investment with the "outcome" of profit margins and productivity.
    To begin with, the current status of Japan's innovative activities is outlined using Japan's first comprehensive statistical survey concerning companies' innovative activities, the "National Innovation Survey" of the Science and Technology Policy Bureau, Ministry of Education, Culture, Sports Science and Technology. According to this survey, more than 20% of those companies examined that had more than ten employees had achieved either product innovation (i.e., the introduction to the market of a product that is either new in some way or substantially improved) or process innovation (i.e., the introduction of a process, including a method of providing a service or distributing a product, that is either new in some way or substantially improved) in the three-year period from 1999 to 2001 (hereafter, this percentage is defined and used as the percentage of companies that have achieved innovation). To compare the results of this survey with the status of innovation in other countries, reference was made to a similar survey conducted in the EU. According to this, 40% of companies in EU member countries had achieved innovation, which means that at least judging from these two surveys, innovative activities by Japanese companies are not particularly extensive (Figure 3-4-3).(60)
Figure 3-4-3 International comparison of companies' innovative activities

 Efficiency of research and development affected by managerial and organizational initiative
    According to the above National Innovation Survey, the reasons why companies did not engage in some type of innovative activities or follow through with such activities include staff shortages, inadequate information about technology and markets, and organizational rigidity, which indicates that success in innovation will be affected by disparities in the managerial and organizational initiative of companies, including human resources development. To illuminate this issue, the key results of the Cabinet Office's company survey will be examined to consider problems involved in improving competitiveness by understanding the relationship between managerial and organizational initiative and success in innovation and the relationship with companies' profitability and productivity.(61)
    First, in the company survey, 70% of companies stated that they had achieved product innovation in new products and services (including major improvements in existing products and services) and nearly 50% of companies stated that they had achieved process innovation, such as improvements in production technology and distribution processes, over the past three years (Appended Figure 3-33). Of these successes, most product innovations were achieved by companies' R&D departments, although many were also achieved at the worksites for product manufacturing and service provision, which, in process innovation, constituted a particularly fertile ground for important innovations. As stated at the beginning of this section, there is a strong connection between changes in companies' competitiveness and their capacity for developing products and services. Taking a closer look at the relationship between changes in competitiveness and success in achieving innovations, it is observed that among companies that have strengthened their competitiveness, the ratio of those that have achieved product innovation was 8 percentage points higher than companies that have not strengthened their competitiveness, and 15 percentage points higher than these companies in process innovation (Figure 3-4-4).
Figure 3-4-4 Changes in competitiveness and the proportion of companies that achieved innovation
    Second, when companies were asked the extent to which their R&D activities led to improvements in products and services, more than 80% replied either that half of their R&D activities led to improvements, or that they did not lead to much improvement, or that they led to no improvement at all, which indicates that companies themselves do not rate their R&D efficiency very highly. The main reasons given for these low ratings include human capital-related problems involving the quality and quantity of research staff and the difficulty of ascertaining market needs.
    Third, the managerial and organizational initiative of companies, which is considered to have a strong relationship with R&D effectiveness and achievement of innovation, was examined. Companies were asked whether or not they had taken action in 12 areas, including developing a strategic vision for R&D, forming linkages between R&D strategy, management strategy and marketing, instituting a strategy for securing and developing personnel, and managing the progress of research and development. More than 50% replied that they had taken action to clarify the system of responsibility concerning R&D strategy and to conduct progress management of research and development. However, relatively few had taken measures to prevent the loss of personnel, or to secure and develop personnel, or to flatten their organizational structure (Table 3-4-5). By totaling these results and assigning points to a "management of technology (MOT index)" with a maximum rating of 12, it was confirmed that, generally, the higher the MOT index was, the higher the R&D efficiency (Figure 3-4-6).
Table 3-4-5 Management of technology indicators
Figure 3-4-6 MOT indicator and research and development efficiency

Column 8

Knowledge Management and Innovation

    Of the strategic managerial initiatives that serve as the infrastructure for stimulating companies' innovative activities, knowledge management is a particularly important element. In the EU's Third Joint Innovation Survey (CIS3) performed in France, the concept of knowledge management was defined in terms of four management techniques: (i) establishment of written policies concerning knowledge management; (ii) formation of values and a corporate culture designed to promote knowledge sharing; (iii) creation of incentives for retaining employees and directors; (iv) formation of partnerships and strategic alliances with other companies for knowledge acquisition.
    In a study to determine what type of companies practiced knowledge management, it was found that larger companies and companies in high technology intensive manufacturing industries were more likely to practice knowledge management through any of the above techniques. However, even among large companies and high technology intensive industries, the percentage that implemented an incentive policy to retain employees was less than 30%, which is low compared with the use of other techniques of knowledge management. This lack of incentives is reflected in companies' slow progress in establishing systems for handing the assignment of rights pertaining to inventions developed on the job (i.e. service inventions), as seen in the large number of lawsuits by employees toward companies demanding a fairly substantial amount of compensation.
    To determine whether or not the practice of knowledge management leads to the achievement of product innovation in manufacturing industries, an evaluation was conducted using a probit model. It was observed that if the company practices only one technique of knowledge management, the probability of achieving some type of innovation for that reason alone is high at 10% compared with the case where none of the four management techniques are practiced. This means that managerial and organizational initiative as typified by knowledge management probably has a large impact on the success of companies' innovative activities.

Column Figure 8 Knowledge Management and Innovation

 Success in innovation and the earning power it engenders is influenced by staffing and managerial initiative
    On the basis of the above results, a detailed analysis was performed to determine the degree of impact of various factors on success in innovation and on the proportion of sales accounted for by products and services developed through innovation. These factors included the amount of R&D investment and managerial practices such as management of technology, which is a key element in to increasing the efficiency of research and development and improving company competitiveness. Specifically, four dependent variables were set: (i) "innovation propensity" which indicates whether or not the company achieved product innovation; (ii) "innovation efficiency," or the proportion of a company's sales accounted for by products and services developed through innovation; (iii) "patent holding propensity," which indicates whether or not the company holds patents for protecting technology developed through innovation; and (iv) "patent efficiency," or the proportion of sales protected by those patents. Then, a model was devised to explain these variables, taking into account company size and industry differences, in terms of the past ratio of sales to R&D investment, MOT index, management of intellectual property index,(62) the company's researcher ratio and the existence of alliances with research institutions and universities in Japan (Figure 3-4-7).(63)
Figure 3-4-7 Management of technology and innovation
    The estimation yielded the following results: First, the higher the MOT index or management of intellectual property index was, the higher the innovation propensity, innovation efficiency, patent holding propensity, and patent efficiency tended to be. Of these, higher technology management ratings contributed to raising innovation propensity. An especially strong relationship was observed between high intellectual property management ratings and holdings of patents. Companies with MOT indicator 12 points and companies with 0 points differed by about 40 percentage points in terms of innovation propensity. Second, companies' researcher ratios did not have a significant effect on patent propensity, but did have a significant positive effect on innovation propensity. Companies probably employ researchers to serve as the source of innovative activities rather than as an element of patent strategy. For example, innovation propensity was 2 percentage points higher among companies whose researcher ratio was 10 percentage points higher. Third, companies that have partnerships with universities and other institutions in the form of industry-academia alliances, have a significantly higher scores for patent holding propensity and patent efficiency than for the indexes relating to innovation. This tendency, along with the growing number of TLOs (Technology Licensing Organizations)(64), indicates that the acquisition of patents with high economic benefits using the results of research performed in universities and other institutions is expanding. Fourth, the effect of R&D investment ratios on the various indexes is positive, though not necessarily statistically significant. It is clear, however, that factors associated with company infrastructure such managerial initiative are more important than the amount of R&D investment itself.

 Increasing companies' productivity through innovation fostered by personnel and management development
    Next, to examine the effect on companies' productivity through achievements in innovation fostered by personnel and technology management development, an estimate was made setting labor productivity as the dependent variable. As in the above cases, the results indicated that the amount of R&D investment has not a significant effect on labor productivity. However, the development of management of technology and research personnel clearly has a positive and statistically significant relationship to raising companies' labor productivity by increasing the probability of achieving innovation. In particular, companies whose MOT indicator was in the upper 50% or whose researcher ratio was in the upper 50% both had 20% higher labor productivity than companies whose indicators were in the lower 50% in either of these categories (Figure 3-4-8). It should be noted that the sample was limited because the companies surveyed here included only those for which financial data could be acquired. However, like the above results, it was observed here that infrastructure factors such as management of technology and knowledge management rather than the amount of R&D investment make a larger contribution to productivity resulting from companies' technological creativity by promoting companies' innovative activities.(65)
Figure 3-4-8 Factors which have an impact on labor productivity

 The challenge of stimulating innovation in the service sector
    With the growing importance of the service industry in industrial structure and employment structure, promoting innovation in this industry is likely to be the key to stimulating the economy in the future. In the OECD countries over the past 20 years, market services such as wholesale, retail, finance, insurance, IT, and services for business establishments expanded their proportion of added value to about 50% and constitute an important engine of economic growth. Market services is also the source of job creation in OECD countries. If the added-value growth rate and the job growth rate of the market service from the 1990s to the beginning of the 2000s in industrialized countries are compared, a generally positive relationship is observed, but in Japan the growth capacity of the market services is comparatively low (Figure 3-4-9). Generally, market services contribute significantly to the labor productivity of the economy as a whole, particularly in services for business establishments and the wholesale and retail industry. In the United States and the United Kingdom, the service industry accounts for more than half of labor productivity, but in Japan, labor productivity in the service sector is relatively low. Consequently, manufacturing industries continue to account for the largest part of productivity growth in an economy whose productivity growth rate is low.(66)
Figure 3-4-9 The added value growth rate and job growth rate of the market service industry (1990-2002)
    If innovative activities in Japan's service industry are compared using the results of the surveys of innovation performed in Japan and the EU as described above, the low proportion of services industries that engage in some type of innovative activities does not constitute a major difference compared with manufacturing industries. However, examining the achievement of innovation by product and process innovation shows that Japan's service industry places more emphasis on process innovation than the manufacturing industry does, but its capacity in product innovation is weak (Appended Figure 3-34). From the results of the above company surveys, it is clear that in comparison with manufacturing industries, the product innovation propensity of non-manufacturing industries is low. In Japan's service industry, the most commonly cited factor hindering companies' innovative activities is the lack of capable employees, and this shortage of skilled personnel probably is affecting their ability to innovate (Figure 3-4-10). In particular, Japan's service industry has been singled out for falling behind in the use of IT technology. Like the need to improve systems and practices that hinder wider use of IT, such as in the medical field where standardization of information is required, securing high-level IT staff is a major priority for expanded use of IT in a wide range of fields including medicine and education.
Figure 3-4-10 International comparison of factors hindering innovation in service industries

 The challenge of securing research and technical personnel as numbers decline
    As discussed previously, securing research and technical personnel, whether in the manufacturing industry or in the service industry, is a crucial requirement for innovative activities. However, with the aging of the population and population decline, the number of research and technical personnel is likely to fall in both absolute numbers and as a proportion of the population, and there is particular concern that the pool of talented young people, who are especially endowed with creativity, will undergo a sharp drop (Figure 3-4-11). According to the company survey, many companies cite the shortage of skilled personnel as the reason why research and development does not lead to achievements, and as population constraints strengthen, there will be even greater demand for research and technical personnel. The following is an outline of the main challenges to be met in securing research and technical staff.
Figure 3-4-11 Population projections for research and technical personnel
    First, it is to be hoped that people who hold doctoral degrees serve in companies as staff with high-level specialized knowledge, but the number of Ph.D.'s has been leveling off, and compared with other industrialized countries, the percentage of Ph.D.'s in Japan remains low (Figure 3-4-12).
Figure 3-4-12 Percentage of doctoral degrees by country
    Second, many companies are not enthusiastic about employing doctoral degree holders, and Ph.D.'s are not adequately used in companies. One probable reason why Ph.D.'s are not hired more aggressively is the mismatch between the areas of specialization of Ph.D.'s and the specialties required by companies. More extensive use of Ph.D.'s through measures such as promoting the mobility of young researchers is an important challenge.
    Third, an analysis of new university students in the fields of science, engineering, and agriculture, who constitute the potential pool of research and technical personnel, reveals that amid the overall decline in the growth rate of new university students due to declining birthrates, new students in science and engineering have declined to a greater extent than new university students overall, and thus the ratio of new students in science and engineering is declining (Appended Figure 3-35). In forecasting the trend in research and technical personnel far into the future, it is instructive to examine the interests and aptitudes of children relating to mathematics and science. According to OECD's Programme for International Student Assessment (PISA), Japanese students held the second rank in scientific literacy from 2000 to 2003, and although they remained in the upper ranks in terms of mathematical literacy, they fell from the first rank in 2000 to the sixth rank in 2003 among the countries and regions surveyed. Although the correlation between the aptitude of children for mathematics and science and the production of future research staff is unclear, there is concern that if the current decline in scholastic aptitude and shift away from science(67) speeds up, there will be an adverse impact on efforts to secure research and technical personnel in the future.
    Fourth, women account for only a small proportion of Japan's research and technical personnel. Although, as with other female workers, there is the difficulty of continuing work due to child-rearing, the proportion of female researchers is extremely low compared with other occupations (Appended Figure 3-36). For this reason, an important priority in securing research and technical personnel is increasing the number of female researchers.
    Another problem is the decline in research support personnel such as research assistants, technicians and clerical workers. The decline in research support staff in companies is particularly notable and probably has an adverse impact on the efficiency of research and development.
    While the current number of researchers in the population in Japan is high compared with other industrialized countries, securing the research and technical personnel who can produce innovations in the mid- to-long term is, as described above, a major challenge. In order to maintain Japan's competitiveness through expanded innovative activities, aggressive efforts must be taken for the aim of securing talented staff, such as arousing the interest and awareness of children and young people toward science, improving educational curricula, actively utilizing women, and eliminating mismatches between researchers and their work specialization by promoting the mobility of young researchers.

    This chapter presented an overview of the economic impact of current population movements in Japan. It began with a description of the two major "demographic waves" to strike in 2007, namely, the decline in population and the start of the Dankai generation's mandatory retirement and then discussed the implications that population movements will have for the Japanese economy from the perspective of both flow and stock and the various impacts these movements will exert on household and corporate behavior.
    The following issues were discussed concerning household behavior:
(1) Although consumption of services such as tourism will expand judging from consumption preferences by age and generation, the propensity to consume of the Dankai Jr. generation, which represents the core of the population, is not necessarily high at present, and there is concern about the impact that the long-term downward trend in the population of people in the intermediate age range will have on the overall consumer market.
(2) Although the aging of the population will further the decline in the savings rate, the probability that the savings rate over the medium term will fall below zero is low. Nevertheless, a concern is that there are many people in the younger age groups who have no savings.
(3) Assuming that the risk tolerance of the elderly group is high, the demand for risk assets will increase steadily from now, and if savings move increasingly into investments, there is little fear of a resulting "meltdown" of asset markets.
(4) Amid the slowdown in growth of housing stock along with the number of households, changes of residence by the Dankai generation after retirement and increased housing acquisition by the Dankai Jr. generation should produce some degree of demand. However, in order to realize an affluent society of elderly, the effective utilization of existing stock, including the expansion of the reverse mortgage system, will be an important priority.
    The following issues were discussed concerning corporate behavior.
(1) The retirement of Dankai generation workers, who up to now have placed upward pressure on labor costs, will result in a relaxation of downward pressure on corporate profits in the near term.
(2) It cannot be denied that employment of youth has been dampened by the size of the wage cost burden of older workers, particularly the Dankai generation. However, with the mandatory retirement of the Dankai generation approaching, this dampening effect has reached a peak, and signs of an expansion of youth employment have appeared. These and other developments, some would indicate, represent the positive side of the Dankai generation's retirement. However, the departure of the Dankai generation will also have a negative impact on companies' competitiveness, as explained in the following two items.
(3) Because Dankai generation workers, particularly those who operate the worksites of manufacturing industries, possess mature technical skills, transferring these skills through such means as continued employment of these workers is an increasing challenge.
(4) As the retirement of Dankai generation employees draws near, fears are growing that the burden of retirement benefits will be large. A major priority, then, is promoting reform of company pensions, including a shift to defined-contribution pensions.
    It is needless to point out that the reduction of the labor force due to decreasing population, declining birth rates and the aging of the population will, as an input into the economy, inevitably have a negative impact on growth. In addition, under the present medical system and long-term care insurance system, medical and long-term care costs, assuming the present supply and demand structure and factoring in the impact of the aging of the population, will increase at an unsustainable pace, raising concerns that the burden on the succeeding generation will be enormous. Therefore, reform of the social security system must place as much emphasis on holding costs down to the greatest extent as to maintaining the quality of service. Meanwhile, increasing productivity in the economy as a whole will require first of all innovative activities by companies to create appealing products and services but also efforts to stimulate the goods and services market by arousing the willingness to consume. The core of innovative activities is occupied by the staff that supports these activities (i.e. quality of labor) and by management that utilizes technology and knowledge to maintain earning capacity. With the ongoing progress in improving the efficiencies to resource allocation, including dissolving the "three excesses," through the promotion of structural reform as discussed in Chapter 1, it is doubly important for establishing a stable foundation for growth in Japan to channel effort into improving productivity centering on the strength of human resources.

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