Labor Cost Passthrough: Evidence from Japanese Long-term Subnational Data

In this paper, we analyze labor cost passthrough to price inflation in the pre-pandemic period in Japan, utilizing novel long-term subnational datasets. In the first part of the paper, we construct a long-term prefecture-level dataset of productivity-adjusted labor costs, service prices and local labor market tightness, utilizing relevant disaggregate prefectural data and applying prefecture-level Panel Vector Autoregression to study the interlinkages of the variables. We find statistically significant labor cost passthrough to service prices at the local level for the sample of fiscal year 1985-2018, but also find that the passthrough weakened for the sample after the mid-1990s, when Japan entered low inflation phase. In addition, by utilizing the R-JIP database, the industry-prefectural data available from the 1970s, we find that both the services and manufacturing sectors experienced a decline in labor cost passthrough to the value-added deflators after the mid-1990s. We also find statistically significant asymmetric labor cost passthrough characterized by larger upward passthrough compared to downward passthrough (often called the rockets and feathers effect) in the services sector for the period before the mid-1990s, but such asymmetric effects disappeared in the post-mid 1990s period.