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Japan-sometimes regarded as a model developmental state-faces significant challenges in encouraging innovation and entrepreneurship. The government's selective industrial policy interventions have had little, if any, positive impact on productivity, growth, and welfare. Most resources have gone to large, politically influential "backward" sectors, suggesting that parochial politics determined these resource transfers. Rather than pursuing traditional industrial or science and technology policy, Japan should implement financial and labor-market reforms, which will spur innovative activity. As a group, Japan's industrial firms are competitive relative to their foreign counterparts, but the country falls behind in the heavily regulated service sector. The problems seem due less to a lack of industrial policy than to an excess of regulation, particularly with respect to entry. If the government cannot pick winners, it could at least stop protecting losers. Japan may have more to gain through restructuring the lagging service sector than by expending resources on pursuing marginal gains in the industrial sector.
