This section examines the long-run implications of an aging population for the Japanese economy. Demographic issues are of particular importance to Japan, given that the proportion of the elderly in the population will rise more rapidly over the next twenty-five years than in any other major industrial country.1 Many observers have pointed to the surpluses in Japan’s overall government balance prior to the recent economic downturn as indicating a fundamentally healthy fiscal position. Because the apparent health of Japan’s fiscal position reflects large surpluses in the social security accounts, however, the implications of population aging for future social security receipts and payments are especially relevant. As shown below, the projected sharp future swing in the social security balance in the absence of measures to contain benefits and raise revenues underscores the need to take a forward-looking view of fiscal sustainability.
To summarize the results of simulations undertaken to explore various long-term scenarios, the increasing share of the elderly in the population will exert pressure for higher spending on both social security benefits and medical care. Under the structure of the social security program existing prior to the passage of reforms in late 1994, the ratio of pension benefits to GDP would rise from 5 percent of GDP in 1995 to 13 percent in 2020, and medical spending would rise by 2 percentage points of GDP.2 In the absence of a compensating increase in pension contribution rates, the social security surplus would be eliminated shortly after the year 2000. There-after, rising benefits would lead to a primary social security deficit of 9 percent of GDP by 2020. Together with growing debt-servicing payments, unchanged policies would imply an overall government deficit of 16 percent of GDP by 2020, and a rise in net government debt to 150 percent of GDP.
To avoid such a debt explosion, actions must be taken to reform the pension system, and to cut general government spending or raise revenues (or both). The magnitude of the adjustments needed to achieve a sustainable longrun fiscal position—defined as a stable ratio of debt to GDP—is estimated at 6½ percent of GDP if implemented in 1995. In other words, combined measures to raise revenues or reduce spending (or both) by this amount would be needed to put the fiscal position on a sustainable track. The longer the required adjustments are postponed, the larger they will ultimately need to be, given the intervening buildup in government debt.
The pension reform plan introduced in late 1994 envis-ages a phased-in rise in contribution rates, reduction in benefits, and postponement of the eligibility age. These steps will go far in addressing the fiscal imbalance. Even the full implementation over the next thirty years of these (ambitious) changes to the pension system would not be sufficient to put the fiscal position on a sustainable path, however. Further measures, totaling almost 2 percent of GDP if implemented in 1995, would be needed to fully offset the burden of the aging population. Of course, these conclusions are subject to the many provisos and uncertainties surrounding long-run projections. Nevertheless, the baseline projections provide strong warning signals about the future fiscal situation.
Population Dynamics and Output Growth
The upper panel of Chart 5-1 shows the magnitude of the rise in the old-age dependency ratio implied by the 1993 official population projections.3 The ratio is projected to more than double, from 20 percent to almost 45 percent, during 1994–2020. Expressed as the ratio of the working population to the elderly, the number of people of working age for each elderly citizen will be more than halved, from 5 in 1995 to 2¼by 2020. As shown in the middle panel, growth in the working-age population turns negative beyond 1995, with the pace of decline peaking at almost 1½ percent a year in 2015.
The bottom panel of Chart 5-1 illustrates the implications for Japan’s potential output growth of slower growth in the working-age population. This projection is based on the assumptions that total factor productivity growth will continue at the rate expected for the 1990s; that the capital-to-output ratio will increase in line with the declining relative price of capital goods; and that the participation rate of the working-age population will be roughly constant beyond the year 2000. Under these assumptions, potential growth drops gradually from 2 ½ percent over the remainder of the 1990s, to about 1 percent in 20.15, before recovering to about1½ percent in 2025.
Alternative Fiscal Scenarios
The most important direct impact of population aging on the fiscal position will occur through a rise in social security benefits for the Employees’ Pension Insurance Scheme (EPIS) and the National Pension Scheme (NPS). Benefits will increase in relation to GDP, not only because of the growing share of the elderly in the population, but also because of the maturation of Japan’s pension scheme. Assuming that the key parameters determining pension benefits remained unchanged at their pre-reform levels—that is, eligibility at age 60 and full indexation to wage and price growth4—the ratio of bene-fits to GDP would rise from 5 percent in 1994 to 6 ¾ percent by 2000, and then to 13 percent by 2020. Another source of spending pressures will come from higher medical and health insurance payments, which are expected to rise by 2 percent of GDP during 1995–2020.5
Under the assumption of pre-reform program parameters, then, total spending on social security would rise from 12 percent of GDP in 1994 to 22½ percent in 2020 (Chart 5-2; upper panel). Social security contributions, meanwhile, would remain stable at 9½ percent of GDP.6 The other components of government spending—current spending (excluding debt-servicing payments), public investment, and other revenues—are assumed to grow in line with nominal GDP. These developments would dramatically alter the overall fiscal position, as shown in the middle panel of Chart 5-2. The increase in social security benefits implies a swing in the primary social security balance of 10 percent of GDP from 1995 to 2020; including debt-servicing costs, the overall social security balance would shift from the current surplus of 3½ percent of GDP to a deficit of 12 percent. Adding to this the deficit on government operations excluding social security implies a rise in the overall deficit to 16 percent of GDP. The ratio of government debt to GDP grows slowly over the remainder of the 1990s and then accelerates sharply beyond 2000, rising to 150 percent of GDP by 2020.
These developments are clearly unsustainable, and significant measures must be taken to prevent an explosive rise in debt over the long run. An indication of the size of the required actions can be obtained by comparing the discounted present values of government revenues and spending (in the absence of additional measures).7 The resulting gap is a measure of the “fundamental” imbalance in the fiscal position, taking both current and future revenues and spending into account. Performing this exercise for Japan using the assumptions described above gives an imbalance of 6½ percent of GDP as of 1995. In other words, if the required adjustments were made in 1995, either a permanent increase in revenues of 6½ percent of GDP or a cut in expenditures of the same size (relative to the baseline scenario) would be needed to ensure that the debt stock does not rise without bound in the long run. If the adjustments are postponed, their ultimate size would need to be larger, since the debt stock and thus the debt-servicing burden would accumulate over the interval.8
To address the strains presented by population aging, the Ministry of Health and Welfare has introduced a package of reforms to the EPIS to be implemented in stages during 1995–2020.9 There are three key elements to this package: (1) an increase in the combined employer/employee contribution rate to the EPIS from the current 14½ percent of earnings to 29½ percent by 2020;10 (2) a phased rise in the eligibility age for EPIS benefits from 60 to 65 starting in 2000; and (3) a shift to the use of “net” earnings—after payment of social security taxes—to index EPIS benefits. In addition, it is envisaged that monthly contributions to the NPS be roughly doubled in real terms by 2015, implying a rise of about 50 percent in contributions relative to household income.
The combined effect of these measures would be to raise social security contributions to14½ percent of GDP by 2020 from the 9½ percent share in the absence of reform (Chart 5-3). As regards benefits, pension payments would be reduced to 20 percent of GDP by 2020 from the “unchanged parameters” level of 22½ percent. Together, these reforms would be sufficient to balance the EPIS and NPS components of the social security program. They would not, however, offset the rise in medical care costs, or the burden of rising government debt. This is evident in the middle panel of Chart 5-3, which shows that, although the overall deficit would narrow over the rest of this decade, it would start to widen beyond 2005. The subsequent rise in the deficit and the stock of debt in relation to GDP would be more gradual than in the absence of pension reform, but it is apparent that further measures would be needed to achieve a sustainable long-run fiscal position.
On the present-value basis described above, the remaining imbalance amounts to 2 percent of GDP. The required adjustment could be achieved in the form of either revenue or expenditure measures. Assuming that revenues are the source of adjustment, one solution would be to alter the consumption tax rate over the longer run to compensate for the rising social costs of an aging population. Beyond the rise in the consumption tax rate in 1997 that is incorporated in the baseline scenario, a further increase to roughly 10 percent would be needed by the end of the decade to achieve the required adjustment.11 An alternative approach on the revenue side could involve eliminating the special deduction for pension income in the personal income tax system.12 Although it is difficult to assess the precise impact of such a reform in the absence of microeconomic tax data, a hypothetical rise in the average tax rate on public pension benefits of 30 percent would raise about 2 percent of GDP in additional revenues by 2000.
Implications for the Saving-Investment Balance
The long-term prospects for Japan’s saving and investment depend on the behavior of public and private saving, as well as overall investment. Public saving will be determined by the policy actions taken to address population aging: as discussed above, pre-reform policies would lead to an explosive rise in the deficit and debt, whereas pension reform moderates the size and timing of the fiscal deterioration. Private saving will be influenced by the shift in the demographic structure itself, asset accumulation, and expectations of future social security benefits and tax liabilities. Finally, investment will depend on the desired capital-to-output ratio, the trend growth rate of output, and the depreciation rate of the capital stock.
Operationally, the projection for (gross) public saving is obtained as the sum of the overall government balance plus the rate of (gross) public investment, based on the fiscal scenarios described above. Private saving is determined residually as the difference between income and consumption: the latter moves in line with wealth, which is defined as the discounted value of labor income and social security benefits, less the discounted value of taxes and social security contributions, plus the stock of financial and physical wealth. In addition, consumption increases as the overall dependency ratio rises, with a response parameter given by the relationship between Japanese demographics and household behavior.13 The desired capital-to-output ratio continues to grow in line with the declining relative price of capital goods. Gross investment is then determined by the investment needed to keep the capital stock growing in line with potential output and the desired capital-to-output rate, and by the depreciation rate (which is assumed to remain at its historical level).
The projections for the components of saving and investment along with the implied current account balance are shown in Chart 5-4. Under the assumption of pre-reform social security parameters—and no other fiscal initiatives to deal with population aging—the dramatic rise in public dissaving is reinforced by a downward trend in the private saving rate. The investment ratio declines moderately until 2015, reflecting slowing growth in potential output, before rising slightly near the end of the projection horizon. The net result is a swing in the external balance from a surplus of slightly over 2 percent of GDP in 2000 to a deficit of 15 percent of GDP by 2020. Such a huge deterioration in the external balance would almost certainly not be “financeable” in reality;14 neither would the government deficits associated with an exploding debt stock find a ready market. Finally, predicting the response of private saving in the face of unsustainable fiscal policies is problematic when the eventual resolution of the situation is not specified. But the very unsustainability of these outcomes serves to underscore the imbalances that would potentially result from shifts in the Japanese demographic structure.
As shown in the lower panel of Chart 5-4, full implementation of the pension reform proposals sharply reduces the decline in public saving, which falls from 8 ½ to 4½ percent of GDP from 2000 to 2020. Nevertheless, combined with a 3 percentage point drop in the private saving rate over this period and roughly flat investment, the current account balance falls steadily to a deficit of about 5 percent of GDP by 2020. Although the decline is smaller than in the previous scenario, the underlying fiscal position would remain unsustainable, and further adjustments would be required to prevent both government debt and external liabilities from rising without bound beyond this horizon. Scenarios that incorporate the needed fiscal adjustments suggest that the current account deficit would stabilize in a range of 1-2 percent of GDP beyond 2015.
References
Feldman, Robert A., “Japan: Outlook for Social Expenditure, 1980–2025” (unpublished; Washington: International Monetary Fund, July 1985).
Takayama, Noriyuki, The Greying of Japan: An Economic Perspective on Public Pensions, Economic Research Series, No. 30 (Tokyo: Institute of Economic Research, Hitotsubashi University, 1992).
Van den Noord, Paul, and Richard Herd, “Pension Liabilities in the Seven Major Economies,” Economics Department Working Paper 142 (Paris: Organization for Economic Cooperation and Development, 1993).
See, for instance, Van den Noord and Herd (1993).
Long-run scenarios are subject to many uncertainties and provisos regarding, for instance, productivity growth and inflation. In Japan’s case, however, over four fifths of all public pension benefits are ultimately indexed to wage growth, so different assumptions about economic growth would have little effect on the relative magnitude of future transfers to the elderly. In this case, the burden of an aging population depends more on the projected share of the elderly in the overall population, which is relatively robust to alternative demographic assumptions over the horizon considered here.
These are based on the “middle series” published in 1993 by the Ministry of Health and Welfare. This projection assumes a recovery in Japan’s fertility rate over the longer run to 1.8 births per woman from the current level of 1.5. If, instead, the fertility rate were to remain near the current level (as assumed in the Ministry’s “low” projection), the rise in the old-age dependency ratio would be even larger, although most of the impact would be felt beyond the year 2020. Some analysts have expressed concern that even the “low” projection embodies too high a fertility rate, implying an even sharper rise in the old-age dependency ratio beyond about 2015. Beyond 2025, the fiscal position would worsen further because of continuing increases in the old-age dependency ratio. However, because these very long-term results are sensitive to demographic assumptions, the focus here is on the horizon over which the projected population structure is relatively robust to alternative assumptions.
Benefits under the EPIS are currently indexed to annual consumer price inflation, with a rebasing every five years to reflect the gap between average wage growth and inflation. NPS benefits are indexed to consumer price inflation.
Based on updates to the estimates provided in Feldman (1985) using revised population projections.
Excluding net transfers from the central Government and interest receipts.
Specifically, the present value of primary expenditures plus the level of the initial debt stock is subtracted from the present value of revenues. Dividing the result by the present value of GDP indicates the actions that need to be taken—as a share of GDP, on a present-value basis—to stabilize the debt-to-GDP ratio over the long run and thus to achieve a sustainable fiscal position.
For instance, if the required adjustments were postponed by five years until 2000, they would rise to7¼percent of GDP; if postponed until 2020, they would reach almost 11 percent of GDP.
This long-term reform scenario has been constructed by the Ministry of Health and Welfare in conjunction with the latest five-year review of the pension system.
The contribution rate would be raised in increments of roughly 2½ percentage points every five years, beginning in 1995–96.
This is based on the authorities’ estimate that each percentage point rise in the consumption tax generates about 0.4 percent of GDP in additional revenues. An option that would moderate the required rise in the tax rate would be to bring small businesses, which are currently tax-exempt, into the consumption tax base.
In 1990, the tax-exempt threshold of a childless retired couple whose household head was aged 65 or over ranged from ¥3.1 trillion to ¥4.5 trillion, whereas for a working-age couple the threshold ranged from ¥1.7 trillion to ¥2.3 trillion (see Takayama (1992)).
See Section IV of this volume for a discussion of the methodology.
Especially because several other large countries face problems associated with future population aging.
