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3 Public Debt and Economic Growth in an Aging Japan

Author(s):
Keimeir Kaizuka, and Anne Krueger
Published Date:
July 2006
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Author(s)
Toshihiro Ihori, Ryuta Ray Kato, Masumi Kawade and Shun-ichiro Bessho 

Introduction

This chapter examines the effects of demographic changes and the government’s debt policy on economic growth and economic welfare in Japan, taking into account the institutional features of the current public pension and health insurance schemes. The analysis uses a computable, general equilibrium model of overlapping generations.

One of the main features of this chapter is to model medical expenditures implied by the existing public health insurance scheme, thus extending the literature that uses computable overlapping generations models in a general equilibrium context to evaluate possible government policies (for example, Kawade et al., 2005; Kato, 2002a, 2002b).

As has been pointed out in several papers (for example, Iwamoto, 2004; Tokita, 2002), Japan’s rapidly aging population will result in a steady increase in national medical expenditure under the current public health insurance, as well as in a rapid increase in the contribution rate to the present pay-as-you-go public pension scheme, if these systems are maintained. From the point of view of an individual, the implications of an aging population would be far-reaching: with public health care benefits to people over 70 years of age more than four times those for other cohorts, health insurance premia are bound to increase as society gets older. Technological progress in medical sciences will further increase national health spending with an aging population.

All data used in this chapter have been based on the System of National Accounts (SNA). Some data were obtained from other sources, but they have been adjusted to be consistent with the SNA methodology. Outstanding government debts and the net asset position of the public pension fund have been taken from the SNA. The public pension fund is considered separately from outstanding government debts, and in this sense government deficits are given in gross terms here.1

Broda and Weinstein (2004) explored the Japanese government deficits in net terms by consolidating the general account and the social security account. In the actual Japanese budget system, apart from certain transfers from a general government account to the public pension account, the general government account and the public pension account are financed separately, and the budget of each is fundamentally independent. In particular, the government is not allowed to pay its outstanding debts back by drawing down the accumulated assets in the public pension fund without a political agreement on the consolidation of the two budgetary accounts. Under the current budget system, a discussion based on net aggregates would distort the evaluation of current and future government policies. In fact, treatment of both accounts on a consolidated basis, or a discussion based on aggregates in net terms, would not reflect the actual system. For this reason, the gross value of the outstanding stock of government debt is used in this chapter. 2

This chapter also differs from Broda and Weinstein (2004) in the following important respect: it incorporates the optimizing behavior of individual agents within an intertemporal general equilibrium framework, opening the door to several channels for the determination of key variables. In particular, the interest rate and GDP are endogenously determined through the optimal behavior of each agent.

As regards population projections, the latest version of Projection of Future Population in Japan has been used in our simulation under the assumption that fertility and mortality rates are constant from 2100 onward, allowing the future population to gradually converges to a new steady state.

Since the future age structure of the population affects savings at an aggregate level, endogeneity of the interest rate in the capital market—and of GDP in the goods market, given a conventional aggregate production function—is crucial. The interest rate is endogenously determined in the capital market, where outstanding government bonds, a public pension fund, and aggregated private savings are all taken into account consistently.

Endogeneity of GDP also plays an important role, since the rapid, prospective demographic changes in Japan obviously affect the labor force and aggregated savings. A change in aggregate savings affects private capital in the capital market and the endogeneity of the interest rate and GDP can capture this effect. Japan will experience not only rapid population aging but also a reduction in the total population. If the future government deficits arising to this unprecedented demographic change are anticipated, then the optimal response of each agent in relevant markets needs to be considered to assess the overall impact on the economy.

Technological progress of private production also plays an important role. A 1 percent difference in the annual rate of technological progress results in a substantial difference in future GDP over the relevant horizon, as pointed out by Kato (2002d). This author showed that a 0.5 percent reduction in the growth rate of technological progress over 40 years gave rise to an 8.4 percent fall in per capita income in a new steady state, and a 1 percent reduction caused an 18.3 percent fall in per steady-state capita income. Since the gap between the real interest rate and real GDP growth obviously impinges on the evaluation of future deficit policies, careful attention needs to be paid to the underlying assumption about the rate of technological progress. As will be described later, technological progress in Japan (as measured by the Solow residual) has been around zero percent in the past two decades.3 Accordingly, the rate of technological progress in our benchmark simulation is assumed to be zero. Although the zero assumption on technical progress reflects Japan’s experience of the last two decades, its validity going forward remains a matter of speculation. Thus, for completeness of analysis, alternative cases with a 0.5 percent as well as a 1.0 percent rate of technological progress will also be explored in our simulations.

The gap between the interest rate and the growth rate in this chapter is much bigger than that in Broda and Weinstein (2004), which results in different assessments of the sustainability of the debt dynamics—theirs is optimistic and ours is pessimistic.

The main results in this chapter are as follows: the tax burden (that is, the taxes-to-GDP ratio) will increase to about 36 percent, and the social security burden (the ratio of social contributions to GDP) will increase to 23.3 percent by 2050, even though the government tries to have a primary surplus by 2010. Note that all ratios in this chapter are relative to GDP, and the above figures do not coincide with the figures usually defined with reference to national income. If the ratios from our simulations are recalculated on the basis of national income, they become larger. However, the result that high burdens on future generations cannot be avoided does not change, since the difference between the values in the conventional definition and those in our definition does not affect materially the debt dynamics.

The national burden in terms of GDP, defined by the sum of the tax burden and the social security burden, will be around 59 percent in 2050, in the benchmark case. By contrast, the national burden ratio in terms of national income will have to be around 80 percent in 2050. Our striking result is that if the government aims for a primary surplus by 2010, then the future burden will be very high, implying that the current fiscal situation facing the Japanese government is very dangerous. If the government delays fiscal adjustment, the situation worsens as mounting interest payments on the ballooning stock of debt destabilize further the evolution of debt-to-GDP ratio.

Future high debt burdens owe much to future GDP decreases due to a substantial contraction in labor force and an assumed zero rate of technological progress.

Another striking result in this chapter is that future technological progress will result in higher future tax burdens, although future GDP will increase. In our simulation a prospective acceleration of technological progress results in an increase in the future equilibrium interest rate, thus inducing an increase in the future consumption tax rate to finance larger interest payments on government debts. The gap between the interest rate and GDP growth rate becomes bigger, rather than smaller.

An aging population will result in an increase in the total amount of the public pension benefits as well as the total amount of the public health insurance benefits, even though per capita benefits are fixed at the 2002 level indefinitely, under the scheme currently in force. The ratio of public health insurance benefits to GDP is expected to increase by 1 percent every ten years, and the ratio will be around 9.6 percent by 2050. The 2004 public pension reform will successfully result in a 13 point decrease in the contribution rate from 36.44 percent to 23.5 percent, and reduce the social security burden by 8 points from 23.3 percent to 15.0 percent in 2050, compared with the benchmark case.

The sustainability problem

The largest sustainable debt

Japan is suffering from large government deficits. This is mostly due to a slowdown of economic growth in recent years. When national income does not grow much, tax revenue will not increase either. On the contrary, public spending and transfer payments have been gradually raised as a result of political pressure by interest groups, resulting in persistently large budget deficits. Whether Japan’s fiscal policy is sustainable, in the sense of being consistent with the government’s intertemporal budget constraint, has become an important concern.

In order to explore the determinants of the largest amount of per capita debt consistent with competitive equilibrium, b*, consider a simple pure-exchange two-period overlapping generations economy with constant population, a set-up consistent with Ricardian debt neutrality. The growth rate of population, n, is assumed to be zero (see Samuelson, 1958, and Azariadis, 1993, for the building blocks of this framework). The per capita saving function of the younger generation s() is given by

where (ignoring the self-explanatory time-subscripts) r is the interest rate and b is per capita debt. It is assumed that savings are increasing with the rate of interest. Then, from (1) we have

The government budget constraint at time t + 1 is given by

where g is public spending and τ is tax revenues. The primary deficit q is defined as the difference between g and τ. Suppose for simplicity q = 0. Then, substituting (2) into (3), we get

Figure 3.1 describes equation (4) in the (bt+1,bt) plane. We call this curve the Φ curve. Equation (4) has two stationary solutions. One equilibrium is the origin, and the other lies at the intersection of the 45 degree line with the phase line of equation (4), the O curve. Figure 3.1(a) represents the Samuelson case and Figure 3.1(b) describes the classical case.

Figure 3.1(a)The Samuelson case

Figure 3.1(b)The classical case

Let us run a primary budget deficit q0 = b0 > 0 per capita at the beginning of time and preserve primary budget balance (qt= 0) thereafter. How big can the initial debt be? Figure 3.1(a) shows that in the Samuelson case b0 cannot exceed s(n), the golden rule stock of per capita public debt, which is associated with point A. Figure 3.1(b) shows that in the classical case b0 cannot exceed zero. Hence, the largest amount of per capita public debt that is consistent with competitive equilibrium b* is either zero or s(n), whichever is greater, b* = Max[0, s(n)]. As shown in Azariadis (1993), when the primary deficit q increases, b* will be reduced.

If b0 > s(n), the interest rate needed to induce households to hold b0 would exceed the growth rate n in each period. National debt would grow faster than the economy, with debt service surpassing in finite time the maximal flow of saving which the household sector is capable of generating. The government debts will not be willingly held by the household any more and the government goes bankrupt.

Example

Identical households have the following utility function

where c1i is the first-period consumption of generation i and c2i is the second-period consumption of generation i. The endowment vector is (e1,e2), where the second-period endowment e2 is smaller than the first-period endowment e1.

Fiscal policy is described by the vector (g,τ12), where g is per capita government spending, τ1 is lump sum taxes levied on the young in the first period, and τ2 is lump sum taxes levied on the old in the second period of an agent’s life. Assuming for simplicity that the primary deficit q is zero, the government budget constraint is given by

or

It is assumed that τ1 < e1, g < e2; and beginning-of-time national debt b0 is zero.

The lifetime budget constraint of the representative household is

which implies a savings function of the form

Considering (7), the equilibrium sequence of national debt must then satisfy the equation

Stationary solutions are b=0at1+r=(e2τ2)(e1τ1)andb=[e1τ1(e2τ2)]2atr=0. The latter is an asymptotically unstable equilibrium if e1τ1 > e2τ2. The largest sustainable value of public debt b* is hence given by

Equation (11) implies that b* is increasing with the first-period disposable income (e1 -τ1) and is decreasing with the second-period disposable income (e2- τ2). An increase in τ1 with a decrease in τ2 means an intergenerational transfer from young to old. Thus from (11) we can say that the higher the intergenerational transfer from young to old, the smaller the amount of b*.

Given public consumption g per capita, the largest sustainable value of public debt per capita is attained if τ1 is as small as possible, that is, at τ1 = 0, τ2 = g. Then, the largest amount of per capita deficit is

which is positive when e1+ g > e2.

Sustainability and policy implication

As shown later, the higher the primary surplus, the propensity to save, the growth rate, or the intergenerational transfer from old to young, the more likely the sustainability problem will be alleviated. Put differently, lower growth and saving or higher public spending and intergenerational transfer payments would contribute to an increase in the primary deficit, and higher pressure on sustainability.

As explained in Ihori and Sato (2002), the fiscal deficits of the 1980s have been reduced. The adjustment has relied on cuts in public spending to a great extent in the first half of 1980s, and higher taxes in the second half of 1980s. In the 1990s Japan experienced again a rapid increase in fiscal deficits. In the 2000s so far, an increase in transfer payments due to aging (or a decrease in net tax revenues) has contributed to higher primary deficits. Going forward, it will be very important to restrain this trend in transfer payments.

There have been a few analyses of the sustainability of government debt in Japan. So long as we use the data until 1990, it seems that the government debt has been on a sustainable path. However, as explained in Ihori and Sato (2002), among others, deficits have increased rapidly since 1990 and the present fiscal system may not be sustainable in the long run.

Ihori et al. (2002) attempted a standard approach to test the fiscal sustainability condition, using the methodology of Hamilton and Flavin (1986). They conducted an empirical analysis of the Japanese fiscal data for the period 1957-99. To conduct the test, the values for the nominal growth rate, n, and the nominal interest rate, r, must be specified. Their strategy was to set various values for r- n and to check whether the results were sensitive to the values chosen. The estimated results imply that the null hypothesis of sustainable public finances cannot be rejected at a 5 percent significance level, suggesting that government solvency was not a serious problem until FY 1996. By contrast, the calculations for the period 1957-97 reject the null hypothesis when r - n is above 0.05, and the results for the period 1957-98 and the period 1957-99 also reject the null hypothesis when r- n is above 0.04.

Bohn (1998) showed that a positive relationship between the primary surplus and changes in the public debt in the U.S. suggests that U.S. fiscal policy is satisfying an intertemporal budget constraint. Japan’s case raises two questions in terms of Bonn’s theoretical framework. First, the Japanese primary surplus has been apparently a decreasing function of the debt/GDP ratio since 1990, and hence it does not satisfy Bohn’s test (see Figure 3.2). Furthermore, Doi and Ihori (2003) showed that the Japanese government debt does not satisfy a transversality condition for the period FY 1965-2000.

Figure 3.2Primary surplus and government debt (% GDP)

These observations indicate that fiscal sustainability is a serious issue for Japan. The longer the sample period, the more likely a fiscal crisis is. To recap: first, the Japanese primary surplus is apparently a decreasing function of the debt/GDP ratio since 1990 and hence it does not satisfy Bohn’s test. Second, the rate of interest has been greater than the growth rate in Japan in the 1990s. It follows that a further expansion of social security spending will cause a debt crisis in the near future. Thus Japan has two serious difficulties in terms of the sustainability of its fiscal position. It will be critical to reduce the government deficit in the near future to address the issue.

The path of fiscal consolidation

Japan must now move quickly to put its fiscal house in order. Government bonds now sell at a low interest rate despite the huge fiscal deficit. This means that investors are optimistic about the future of Japan’s fiscal system. They consider a collapse of public finance unlikely. Such investor confidence reflects the fact that the overall tax burden as a percentage of national income remains relatively low. Investors therefore believe that the Japanese economy can withstand further tax increases as stressed by Broda and Weinstein (2004).

However, if the expansionary trend in government spending continues at the current pace, the fiscal deficit will expand further and the ability to raise taxes in the future will be politically limited. Investors will lose confidence in Japan’s public bonds if they believe that the nation’s public finance is bound for long-term crisis. The result is that interest rates will rise sharply as market sentiment deteriorates, and a fiscal crisis will become a more tangible reality.

Another concern is what happens when a large debt stock accumulates over time, even if a fiscal crisis is averted. Public finance will not collapse as the debt grows, unless the ratio of debt to GDP also increases. But as the debt ratio rises, private investment may be crowded out. Public borrowing—the fiscal deficit—would cut into private sector savings and private investment. If the government’s borrowing is squandered on wasteful public works projects, private investment could be restricted even more. Japan’s long-term economic prospects would dim as growth is undermined, even if the deficit is sustainable and a fiscal collapse is averted.

It is thus critical to promote fiscal consolidation in two ways. The first is by revamping the fiscal system drastically. The following changes are needed:

  1. introduction of a taxpayer-identification numbering system and other useful measures to correct horizontal inequalities in the tax burden

  2. overhauling the project evaluation system to eliminate wasteful public works programs

  3. streamlining the revenue-sharing system (the so-called local allocation tax) that is creating “moral hazards” on the part of local governments

  4. streamlining the “pay-as-you-go” pension and health insurance system that now taps contributions by the young to pay the elderly and thus is spreading a sense of mistrust among young contributors.

The current Koizumi administration, seeking to enhance both efficiency and transparency, has taken steps to reduce costs and utilize cost-benefit analysis as well as adopt a new reassessment system for public projects. These changes are desirable but the pace of structural reform could be faster. Confidence in fiscal management could be enhanced by implementing these and other structural reforms intensively over the next three years or so. Further determined efforts are needed to reform public spending and taxation in a more efficient way. A successful outcome of fiscal consolidation may increase overall political support for drastic fiscal reforms.

The other way to promote fiscal reform is to reduce the massive deficit. Needless to say, it is not rational to give top priority to deficit reduction in isolation. Even so, deficit reduction is still an important policy objective, given the nation’s deteriorating fiscal health. The question is how long it should take to reduce the deficit. Considering the problems that could arise from delays, a consolidation program should be implemented as soon as possible, just as should the reform of the fiscal system.

We now consider the long-run macroeconomic effects of deficit reduction, using a computable overlapping generations model.

The model

The following simulation section employs a multi-period overlapping generations model developed by Auerbach and Kotlikoff (1983). Taxes, a public pension scheme, and a public health insurance scheme are also incorporated into the basic model, to reflect institutional features of the existing Japanese system. The economy in the model consists of a household, a firm, and a government sector. Only one good is considered for simplicity.

The representative household is assumed to optimize its intertemporal consumption through its lifetime, taking the wage rate, the interest rate, and its own survival rates as given. The tax system, the public pension scheme, and the public health insurance scheme are also assumed to be taken as given by the household. The household is assumed to obtain its wage by supplying labor inelastically until it retires, and once it retires it never returns to the labor market. There are no altruistic bequest motives and Ricardian equivalence does not hold.

The firm is assumed to maximize its profits, taking the wage rate and the interest rate as given. The wage rate and the interest rate are determined in each factor market by their market-clearing condition.

The government sector is assumed to collect taxes from the household, and also to issue government bonds in order to finance its consumption and its transfers to a social security system. The government sector is also assumed to run a pay-as-you-go public pension scheme and a public health insurance scheme. The government is assumed to accumulate a public pension fund out of the contributions collected from working generations. This assumption is consistent with the working of the Japanese public pension scheme at present.

It is assumed that there is no private life insurance, and thus there is no mechanism for the household to hedge against the risk of dying in each period. Since the household is assumed to have no bequest motives, this assumption implies that the household leaves an accidental bequest when it dies. However, it is also assumed that there is no uncertainty in the whole economy in terms of the size of each generation, and thus there is no uncertainty in the total (aggregate) amount of bequests inherited in each period.

The household

The household appears in the economy at age 20 as a decision maker. Although in each period the household will face the risk of dying, death will occur for certain at 99 years of age if it works until that age. Denoting the conditional survival rate of the j + 20 generation to age j + 21 by qi,j+1,j the unconditional survival rate to age s + 20 of generation i is given by

The survival risk is assumed to be idiosyncratic, and there is no uncertainty in the aggregate population in each period. Each qi,j+1,j, is calculated from the life table in Population Projections for Japan: 2001-2050 by the National Institute of Population and Social Security Research.

The household is assumed to maximize its expected lifetime utility with respect to its own consumption. The household’s expected lifetime utility of generation i is given by 4

where ci,s is consumption at age s, and δ is the time discount rate. U(ci,s;mi,s), the instantaneous utility function, is assumed to be a CRRA type such that

where ρ is the index of relative risk aversion, mi,s represents a subsistence level of consumption at age s, and it is the minimum level of consumption at which the household can be “healthy” in the sense that it can only enjoy its consumption in excess of mi,s. But the net amount of consumption over mi,s gives utility to the household. Consumption of medical services is not considered explicitly here, but mi,s can be interpreted as the amount of medical expenditure measured in consumption goods to be spent in order for the household to be healthy at each age. 5 Note also that the household only chooses its consumption, taking mi,s as given, but mi,s differs according to its age, reflecting the fact that it would be more expensive to be healthy as age advances.

The budget constraint of the s-year-old household of generation i at time t is given by

where ai,s denotes the initial level of its assets of generation i at period t, rt denotes the interest rate, and ei,s denotes a measure of effective labor. Effective labor differs according to s, the household’s age, which is equal to t - i. 6 The household supplies labor inelastically, for simplicity. wt is the wage rate per efficiency unit of labor, and wtei,s. is pre-tax labor income. All taxes considered in this chapter are proportional. τy,t τr,t and τc,t denote the wage income tax rate, the interest income tax rate, and the consumption tax rate, respectively. The contribution rate to a social security system is denoted by τp,t The social security system consists of a public pension scheme as well as a public health insurance scheme, and the total contribution collected is divided into the two schemes. psi,s and (1 - cpi,s)mi,s represent public pension benefits and public medical insurance benefits, respectively.

The values of both benefits in the simulation are based on calculations from actual data. cps,t is the self-payment rate of the public health insurance, and its value in the simulation is set so as to reflect real institutional aspects. An ex post moral hazard problem of medical insurance is not considered in this chapter. Denoting the age when the household starts obtaining pension benefits by R, and the replacement rate by βp, the amount of pension benefits is given by

where Ht, the annual amount of the average compensation, is given by

where R + 20 denotes the household’s retirement age. It is assumed that the household contributes to a public pension scheme from age 20 to age 64. It is assumed that there is no private pension market.7

The amount of medical expenditure measured in consumption goods, represented by mi,s depends on age s and period t, and it is given exogenously. As pointed out by several authors (for example, Reinhardt, 2000), the amount of real per capita health expenditure plotted by age shows a U-shaped pattern, and mi,s is assumed to be U-shaped in this chapter. Thus the total amount of public medical insurance benefits increases as the population ages. As implicit in (13), the public medical insurance benefits to keep the household healthy are given as money payments here.

The amount of savings of the household which dies is left as an accidental bequest. This accidental bequest is assumed to be redistributed to the household which survives in period t and is denoted by bi,s. It is assumed throughout this chapter that the household in all generations which survive obtains an equal amount of the accidental bequest in each period.8

The first order necessary conditions yield the Euler equation such that

from which the optimal consumption path can be derived once the initial value of the household’s consumption is given.

A liquidity constraint is not taken into account in this chapter. Thus the household can borrow when it is relatively young. As will be studied later, a decrease in its disposable wage income due to an increase in contributions to the social security scheme makes the household have negative savings at an early lifetime stage. In reality, there are several opportunities to borrow money, making the absence of a liquidity constraint in this chapter not altogether unrealistic.

The firm

The firm is assumed to maximize its profits, taking the wage rate and the interest rate as given. The wage rate and the interest rate are determined in perfectly competitive factor markets by the equilibrium conditions. The aggregate private production function is assumed to be Cobb-Douglas such that

where Yt represents aggregate output at time t, Kt the aggregate private capital stock, Lt aggregate labor supply measured by effective labor unit. Aproc,t represents technology of production of the private sector. Assuming that each factor market is perfectly competitive with the above aggregate production function, output is fully distributed to labor and capital. The first order necessary conditions yield

where δk denotes the depreciation rate for the capital stock. Substituting (17a) and (17b) into (16) yields

The government sector

The government sector consists of a general account and a social security account.

Expenditure of the general account includes general government expenditure and transfers to a social security account. The expenditure of the general account is financed by taxation and by issuing government bonds. The general government expenditure includes government consumption, government investment, interest payments on the national debt, and transfers to the household. Note that these transfers to the household are different from the transfers to the social security account.

The social security account consists of a public pension account and a public health insurance account. The amount of transfers to the social security account from the general account is characterized by ηt, which is the ratio of the amount of transfers to the total amount of social security benefits. The government sector is assumed to have no particular objective function which it maximizes.

The budget constraint of the general account is

where BONDt, GRt, and GEt denote the amount of outstanding government bonds, the total tax revenue, and the total general government expenditure, respectively. TG_BONDt is the target level of outstanding government bonds. Transfers to the public pension account are denoted by ηtBt, where Bt is total social security benefits. τr,t, τy,t, τc,t, and τh,t denote the capital income tax rate, the labor income tax rate, the consumption tax rate, and the inheritance tax rate, respectively. In the following simulations only the consumption tax rate is endogenously determined to finance future budgetary imbalances, and all other tax rates are exogenously fixed at the 2002 values. CGt denotes government consumption. The amount of bequests is represented by BQt, and Kt is the private capital stock.

The social security account consists of the public pension account and the public health insurance account. The budget constraint of the social security account and the contribution rate are defined as

where Ft is an accumulated public pension fund at the end of period t. Bt and Pt denote the total amount of benefits and the total amount of the contributions. The total amount of benefits includes the public pension benefits and the public medical insurance benefits. The contribution rate is determined endogenously in order to satisfy (20) with the target level of the public pension fund, F*t+1, which is given exogenously in each scenario.

Market equilibrium

The equilibrium condition of the capital market in period t is that the total amount of savings of the household (At) plus the total amount of the public pension fund (Ft) are equal to the private capital stock plus the total amount of outstanding government bonds, such that

At + Ft = Kt + BONDt

The equilibrium condition of the goods market is that aggregate output is equal to the sum of private consumption (Ct), private investment (Kt+1 - (1 - δk)Kt) and government expenditure (GEt), which is

Yt = Ct + (Kt+1 − (1 − δk)Kt) + GEt

Data and assumptions

The purpose of this chapter is to examine the long-run macroeconomic effects of future demographic changes and government debt policy numerically, taking into account the main features of the existing public pension scheme and national medical expenditure implied by the current public health insurance system.

In order to make our simulations as realistic as possible, available actual as well as projected data have been used together with estimated values of relevant parameters based on empirical research. The key elements of this exercise are: demography, the government’s deficits policy, a social security scheme (comprised of the public pension scheme and the public health insurance scheme), and the tax structure.

Demography

Actual population data have been used from 1965 to 2000. Before 1965 population data were calculated backward from the 1965 population data under the assumption that the fertility rate and the mortality rate were the same as in 1965. Regarding population projections, the latest edition of Projection of Future Population in Japan (Shourai-Jinko-Suikei, 2002) have been used in our simulation. Life tables in Kanzen-Seimeihyo and NIPSSR (2002) were used to obtain survival rates. Since Projection of Future Population in Japan gives estimates of the future population only until 2100, it has been assumed in our simulation that the number of births and deaths, and the survival rates after 2100 are fixed at the same levels as those in 2100. Figure 3.3 shows demographic changes based on three different scenarios reported in Projection of Future Population in Japan. In our benchmark simulation, the “medium variant” projection has been used.

Figure 3.3Aging rates

Government deficits

Actual data through 2002 from the SNA have been used in our simulations. From 2003 on, the future sequence of government deficits have been given based on the following assumptions. Initially, the deficit keeps decreasing by 0.5 percentage points from 6.57 percent of GDP, the actual ratio of the change in the outstanding government debt to GDP in 2002, until 2013. From 2014 onwards, the growth rate of the outstanding debt stock as a share of GDP keeps decreasing but by 0.1 percent until 2023. Then the ratio of outstanding government debts to GDP has been assumed to be constant thereafter. Under these assumptions the debt-to-GDP ratio converges to a new steady-state level, which is 176 percent in the benchmark case as shown in Table 3.1. Note that the actual gross level of the debt-to-GDP ratio in 2002 is 114.30 percent. Two more cases regarding the evolution of the debt ratios will be discussed later.

Table 3.1.Base simulation results
YearBonds outstanding (GDP ratio)GDP growth rate (%), nPrimary balance (GDP ratio)Tax burden (GDP ratio)Social security burden (GDP ratio)Social security contribution rate (%)Public pension benefit (GDP ratio)Health insurance benefit (GDP ratio)Interest rate (%), rn-r
Actual
20021.140.05-8.4815.629.6918.577.755.89
Simulation results
20031.210.73-3.3021.149.6515.1210.165.063.94-3.20
20051.340.40-2.4322.2110.1815.9410.735.213.59-3.19
20101.600.040.4325.7011.9518.7112.535.672.89-2.85
20151.71-0.603.4629.6214.2422.3015.206.212.29-2.89
20201.75-0.574.6331.3515.8224.7816.746.702.05-2.63
20251.75-0.734.7231.7516.6026.0117.427.141.95-2.68
20301.75-1.115.1932.6217.5327.4518.377.621.83-2.93
20351.75-1.425.5533.5418.9129.6219.878.161.70-3.12
20401.75-1.595.7234.5421.0232.9322.358.661.62-3.22
20451.75-1.495.7835.1522.4235.1323.859.121.76-3.26
20501.75-1.466.2035.9323.2736.4424.689.592.03-3.49
Note: the security contribution rate is defined as the ratio of the total amount of social security contributions to the total of wage income.

Social security system

The social security system in this chapter consists of two schemes: the public pension scheme and the public health insurance scheme.

Actual data until 2002 have been used for both the public pension and the public health insurance schemes. In terms of the contribution rate, the actual data have also been used until 2002. From 2003 on, the total amount contributed to the social security has been assumed to be used to finance both schemes. In Japan’s actual system, the public pension contribution (the long-term contribution) and the public health insurance contribution (the short-term contribution) are typically collected together as the social insurance contribution. The contribution rate has been calibrated in order to satisfy (20), where the target level of the pension fund is exogenously given.

βp, the replacement rate, has been calculated from the SNA, and the actual values have been taken until 2002. From 2003 on, the ratio has been assumed to be fixed at the same rate as in 2002, which is 54 percent.

An aging population affects the endogenous determination of the contribution rate through two channels. One is through the pay-as-you-go public pension scheme. The amount of per capita benefits is determined by (14) and (15), and if the current scheme does not change in the future, then an aging population should increase the contribution rate in order to maintain the same amount of per capita benefits. Another channel is through the public health insurance scheme. mi,s, medical expenditure, has been assumed to be U-shaped in this chapter. Thus, even though the shape of a medical expenditure pattern will not change in the future, an aging population increases medical expenditure through an increase in the relative number of an older people, which collectively are a more expensive group than other groups in the populations. Figure 3.4 shows actual and simulated data of social security burden ratios (contributions in percent of GDP).

Figure 3.4Ratios to GDP

Public pension scheme

The public pension scheme has been assumed as that of 2002 in a benchmark case, in a sense that it provides the same amount of per capita benefits in the future. The actual data until 2002 have been used in our simulations. In terms of the size of the public pension fund, actual data until 2002 have been used. From 2003 on, the size of the fund has been assumed to be the same as that of 2002, in the benchmark case. Furthermore, the effect of the public pension reform of 2004 has been investigated. A detailed explanation of the reform will be given later. The calculated future contribution rate and public pension benefits are given in Table 3.1.

Public health insurance

Actual data until 2002 have been used for the simulations. Based on National Medical Expenditure issued by Japan’s Ministry of Health, Labor, and Welfare, the SNA data have been modified to obtain per capita public health insurance benefits at each age. Until 2002, the actual per capita benefits at each age have been calculated, and they show a U-shaped profile, conditioned on age. From 2003 on, it has been assumed that the U shaped pattern does not change. This implies that mt,s changes with s but not with i from 2003 onwards. However, due to the aging population, the ratio of the public health insurance benefits to GDP increases gradually as shown in Table 3.1.

Taxes

Except for a consumption tax, all taxes (a labor income tax, an interest income tax, and an inheritance tax) have been assumed to be fixed at the 2002 rates. The 2002 tax rates were obtained from the SNA data. Note that the consumption tax is the only indirect tax, and its rate has been calculated from the actual total amount of indirect taxes revenue in the national accounts. Thus the consumption tax rate calculated here does not coincide with the actual rate. Figure 3.4 also shows actual and simulated tax burden ratios (taxes as a share of GDP).

Technological progress

Technological progress of private production plays a very important role. As mentioned earlier, a 1 percent difference in an annual rate of technological progress results in a substantial difference in future GDP. Thus careful attention should be paid to the assumption on technological progress.

In this chapter technological progress is measured by the Solow residual. Following Hayashi and Prescott (2002), the capital share is set at 0.361585 in the estimation. The calculated values of technological progress are given in Figure 3.5. Average values between 1993 and 2002 and between 1983 and 1992 are -0.5 percent and 0.1 percent, respectively. Thus in our benchmark simulations the value of technological progress from 2003 onwards is assumed to be zero in order to reflect the experience of the last two decades. Note that these estimated values have, however, been obtained on the assumption that public capital does not affect any private production. With a positive effect of public capital, these figures might be bigger. Alternative scenarios with positive technological progress are also explored below. The assumption of zero technological progress for the future might be too strong, but it is maintained in this section.

Figure 3.5Technological progress

The values of parameters have been obtained from existing empirical research9 and are summarized as follows:

Values of parameters
δραδkβpη10
-0.012.50.638420.0890.50.2776

Simulation analysis

Benchmark simulation

In the case of the benchmark simulation, the government debt ratio has been assumed to converge to 176 percent in a new steady state. The public pension fund has been assumed to converge to 42.1 percent of GDP. Per capita public pension benefits and per capita medical insurance benefits have been assumed to be fixed at the 2002 rates. The consumption tax rate is determined endogenously to satisfy the budget constraint of the general government account, and the contribution rate is determined endogenously to satisfy the budget constraint of the social security account (comprising the public pension and the public health insurance schemes).

The total amount of the public pension benefits and the total amount of the public health insurance benefits change due to demographic changes even though per capita benefits are constant at the 2002 level. GDP also changes endogenously, and thus the ratios to GDP change, as shown in Table 3.1.

Table 3.1 shows clear differences between our results and those of Broda and Weinstein (2004) in terms of GDP growth rates and interest rates. These authors assumed rate gaps ranging from 0 to 4 percent between the interest rate and the GDP growth rate in their simulations.11 In their paper the GDP growth rates were assumed to be positive. By contrast, our GDP growth rate will be negative from a certain time in the future. Thus in this chapter the gap between the interest rate and the GDP growth rate can be bigger than 4 percent, as shown in the last column of Table 3.1.

As shown in Table 3.1, the GDP growth rate becomes negative from 2015 for two reasons: a rapid decrease in labor force and the zero rate of technological progress.

Tax burdens will increase to nearly 36 percent by 2050 because of the large, debt-destabilizing differential between the GDP growth rate and the interest rate. The high tax burdens are needed to finance interest payments on the outstanding public debt, even though the government tries to maintain a positive primary balance from 2010. Note that the simulated value in 2002 is slightly higher than the actual value. This is because the primary balance in the benchmark simulation is assumed to become positive earlier than in reality. In the benchmark case it has been assumed that the primary balance will be positive by 2010, and the difference in the value of the tax burden between the actual and the simulated one reflects the fact that that it would be difficult to achieve a positive primary balance by 2010 with the current tax level.

The increasing trend in the ratio of public pension benefits to GDP, as well as in the ratio of public health insurance benefits to GDP, can be explained by the aging population, as pointed out by several papers (for example, Takayama and Kitamura, 1999; Dekle, 2002; Broda and Weinstein, 2004). The social security burden ratio will reach 23.3 percent in 2050 if the current system is maintained.

The result of the increasing trend in the public health insurance benefits is in line with existing empirical research. Public health insurance benefits are expected to increase by 1 percent every ten years, and the ratio of public health insurance benefits to GDP will be around 9.6 percent by 2050.

This figure also reappears in the conventional definition, the national income burden ratio. The national income burden ratio is defined as the ratio of taxes to national income, and it will have to be around 80 percent in 2050 in order to prevent a divergent evolution of the debt ratio. Strikingly, our model shows that if the government wants to have a positive primary balance by 2010, then the future tax burden needs to be very high, implying that the current fiscal situation facing the Japanese government is dangerous. If the government postpones the timing to pay back the national debt, then the situation is worse due to compounding of interest payments. If the government targets a 50 percent level for the burden ratio, then our simulations suggest that this level will be reached by 2009 under the national income definition of a tax burden—or by 2030 under the burden definition used here.

Due to the big differential between the GDP growth rate and the interest rate, and Japan’s aging population, the national burden ratio, defined as the sum of taxes and social security contributions as a share of GDP, will increase to around 59 percent by 2050 in this benchmark case.

In terms of distortions arising from high taxation and the public pension scheme, an increase in the contribution rate does not generate distortion in this model since the labor supply is assumed to be exogenous.

However, an increase in overall taxation results in a decrease in disposable income. In particular, a rapid increase in the contribution rate shifts the burden of fiscal adjustment to future generations under the current modified pay-as-you-go public pension scheme, and future generations will be worse off.

An increase in the consumption tax rate in the future makes future goods relatively more expensive, and distorts a lifetime consumption path. It also generates distortions in savings, and in the capital market as well. If the increase in the consumption tax to regain fiscal sustainability induces an increase (a decrease) in private savings, then it results in higher (lower) GDP in the future, and thus future generation will be better (worse) off. Furthermore, an increase in interest payments on the outstanding government debt implies an increase in interest income, and an increase in the consumption tax does necessarily result in a decrease in disposable income.

The increase in the consumption tax and the increase in the pension contribution rate changes the path of savings, and thus the path of key variables such as the interest rate and GDP. Different generations are differently affected in the transition. Thus intergenerational redistribution through the current tax and the public pension scheme should be evaluated based on the utility of different generations. This welfare comparison has been explored by comparing the benchmark case with the following extended cases.

Extensions

The simulation results depend on the underlying assumptions, particularly those regarding the evolution of the outstanding government debt and the population structure. Different scenarios have been explored, as follows.

Outstanding government debts

Two different scenarios for future outstanding government debts have been considered. The benchmark case and two variants (“high” and “low”) are shown in Figure 3.6 The “high” debt scenario would correspond to the current situation in a sense that it seems quite difficult to have a positive primary balance soon. In the “high” debt scenario, the primary balance does not become positive until 2022. As a result, the (gross) debt ratio becomes 450 percent of GDP in the steady state. On the other hand, in the “low” debt scenario, outstanding government debts are paid back at a relatively early stage. The primary balance becomes a surplus by 2006, and the final debt ratio in a steady state is 150 percent. Depending on when the primary balance turns into surplus, the final debt ratio in a steady state differs markedly. The effects of alternative paths for fiscal policy on key variables are summarized in Tables 3.2 to Tables 3.6. In each table, the third/fourth and fifth/sixth columns show the effects of the different policies. The second column shows the benchmark case for ease of reference.

Figure 3.6Primary balance

In the “high” debt policy scenario, the future tax burden ratio is higher than in the benchmark case, and the tax burden ratio will increase beyond 50 percent. Under the “Tow” debt policy, the tax burden ratio is higher than the benchmark case until around 2020, but the lowest tax burden ratio can be achieved eventually.

Welfare comparison

Table 3.7 shows the welfare comparison of two alternative policies relative to the benchmark case. (Note that the year corresponds to the year when a generation becomes 20 years old. So, for instance, the entry for year 2002 reports the welfare of the generation which becomes 20 years old in that year.) A positive (negative) number implies that the generation does (does not) prefer the policy to the benchmark case. As Table 3.7 illustrates, the “high” debt policy is not preferred by all future generations, since the policy postpones the burden of adjustment to them. On the other hand, the “low” debt policy is not preferred by the current generations, since they would have to shoulder the burden of relatively high tax.

Alternative demographic evolutions

The latest issue of Projection of Future Population in Japan (Shourai-Jinko-Suikei, 2002) presents three different scenarios (low, medium and high variants) regarding the future population, as shown in Figure 3.3. In the benchmark simulation the medium variant estimation has been used. Table 3.2 to Table 3.6 show the effect of alternative demographic assumptions on relevant variables. As expected, different population trajectories affect in the contribution rate and the social security burden ratio.

Table 3.2.Bound outstanding (GDP ratio)
YearBaseDebtPopulationPension
HighLowHighLow
20031.211.221.211.211.211.21
20051.341.371.331.341.341.34
20101.601.811.481.601.601.60
20151.712.301.501.711.711.71
20201.752.821.501.751.751.75
20251.753.341.501.751.751.75
20301.753.801.501.751.751.75
20351.754.181.501.751.751.75
20401.754.441.501.751.751.75
20451.754.501.501.751.751.75
20501.754.501.501.751.751.75
Table 3.3.Primary balance (GDP ratio)
YearBaseDebtPopulationPension
HighLowHighLow
2003-3.30-3.53-3.32-3.30-3.29-4.17
2005-2.43-3.57-0.97-2.43-2.41-3.46
20100.43-3.732.970.430.45-1.02
20153.46-2.454.163.463.471.68
20204.63-1.133.784.634.632.53
20254.721.813.894.694.742.37
20305.196.254.305.145.242.60
20355.5511.004.605.475.622.72
20405.7215.444.755.635.802.66
20455.7819.654.795.705.862.45
20506.2020.945.136.096.312.54
Table 3.4.Tax burden (GDP ratio)
YearBaseDebtPopulationPension
HighLowHighLow
200321.1420.9221.1221.1421.1520.21
200522.2121.0823.6722.2122.2221.07
201025.7021.5628.2425.6925.7023.99
201529.6223.7530.3129.6029.6127.36
202031.3525.6530.4931.3431.3328.55
202531.7528.9330.9131.7031.7628.38
203032.6233.7931.7232.5132.6928.65
203533.5439.1232.5933.3533.7128.83
204034.5444.4033.5634.2234.8828.82
204535.1549.1634.1534.6735.7128.63
205035.9350.8234.8535.2236.8028.77
Table 3.5.Social security burden (GDP ratio)
YearBaseDebtPopulationPension
HighLowHighLow
20039.659.629.669.639.639.82
200510.1810.1310.1810.1510.1510.23
201011.9511.8411.9911.9111.9111.65
201514.2414.0814.2714.1914.1913.43
202015.8215.6215.8415.7615.7714.47
202516.6016.4016.6216.5316.5614.50
203017.5317.3417.5417.3917.5714.57
203518.9118.7518.9218.6119.1514.67
204021.0220.9121.0320.4121.6714.82
204522.4222.3522.4321.3923.6414.94
205023.2723.1823.2821.7325.2215.02
Table 3.6.Social security contribution rate
YearBaseDebtPopulationPension
HighLowHighLow
200315.1215.0615.1315.0915.0815.38
200515.9415.8615.9415.9015.8916.02
201018.7118.5518.7818.6518.6518.25
201522.3022.0522.3622.2322.2321.04
202024.7824.4724.8124.6924.7022.66
202526.0125.6826.0325.8925.9422.72
203027.4527.1527.4727.2427.5222.82
203529.6229.3729.6329.1430.0022.98
204032.9332.7532.9531.9733.9423.22
204535.1335.0035.1433.5037.0323.40
205036.4436.3136.4634.0439.5123.53
Note: The social security contribution rate is defined as the ratio of the total amount of social security contributions to the total amount of wage income.

Welfare comparison

Table 3.7 shows the effect of alternative demographic assumptions on utility. The fourth and fifth columns show the comparison with the benchmark case. Since there are fewer people in the low variant scenario the contribution rate and the social security burden ratio are higher than in the benchmark case (and the medium variant scenario). If the future population is lower than in the benchmark case, then utility is adversely affected, as shown in Table 3.7.

Table 3.7.Deviation from the base case of utility
YearDebtPopulationPension
HighLowHighLow
2003-0.150.050.010.01-1.03
20050.02-0.330.020.01-1.03
20100.60-0.590.040.00-0.99
20150.86-0.130.07-0.03-0.90
20200.730.230.11-0.09-0.65
20250.000.230.19-0.20-0.28
2030-0.960.250.31-0.400.18
2035-2.050.270.49-0.720.77
2040-3.160.300.77-1.201.53
2045-4.330.331.14-1.882.31
2050-4.670.371.61-2.773.07

Public pension reform

As can be seen from Table 3.1 to Table 3.5, a future increase in the contribution rate as well as in the amount of public pension benefits cannot be avoided due to a rapidly aging population, if the current system is maintained. In 2004 the public pension scheme was reformed with the view to trying to limit the contribution rate in an aging Japan. The following points capture the main features of the reformed system. Instead of keeping constant the amount of future benefits, the amount of future contributions are maintained. Actually the contribution rate will be increased through 2017 in order to finance an increase in the total benefits accruing to an aging population. After 2017 the contribution rate is fixed at the 2017 level, and the amount of total benefits will be adjusted in order to finance an increasing amount of total benefit outlays. In order to investigate the effect of the reform, βp, the replacement rate, has been chosen as a control variable to maintain the future contribution rate. In other words, βp has been calibrated so that the endogenously determined contribution rate takes on the values planned in the reform. The effect of the reform is given in the last column in Tables 3.2 to 3.6. A comparison can be made with the second column (the baseline case) in each table. For example, the effect of the reform on the social security burden ratio can be assessed by comparing the second column with the last column of Table 3.5. As shown in Table 3.5, in 2050 the reform will succeed in reducing the social security burden ratio from about 23.3 percent to about 15.0 percent.

Welfare comparison

The impact of the reform on welfare is shown in Table 3.7. The last column gives the comparison with the benchmark case in which the current system is maintained. The 2004 reform tries to reduce the burden of fiscal consolidation on future generations through the public pension scheme. As Table 3.7 shows, the reform is preferred by more future generations.

Positive technological progress 12

Different assumptions on the pace of technological progress produce different simulations results. Kato (2002d) showed that a 0.5 percent reduction in the rate of technological progress for 40 years resulted in an 8.4 percent fall in per capita income in a new steady state, and that a 1.0 percent slowdown produced an 18.3 percent fall in per capita income. It has been assumed so far that the rate of technological progress is fixed at zero over the entire simulation period. However, alternative assumptions in this regard can have far-reaching effects on the evolution of the debt ratio. Thus, although the zero assumption on technological progress reflects Japan’s experience for the last two decades, alternative scenarios with a 0.5 percent as well as a 1.0 percent rate of technological progress are worth exploring to draw out how much different assumptions for the speed of technological advances change simulation results.

Another assumption introduced in this section regards the prospective growth rate of medical expenditure. Available data shows that the annual growth rates of medical expenditure of all cohorts except a cohort between age 0 and 14 are between 0.7 percent and 0.9 percent,13 and thus it is assumed in both cases (0.5 percent and 1 percent technological progress cases) that medical expenditure increases at 1 percent annually in the future. Furthermore, in order to distinguish the effect of increasing medical expenditure from the effect of technological progress, another case is investigated, where technological progress increases at a 1 percent rate with a zero growth rate of medical expenditure.

Tables 3.8 and 3.9 show the effects of alternative paces of technological progress. A comparison between Table Table 3.1 and Tables Table 3.8 and Table 3.9 highlights these effects. As shown in Table 3.8 and Table 3.9, the GDP growth rate is higher the higher the rate of technological progress. Compared to the benchmark case with zero technological progress in Table 3.1, the GDP growth rate would not be negative until 2040 if technological progress increases at 1 percent annually, which is intuitively plausible.

Table 3.8.0.5 percent of annual technological progress and 1 percent of annual increase in medical expenses
YearGDP growth rate (%), nPrimary balance (GDP ratio)Tax burden (GDP ratio)Social security burden (GDP ratio)Social security contribution rate(%)Interest rate (%), rn-r
Simulation results
20031.11-3.0321.459.6315.094.57-3.46
20050.84-2.0122.6810.1615.924.37-3.53
20100.591.1826.5411.9918.773.93-3.34
20150.014.4030.7014.3722.503.48-3.47
20200.095.7232.6316.0425.123.36-3.27
2025-0.025.8833.1516.9226.503.34-3.36
2030-0.386.3934.1017.9628.133.26-3.64
2035-0.686.7735.0919.4730.503.16-3.84
2040-0.856.9736.1821.7234.023.10-3.95
2045-0.747.1136.9223.2536.423.29-4.03
2050-0.717.6037.8324.2237.943.61-4.31
Note The social security contribution (GDP ratio) is defined as the ratio of the total amount of social security contributions to the total amount of wage income.
Table 3.9.1 percent of annual technological progress and 1 percent of annual increase in medical expenses
YearGDP growth rate (%), nPrimary balance (GDP ratio)Tax burden (GDP ratio)Social security burden (GDP ratio)Social security contribution rate (%)Interest rate (%), rn-r
Simulation results
20031.39-2.3322.179.4614.815.48-4.09
20051.19-1.0523.669.9115.525.49-4.30
20101.072.7528.1011.5318.075.45-4.38
20150.586.3732.6113.7221.485.24-4.66
20200.728.0234.8015.1623.745.33-4.61
20250.658.3635.4215.8024.745.46-4.81
20300.338.9836.4016.5725.965.48-5.15
20350.049.4237.3517.8027.875.43-5.39
2040-0.129.7138.4119.7330.905.42-5.54
20450.009.9839.1520.9132.755.70-5.70
20500.0510.6140.0721.5133.696.11-6.07
Note: The social security contribution (GDP ratio) is defined as the ratio of the total amount of social security contributions to the total amount of wage income.

A striking result is that the interest rate is higher the faster technological progress is. The equilibrium interest rate is determined in the capital market by the demand and supply of savings; a higher interest rate can be explained by the following four reasons. The first reason is the effect on the demand side. An increase in technological progress shifts the production function upward, resulting in an increase in demand for private capital. This implies an upward shift of the demand curve in the capital market, inducing an increase in the interest rate.

The other three reasons relate to the effects on the supply side. The second reason is the effect of an expansion of technological progress on income. The increase in income generates a positive income effect, but it does not determine whether or not private savings are stimulated either if goods are normal with the utility function specified here. As long as both current and future consumption are normal goods, the income effect is ambiguous.

The third reason is the effect on the relative price. Since an increase in the interest rate implies a decrease in the relative price of future consumption, it stimulates private savings through the substitution effect.

The fourth reason is related to the third one in the sense that it also concerns the relative price of consumption. An increase in the interest rate results in more interest payments on government debts. This implies a future increase in the consumption tax rate. Since the increase in a future consumption tax rate implies an increase in the relative price of future consumption, the increase in the tax rate results in a decrease in private savings through the substitution effect. Thus an expansion of future technological progress affects both the supply and the demand sides of the capital market in a complicated way. In particular, the overall effect on the supply side cannot be determined, in light of offsetting or ambiguous effects through the above-mentioned channels. In our simulations, an acceleration of technological progress results in an increase in the interest rate. Although the acceleration of technological progress also induces an increase in the GDP growth rate, the higher real interest rate widens the gap between the interest rate and the GDP growth rate, as shown in the last column of Table 3.8 and Table 3.9.

In addition, the amount of current and prospective interest payments increase, requiring an increase in prospective tax burdens, as shown in the fourth column in Table 3.8 and Table 3.9. However, the effect on the social security system is different. There are two effects at play: on the one hand, since the replacement rate is assumed to be constant, an increase in future GDP and future income caused by an acceleration of technological progress results in an increase in the amount of pension benefits after retirement. This effect pushes up the contribution rate of the social security system. On the other hand, an increase in future GDP also has the effect of reducing the contribution rate, since the contribution rate is determined endogenously based on the ratio of the total amount of the aggregated pension benefits to GDP. Table 3.8 shows that the former effect is stronger than the latter when technological progress grows at 0.5 percent, but a 1.0 percent increase in technological progress is large enough in a sense that future contribution rates can be maintained at lower levels, as shown in Table 3.9. Our simulation shows not only that an expansion of future technological progress results in more tax burdens in the future, but also that an insufficient expansion of technological progress results in more stress on the social security system as well.

Table 3.9 and Table 3.10 show the effect of alternative assumption for future medical spending. Lower medical expenditure in the future obviously results in a lower prospective contribution rate, resulting in an increase in future disposable income. The increase in future disposable income weakens the incentive to save for future consumption, and it reduces the amount of aggregated savings. The decrease in savings results in an increase in the interest rate, as shown in Table 3.10, and future tax rates must increase to finance more interest payments, although medical expenditure is lower in the future. Thus, as shown in Table 3.10, future tax burden ratios are relatively higher, even though future contribution rates are lower.

Table 3.10.1 percent of annual technological progress and 0 percent of annual increase in medical expenses
YearGDP growth rate (%), nPrimary balance (GDP ratio)Tax burden (GDP ratio)Social security burden (GDP ratio)Social security contribution rate (%)Interest rate (%), rn-r
Simulation results
20031.33-2.0222.489.3414.625.69-4.36
20051.14-0.6724.019.7015.205.73-4.60
20101.033.2828.5211.1117.405.75-4.72
20150.557.0033.0413.0520.445.58-5.03
20200.708.7035.1914.2422.305.70-5.00
20250.649.0635.7314.6222.915.85-5.21
20300.339.6736.6015.1423.725.87-5.54
20350.0510.0837.4216.1025.225.81-5.77
2040-0.1110.3438.3417.7727.845.79-5.90
20450.0210.5738.9518.7129.306.06-6.04
20500.0711.1639.7319.0629.856.46-6.38
Note The social security contribution (GDP ratio) is defined as the ratio of the total amount of social security contributions to the total amount of wage income.

Summary and conclusions

This chapter has examined the effects of demographic changes and the government debt policy in Japan on economic growth and economic welfare. The analysis relies on a computable general equilibrium model which incorporates salient features of Japan’s current pension and health care systems.

One of the main results is that the tax burden (tax to GDP) will increase up to about 36 percent, and the social security burden (in terms of GDP) will increase up to 23.3 percent by 2050, even though the government tries to have a positive primary balance by 2010.

The national burden in terms GDP, defined by the sum of the tax burden (as a share of GDP) and the social security burden (also as a share of GDP), will be around 59 percent in 2050 in the benchmark case. Comparable figures apply if tax burdens are defined in terms of national income rather than GDP. A striking result is that if the government wants to have a positive primary balance by 2010, then the future burden will need to be very high to safeguard the sustainability of Japan’s fiscal position, implying that the current fiscal situation is very problematic. If the government postpones fiscal adjustment, the situation would be even worse as interest due on an expanding stock of public debt mounts.

An aging population will result in an increase in the total amount of the public pension benefits paid as well as in the total outlays for public health insurance benefits, even though in our simulations per capita benefits are kept constant. The ratio of public health insurance benefits to GDP is expected to increase by 1 percent every ten years, and the ratio will be around 9.6 percent by 2050. The 2004 public pension reform will succeed in reducing the contribution rate from 36.4 percent to 23.3 percent, and in reducing the social security burden ratio to GDP from 23.3 percent to 15.0 percent in 2050, compared with the benchmark case.

Another striking result is that future technological progress will increase future tax burdens, although an expansion of technological progress increases future GDP. In our simulation an expansion of future technological progress results in an increase in the future equilibrium interest rate, thus inducing an increase in the future consumption tax rate to finance ballooning interest payments.

The interest rate is very low at present, but our simulation result shows that if the future interest rate increases due to an expansion of technological progress, or other reasons, then a drastic increase in tax rates cannot be avoided. Japan’s role in the world economy implies that the domestic interest rate cannot indefinitely be below those of other countries in the global economy. In order to explore this effect, our model should be extended to an open economy model. However, an insight can be gained even within our closed economy framework. An extension of the model to incorporate interactions between Japan and other world economies through the capital market will likely result in an increase in the Japanese interest rate in the simulations, exacerbating the fiscal situation and calling for even more fiscal adjustment than the simulations in this chapter suggest.

Different assumptions about the interest rate-growth rate differential ultimately lie at the heart of different assessment of fiscal sustainability. If our simulation results are compared to the actual fiscal situation, our results may seem too pessimistic and unrealistic. However, once the possibility of an increase in the future interest rate is taken into account, our simulation results can be seen in a different light—and the warning they carry will be recognized as realistic and the advice prudent.

Notes

In SNA the figures of governments’ debts are given as net values of central and local governments’ debts, where financial assets owned by governments are taken into account. Since our chapter uses SNA data, financial assets owned by governments are incorporated into our analysis.

Although all discussions in this chapter will refer to gross debt aggregates, the net value of government debt as a share of GDP in 2002 is calculated at around 60 percent, close to the value in Broda and Weinstein (2004). The main reason why our simulation results are much more alarming than theirs comes from a different view on the difference between the interest rate and the economic growth rate, arising particularly from a less optimistic assumption on economic growth.

Our recalculation of the Solow residual does not take into account the effect of public investment on technological progress. An inclusion of this effect would obviously result in a faster technological progress. Kawade et al. (2005) and Kato (2002b, 2002c, 2002d) discuss the effect of public investment on private production.

According to the result by Hayashi (1995), bequest motives are not considered here. Strategic bequest motives (Bernheim and Shoven, 1985) are also not considered. Since there is no uncertainty in wage income in this chapter, a precautionary saving motive for uncertain wage fluctuation is not considered (as discussed in Horioka and Watanabe, 1997).

Some studies include the amount of medical services or of the health stock into utility as a control variable in the OLG models (Johansson, 2000; Bednarek and Pecchenino, 2002). Here, however, as expressed in (12), the amount of medical expenditure has simply been introduced as an exogenous variable in order to avoid having misleading simulation results, since it seems that there has been no consensus yet in the literature regarding the functional form of utility or the values of key parameters. Although a considerable number of empirical studies have been made on “price elasticity” (for example. Manning et al., 1987), and relationships between aggregate medical expenditure and GDP (for example, Gerdtham and Lothgren, 2000), the simplest assumption on the treatment of medical expenditure in the utility function has been made in this chapter.

The profile of effective labor follows Kato (2002a).

See Iwamoto (1990), Iwamoto et al. (1993), or Friedman and Warshawsky (1988, 1990) for models which include the private pension market.

Kato (2002a) assumed that only the generation of age 65 in each period received bequests. Atoda and Kato (1993) discuss the timing of bequests.

See Uemura (2002) for detailed discussions.

It is fixed at this value only from 2003.

The rate gap is the interest rate minus the nominal GDP growth rate.

This section has been added to an earlier version based on detailed comments by Robert Dekle, David Weinstein, and Takatoshi Ito. We would like to thank them for their valuable comments.

The annual growth rate of medical expenditure of the cohort between ages 0 and 14 is 4.3 percent.

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