6. Pension Reform Issues
- Alessandro Zanello, and Daniel Citrin
- Published Date:
- November 2008
Japan has the most rapidly aging population among developed countries. A number of factors contribute to this trend. The Japanese population has the longest life expectancy and one of the lowest birth rates in the world, and immigrants constitute a very small proportion of the population. Japan’s National Institute of Population and Social Security Research (NIPSSR) projects that the nation’s population will decline by half between 2006 and 2100. Over this period the elderly dependency ratio will increase rapidly—based on the NIPSSR projections, for every person above 65 there will be only 1.5 people of working age in 2050 (Figure 6.1).
Figure 6.1Elderly Dependency Ratioa
a Defined as the number of people 65 years or older per 100 people aged 15-64 years.
Source: United Nations 2002 Population Projections, medium projection.
These demographic developments present a serious challenge to long-term fiscal sustainability. A combination of an aging population and relatively generous pension and medical benefits for the elderly has put a strain on social security finances. Social security expenditure has been the fastest growing component of government expenditure over the last decade and will continue outpacing GDP growth in the future. Estimates of the Ministry of Health, Labor, and Welfare (MHLW) suggest that expenditure on social security will increase from 17 percent of GDP in 2004 to about 21 percent of GDP in 2025 (with implementation of the 2004 pension reform) (Figure 6.2).
Figure 6.2Government Expenditure
Source: National Income Accounts, Cabinet Office.
This chapter assesses the financial situation of the public pension system and the effects of the 2004 pension reform. First, it reviews the structure of the pension system and projects its finances over the next 50 years under unchanged policies. Then it assesses the 2004 pension reform. The final section discusses policy issues to consider in choosing further reform options in the upcoming five-year review.
The current pension system
Japan has a pay-as-you-go, defined-benefit, public pension system with comprehensive coverage, supplemented by various private pension plans. The public pension system comprises the Employee Pension Insurance and the National Pension—the two major public pension programs—and a number of small mutual pension plans for public employees. Corporate and personal private pension plans supplement the public pension programs. The public pension system has substantial assets (about 35 percent of GDP), but is run essentially on a pay-as-you-go basis:
The Employee Pension Insurance (EPI) system covers all private sector employees. The contribution rate was 13.58 percent of annual wages when the reformed was launched, shared equally by the employee and the employer. The retirement benefit consists of two parts—a wage-related portion and a flat-rate benefit. The wage-related benefit at retirement is a function of the number of months the employee has made contributions and his average monthly wage over his working life. The current combined benefit for a one-earner family at retirement (the replacement rate) is on average 59.3 percent of income. After retirement, the pension increases in line with the CPI.
The National Pension (NP) is a flat-rate benefit system. Participation is compulsory for everybody between 20 and 60 years of age, and benefits are payable from age 65. The full benefit for a person who has contributed for 40 years is now ¥66,208/month (the benefit is indexed to CPI). There are three categories of insured people. Non-employed and self-employed (“type 1” insured) pay a flat-rate contribution (¥13,300/month in 2004). Those covered under the EPI program (“type 2” insured) receive the NP flat rate benefit in addition to the wage-related benefit. Nonworking spouses of EPI participants (“type 3” insured) receive full NP benefits in their name, without having to make contributions. The contributions to the NP system for “type 2” and “type 3” insured are paid for by employers of EPI participants.1
Public sector employees are covered by different mutual pension schemes, which are similar in structure to the EPI, and are also run by the government.
Most large companies offer private corporate pension plans (Employees’ Pension Funds)—until recently these were mainly defined benefit (DB) plans. The combined assets of such plans were estimated at US$0.6 trillion in 2001 (Clark and Mitchell, 2002). Following a major legislative reform of private pensions in 2001, companies have been allowed to offer defined contribution (DC) plans and new types of DB plans. The funds in DC plans are portable if the worker changes companies. There are two types of DC plans—either fully financed by the employer or fully financed by the employee through pre-tax contributions (employees can join the latter plan if their employer does not provide any corporate pension plan). The annual contribution limits for these plans are very low—only ¥432,000 (about US$4,000) for employer-financed DC plans and ¥180,000 for employee-financed DC plans. Despite an initial positive reaction by the market, the adoption of DC plans has been slow so far.
The limited available data for private corporate pension plans suggest that many of them are seriously underfunded. Underfunding is defined as the gap between the market value of assets and accrued liabilities. Chunhong (2000) and Goldman Sachs (1999) estimated that the total unfunded liabilities of private corporate pension plans were between ¥40 trillion and ¥60 trillion (about 10 percent of GDP) as of 1999. A reform in 2002 made it possible for corporate pension funds to discharge their responsibilities in the management of pension reserves on behalf of the government by returning to it certain funds accumulated in the past (the so called Daiko-Henjo). In part due to this reform, official data provided by the MHLW suggests that the unfunded liabilities of private corporate pension plans have been reduced to ¥11 trillion as of the end of March 2003. Significant underfunding affects the financial health of companies (since they have to provision for the excess liabilities) and can make the transition to new DB or DC plans more difficult.
Japan has already made a number of parametric reforms to its public pension system in the past (see Appendix 6.1). In the first decades after public pensions were introduced, rapid economic growth allowed steady increase of the generosity of the system. However, in the last two decades, slowing population growth necessitated gradual cutbacks in benefits. Since 1986, the regular five-year reviews of the pension system have sought to reduce benefits and raise contributions by increasing the number of years of required contributions, reducing the accrual rate for benefits, changing the indexation method for annual benefits increases, and raising the pension eligibility age.
Despite these reforms, the financial condition of the public pension systems has deteriorated over time. Operating surpluses have narrowed in the last decade and have given way to operating deficits starting in 2001.2 In the 1999 Actuarial Report, the MHLW estimated the present discounted value of all future unfunded liabilities of the EPI system alone at about 90 percent of GDP.
Figure 6.3 presents staff projections of the pension system primary deficits until 2050 under a baseline scenario. The primary deficit is estimated to widen rapidly to reach 5 percent of GDP by the end of the forecast period. The scenario is based on the median 2002 NIPSSR population projections, which assume a gradual increase of the birth rate from 1.32 in 2003 to 1.39 in 2050. Further assumptions include: the EPI benefits replacement rate remains at its current level; the flat-rate pension benefit increases at the rate of inflation; the EPI contribution rate remains at 13.58 percent of salary; and the flat contribution amount grows at the same rate as wages. Government transfers are assumed to cover one-third of the flat-rate pension benefits and all administrative expenses. The macroeconomic assumptions are similar to those used by the MHLW in its forecast (one exception is that the MHLW projects a rise in the labor force participation rate, while this projection assumes unchanged participation rates). GDP is assumed to grow at the same rate as the total wage bill.
Figure 6.3Projected Primary Deficits of the Public Pension System, 2005–50
Note: These projections reflect the combined deficits of the EPI and the NP systems. Main assumptions: median version of the NIPSSR population projections; nominal wage growth of 2 percent; inflation rate of 1 percent; GDP growth is equal to the total wage bill growth. The long-term personal finances forecasting model was provided by Robert Gilligham.
a The scenario prior to reform assumes that benefits remain at their 2003 level, the EPI contribution rate stays at 13.58 percent, the NIP contribution rate grows at the rate of wage increases, and government transfers cover one-third of the flat-rate pension and all administrative expenses.
b The after-reform scenario assumes that average EPI benefits decline to 50.2 percent of salsary by 2023, the EPI contribution rate increases to 18.3 percent and the NP contribution rate increases by 27 percent in real terms by 2017, government transfers cover half of the flat-rate pension plus administrative expenses after 2009.
Source:Data from the MHLW, and IMF staff projections.
Evaluation of the 2004 pension reform
The reform introduced the following changes to the system:
Contribution rates to the EPI will increase from the current level of 13.58 percent to 18.3 percent of salary by 2017. The flat-rate contributions to the NP would increase by 27 percent in real terms over the same period.
The EPI benefits would be gradually reduced until the benefits for a typical one-earner family reach 50.2 percent of income (compared to 59.3 percent at present).3
The government contribution to the NP will increase gradually from one-third to one-half of total benefits by 2009.
The reserves of the pension system will be run down gradually until they reach the level of annual benefits expenditure (the EPI reserves are currently five times the annual benefits expenditure). Based on the MHLW projections, the desired level would be reached by 2100, assuming a nominal return of 3.2 percent.
The reform will help improve the financial soundness of the pension system. IMF staff estimates suggest that the reform will reduce the primary deficit of the pension system to near balance over the next two decades (Figure 6.3, second panel). Deficits will increase again once the reduction in benefits stops, and could reach 2 percent of GDP by 2050 (compared to 5 percent of GDP prior to the reform). Under the pension reform, the accumulated assets of the social security system will be used to cover the deficits until 2100.
However, the projections are especially sensitive to the assumed population growth rate. Population forecasts prior to 2002 always assumed a rapid pick-up in the birth rate, while ex post the birth rate kept declining. That was the main reason for the failure of past reforms to stabilize the finances of the pension system. The 2002 “medium variant’’ of the population projection assumes that the birth rate will increase only marginally to 1.39 by 2050, but this may also prove to be optimistic ex post.4 Using the low population growth variant (projected by the NIPSSR), which assumes that the birth rate declines to 1.1 and then remains stationary, the primary deficit of the pension system would reach 2.5 percent of GDP by 2050 (compared to 2 percent in the baseline scenario). An additional source of uncertainty is the population projection beyond 2050. The official population forecast is very optimistic as it assumes a gradual return to the replacement birth rate of 2.1 percent between 2050 and 2150.
Also, if the investment return on assets is lower than in the baseline forecast, the pension assets could be run down much faster than projected. Based on IMF staff projections, the pension assets will decline to 12 percent of GDP by 2050 in the baseline scenario with an assumed rate of return of 3.2 percent. However, if the rate of return is only 2.5 percent (close to the current yield on 20-year government bonds), assets will be run down completely by 2050 in the absence of further reforms.
The improvement in pension system finances would be achieved at the cost of significant increases in contribution rates and government transfers, which may have negative consequences for economic growth. The increase in contributions and taxes (to finance the transfers) could hurt the labor market and affect economic growth. Faruqee and Mühleisen (2001) simulate the effect of different reform options using a general equilibrium model of Japan’s economy. Their results suggest that in terms of maximizing growth and economic welfare, benefit reductions are preferable to contribution rate increases. (Alesina and others (1998) find that fiscal consolidations relying mostly on cuts in transfers and other current public expenditure have typically been expansionary for Organization for Economic Cooperation and Development (OECD) economies, while those relying mostly on tax increases have been contractionary.)
The increase in government transfers to the NP will improve the finances of the social security system, but will not affect the deficit of the general government as a whole. The increase in transfers would cost the government budget about ½ percent of GDP in the near term and more than 1½ percent of GDP in the longer term. Given the government’s stated objective to reduce the budget deficit and stem the accumulation of public debt over the medium term, and with the fiscal situation already affected by higher age-related medical expenditure, this would represent an additional adjustment burden.5 In addition, the increase in government transfers to a universal, not means-tested pension program may be difficult to justify on either efficiency or equity grounds.
If the assumptions underlying the current projections turn out to be too optimistic, further upward adjustment in the contribution rates or government transfers may be necessary. Alternatively, the benefits floor at 50 percent of average income currently built in the reform will need to be revised. It may not be feasible to guarantee fixed levels both for contribution rates and benefit levels.
The reform has been criticized by some observers as deepening the inter-generational inequality in the rate of return on pension contributions. Nishizawa (2003) estimates that, prior to the reform, the ratio of lifetime benefits to contributions changes from 2.68 for those born in 1940 to 0.61 for those born in 2000 (for a typical one-earner couple). The reform would reduce further returns to contributions, especially for younger generations, since the decline in benefits and increase in contribution rates would take place gradually over time. Therefore, younger generations would have increasing incentives to drop out of the pension system. Indeed, the dropout rate from the National Pension system has risen rapidly over the last few years and is now significantly higher than the government had projected.6 To some extent, intergenerational inequality is unavoidable in a partially funded system with a faster than expected population decline. However, the inequality could be mitigated by having the elder generations share the burden of pension reform, for example through greater cuts in benefits or higher taxation for current retirees.7
Policy issues in selecting reform options
The optimal design of a pension system to a large extent depends on social preferences. The basic role of a public pay-as-you-go pension system is to facilitate intergenerational transfers. The size of the transfers, the extent of redistribution involved, and the weight placed on efficiency versus equity considerations are a matter of public choice. Some countries have opted for large intergenerational transfers, with high replacement rates and significant redistribution (mainly European Union countries). Others have emphasized self-reliance and economic efficiency, with private savings being the main source of retirement income (United Kingdom, Australia, Chile). With replacement rates of 50-60 percent, Japan’s public pension system is more generous than the systems in Anglo-Saxon countries, but less generous than those in many European Union countries.
Nevertheless, there are a number of common principles that guide the design of pension systems and reform options:
The system must be financially sustainable and, ideally, should respect intergenerational fairness. Any deviations from sustain-ability due to changing demographics should be corrected as soon as possible, since delaying reforms increases the size of needed adjustments and the burden on future generations.8 Pension systems which maintain a fixed replacement rate and a fixed retirement age at a time of rapid population aging do not satisfy the principle of intergenerational fairness since each new cohort would receive a lower return to its contributions than the previous cohort (with a constant replacement rate and rising dependency ratio, the contribution rates need to be increased to balance the system).
The design of the system should be guided by efficiency considerations in addition to equity principles. Ideally, the pension system should not discourage labor force participation or in other ways affect economic choices. A strong link between contributions and benefits (an actuarially fair system) is desirable since it minimizes economic distortions.
Some countries have introduced automatic adjustment mechanisms in the pension system to address the uncertainty about future demographic developments. Sweden, for example, has adopted a notional defined contribution (NDC) system with automatic balancing rules. Under such systems, the contribution rates are fixed and benefits are indexed to changes in demographic variables that affect the pension system (for example, the elderly dependency ratio or the labor force). Italy, Germany, and Latvia have either adopted or are considering adopting similar systems. Some academics have advocated the introduction of an NDC system in Japan (Takayama, 2003).9 Its main advantages are that it is rule-based and allows a fast response to changing demographic conditions. The structure of the system allows for a relatively transparent relationship between contributions and benefits, making it incentive-compatible; any redistributive goals are typically addressed outside the system. A potential disadvantage is that the risk of adverse developments is entirely born by the retirees. With a fixed contribution rate, it is possible that the benefits could eventually decline to a very low level, necessitating a change in the system.
The reduction in benefits from the public pension system could be compensated by increased private retirement savings. The reform experiences of other countries suggest that as the role of public pensions in ensuring retirement income declines, the role of private savings plans or corporate pension plans becomes more important.10 Clark and Mitchell (2002) review the U.S. experience and find that changes in the regulatory environment and tax policy have precipitated a rapid growth of private defined contribution plans. Under current regulations, limits on contributions to DC plans are much more restrictive in Japan than in the U.S., and employers and employees cannot both contribute to the same DC plan. Relaxation of such restrictions and greater emphasis on increased accountability and transparency of private pension plans are likely to increase the acceptance of DC plans. The 2004 reform will raise the contribution limits for DC plans by 20 percent.
Labor force participation
The effects of demographic developments on the pension system could be mitigated through an increase in the labor force participation rate or through changes in immigration policies. A number of countries have increased the worker retirement age as part of their pension reforms. The retirement age in the United States, for example, will be gradually raised to 67 years. Policies that encourage greater labor force participation by the elderly and by women could also be effective—in that respect, it is especially important that the structure of the tax system, pensions, and various social programs do not discourage labor force participation. High immigration flows have helped mitigate problems associated with aging populations in some countries, although the desirable rate of immigration depends on social preferences. Dekle (2003) analyzes how increased immigration could affect the labor force, economic growth, and social security spending in Japan. He finds that an annual inflow of 400,000 immigrants between 2005 and 2040 could give a significant boost to growth—by 2040, GDP could be 50 percent higher than in a no-immigration scenario; and social security spending could be lower than otherwise by up to 5 percent of GDP.
The EPI pension system favors one-earner couples, thus discouraging labor force participation of married women (Figure 6.4). People with different family and employment status are entitled to different levels of benefits, given the same contribution rate. One-earner couples participating in the EPI have an advantage over single people and two-earner families, since the dependent spouse is eligible to receive the flat-rate benefit without making contributions. The survivor benefits system also favors one-earner families. The surviving spouse is eligible to receive three-quarters of the earning benefits of the deceased, but if she chooses that option, she should forgo her own pension. Comparing two couples with the same combined lifetime family income, the survivor’s benefits are typically lower for wives in the dual-income couple. These rules decrease the incentives for a nonworking spouse to enter the labor market. Given the projected sharp decline in Japan’s labor force, it may be desirable to reform the pension system, so that it does not discourage labor force participation.
Figure 6.4Labor Force Participation Rate for Females
Source: OECD Employment Outlook (2003).
While Japan already has a relatively high elderly labor participation rate (Figure 6.5), efforts should be made to increase it further, given the projected rapid decline of the labor force in the coming decades. In contrast to many European countries, eligibility for disability and other social programs is rather strict and cannot be used as a way of early retirement. However, under the current system earnings-related benefits are cut by 20 percent for everybody who continues to earn a salary between the ages of 60 and 65, and if the salary earned is above average, pension benefits are gradually reduced, creating some disincentives for continued labor participation. The earnings test is less strict for those aged 65-70. The reform will improve incentives for continued work by abolishing the 20 percent uniform cut in benefits. However, the earnings test will be extended to those above 70, so all elderly with above average employment income will be forgoing at least some of their pension benefit.
Figure 6.5Labor Force Participation Rate for the Elderly, 2001
Sources: Labour Force Survey (2002); ILO Yearbook of Labour Statistics.
Elderly labor force participation is likely to be facilitated by a recently adopted increase in the minimum retirement age. There is no centrally-determined retirement age in Japan, but most individual companies set their own mandatory retirement age, which according to the current labor laws should be at least 60. Under the 2000 pension reform, the eligibility age for EPI benefits will gradually increase to 65. That will leave retired people aged 60-65 with no employment or pension income, at a time when it may be difficult for them to find new employment. To address this issue, the Diet enacted a change in the labor legislation in June 2004, which would gradually raise the minimum retirement age to 65 by 2013. Private companies would still be able to choose whether to retain older workers or rehire them under a new contract. The seniority wage system makes elderly workers relatively expensive, so giving companies some flexibility in offering options for continued employment of aged workers would allow them to control labor costs better.
Summary and conclusions
The government reform will improve the finances of the pension system; however, further adjustments may be necessary if the assumptions underlying the forecast turn out to be too optimistic. Frequent partial adjustments in the past have increased uncertainty and reduced public confidence in the pension system. It could be desirable to introduce an automatic benefits adjustment mechanism that would ensure the sus-tainability of the system and reduce the magnitude of intergenerational redistribution.
The discussion of social security reforms should be made in the context of a broader discussion of fiscal sustainability. Increasing the share of pension benefits financed by general government revenue will improve the social security deficit, but not the deficit of the general government as a whole. The overall tax burden is already expected to rise sharply to cover the steady increase in age-related medical and elderly care expenditure and to reverse the deterioration of the fiscal position. The proposed increase in government transfers and pension contributions would add further to the taxpayers’ burden and may have negative effects on economic growth and welfare.
Declining public pension benefits could be supplemented by higher private retirement savings. Further legislative initiatives to increase the range and flexibility, and improve the oversight of private pension plans in Japan would facilitate the transition to a greater self-reliance in securing retirement income.
Efforts to increase the labor force participation rate could complement other reform options. The intragenerational redistribution built in the current pension system discourages married women’s labor force participation. Given the projected sharp decline in the labor force, it would be important to address this issue in future reforms. Although the elderly labor force participation rate is relatively high, efforts to increase it further would help ensure the financial sustainability of the social security system. Higher immigration is another possible option to mitigate the decline in the labor force.
The first pension system with wide coverage, the Employee Pension Insurance (EPI) system, was introduced in 1942. It was mandatory for all private sector employees and initially the contribution rates and benefits in percent of salary were relatively low. Benefits were increased significantly in 1965 and again in 1973. In 1961, the pension system coverage was broadened to include all people of working age. A flat-rate contribution, flat-rate benefit system—the National Pension (NP)—was introduced for everybody who was not covered under the EPI. The generosity of benefits increased over time for this system as well. Indexation of benefits to gross wages was introduced for both the EPI and the NP in 1973. Since 1986, the two systems were integrated financially—the beneficiaries of the EPI started receiving a flat portion benefit (under the NP) in addition to the wage-related component. Eligibility to receive the flat-rate NP benefit was also extended to nonworking spouses of EPI participants (although they do not make contributions to the system).
As a result of the increasing generosity of benefits, public pension income became the main source of income for many retirees (replacing in importance the traditional lump-sum retirement benefits given by employers). The replacement rate for a “typical” pension recipient (married with nonworking wife) was above 60 percent of salary in the 1980s.
In the 1980s, population growth rates slowed down and economic growth rates also slowed starting in the early 1990s. The last three reforms focused on restoring the long-term financial stability of the pension system through a combination of raising contribution rates and reducing the generosity of benefits:
The 1986 pension reform reduced the accrual rate for the earnings-related component from 1 percent per year to 0.75 percent per year. The number of contribution years required to receive a full NP benefit increased from 25 to 40.
The 1994 pension legislation increased the eligibility age for the flat-rate portion of the EPI benefits from 60 to 65, to be gradually phased in between 2001 and 2013 for men and 2006 and 2018 for women. In addition, benefits indexation was changed from gross to net wages.
The 1999/2000 pension reform introduced a number of significant changes. The accrual rate for the wage-related portion of the EPI was reduced from 0.75 percent to 0.71 percent. The indexation of both the flat-rate and the earnings-related benefit increases were changed to CPI from wages. A new earnings test was introduced that reduced the pension benefits of those still employed in their late 60s. The age at which people start receiving the wage-related portion of the EPI benefit was increased to 65, to be phased in between 2013 and 2025 for men and between 2018 and 2030 for women.
However, these reforms failed to restore financial sustainability of the system, since with each subsequent update of the population projections, it became clear that the demographic shock would be much worse than previously expected.
AlesinaA.R.Perotti and J.Tavares1998 “The Political Economy of Fiscal Adjustments” Brookings Papers on Economic Activity.
Cabinet Office2003 “Annual Report on the Japanese Economy and Public Finance, 2002-2003” JapanOctober.
ChandS. and A.Jaeger1999 “Reform Options for Pay-As-You-Go Public Pension Systems” World BankSocial Protection Discussion Paper Series No. 9927December.
ChunhongC.2000 “An Overview of Japan’s Pension System and Pension Reform” NLI Research InstituteWorking PaperTokyo.
ClarkR. and O.Mitchell2002 “Strengthening Employment-Based Pensions in Japan,” NBER Working Paper 8891April.
DekleR.2003 “Financing Consumption in an Aging Japan: The Role of Foreign Capital Inflows and Immigration” mimeoUniversity of Southern CaliforniaLos AngelesNovember.
FaruqeeH. and M.Mühleisen2001 “Population Aging in Japan: Demographic Shock and Fiscal Sustainability” IMF Working Paper 01/40.
GoldmanSachs1999 “Unfunded Liabilities of Japanese Corporate Pensions” Pension Group Services ReportMay.
Ministry of Health Labor and Welfare (MHLW)1999Actuarial Report.
Ministry of Health Labor and Welfare (MHLW)2002 “Basic Survey of Wage Structure, Direction and Issues Regarding Pension Reform Outline” December.
National Institute of Population and Social Security Research (NIPSSR)2002 “Population Projections for Japan: 2001-2100” TokyoJanuary.
NishizawaK.2003 “Major Reform of the Pension System: Postponement is No Longer Allowed” Nihon Keizai Shimbun-sha.
TakayamaN.1998 “The Morning After in Japan: Its Declining Population, Too Generous Pensions and a Weakened Economy” (Tokyo: Maruzen Co. Ltd.).
Since the EPI contribution is a fixed percent of salary independent of family status, the system effectively results in higher benefits for those with dependent spouses and those with low salaries.
See Cabinet Office (2003, Figure 3-3-12).
The reduction will be achieved through a so-called “macroeconomic indexation.” A macroeconomic index will be defined every year, reflecting the decline in the number of pension system contributors and the increase in life expectancy. MHLW estimates that the average annual change of that index will be about 0.9 percent. The initial level of benefits for new retirees will be a function of their average lifetime wages adjusted for the index, and benefits for existing retirees will increase by CPI inflation minus the change in the macroeconomic index (if that is negative, benefits will remain flat). The indexation will be discontinued in 2025—by that time the replacement rate is expected to be down to 50.2 percent. On a technical note, any temporary increases in the CPI due to upward adjustment in the consumption tax rate ought to be excluded from the index for pension benefit adjustment, although the current law does not specify this.
In fact, actual birth rates have fallen short of projections through 2005.
In addition to rising pension costs, the aging of the population will lead in a sharp rise in age-related medical and elderly care expenditure as well. The projected increase in medical and elderly care-related expenditure over the next 20 years alone is about 5 percent of GDP. The portion of medical costs financed by general taxes revenue will rise significantly as the population ages, since the government finances a large share of the medical care provided to the elderly. Estimates by the MHLW suggest that public subsidies as a share of medical expenditure will rise from about 27 percent in 2002 to 36 percent by year 2025. A reform of the healthcare system was launched in 2005 but the impact on the public finances remains uncertain.
Currently more than 37 percent of “type 1” insured do not make the required NP contributions. Although participation is compulsory, enforcement is rather weak. In addition, part-time workers frequently limit their working hours to stay below the EPI participation threshold (currently 30 hours/week).
Takayama (1998) finds that the average disposable per capita income of retirees after redistribution is higher than the average income of middle-aged workers. This is at least partly due to unequal tax treatment of retirees and active workers. Pension recipients enjoy large pension tax exemptions, in addition to age-related deductions. The tax-free income for pension recipients is almost twice as large as the tax-free income for employees. The 2004 tax reform has partially addressed this problem: the age-related deduction has been abolished and the pension deduction has been reduced.
See Chand and Jaeger (1999) for an overview of different reform options and discussion of the benefits and drawbacks of each option.
The present reform will use an indexation mechanism similar to that used in NDC systems to gradually reduce benefits, but it will stop once the desired benefits floor has been reached.
Proponents of pension privatization point to the fact that, historically, market returns have been on average much above the implicit return of pay-as-you-go systems. However, the risks of a private pension system and the administrative costs are also much higher. Nonetheless, private retirement savings are a useful complement to a less generous public pension system.