A. Demographic Trends

A central feature of Japan’s demographics is a long-run decline in fertility. In the postwar era, the total fertility rate—defined as the number of births per woman—experienced a sharp decline in a single ten-year span, falling from over 3½ births in 1950 to just 2 births in 1960 (top panel of Figure 1). Since that time, the fertility rate has continued its general decline, and now remains well below the replacement rate.³ Population projections generally assume the fertility rate to eventually stabilize and increase towards the replacement rate in order to obtain a stationary population by the middle of the century, but the expected point in time for the recovery to set in has been pushed back with every new projection.

Japan: Demographic Trends

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Takayama (1998); Bos et al. (1994); Ministry of Health and Welfare; and staff estimates.1/ “Birth” rate is defined as the entry of workers into the adult population.

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Japan: Demographic Trends

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Takayama (1998); Bos et al. (1994); Ministry of Health and Welfare; and staff estimates.1/ “Birth” rate is defined as the entry of workers into the adult population.

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Japan: Demographic Trends

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Takayama (1998); Bos et al. (1994); Ministry of Health and Welfare; and staff estimates.1/ “Birth” rate is defined as the entry of workers into the adult population.

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The implication of the dramatic fall in fertility is that, for some time to come, fewer young workers are expected to enter the economy. Redefining “births” as the inflow of new adults into the economy, the middle panel of Figure 1 shows the historical and projected evolution of Japan’s “birth rate” since 1960. As evident in the graph, the inflow of young adults as a share of the adult population has declined significantly over the past 40 years; moreover, even assuming a modest recovery in fertility rate over the next fifty years, the “birth rate” is projected to remain far below its historical levels well into the next century.⁴ This does not assume any population increase due to immigration, which has alleviated demographic pressures elsewhere.

The long-run decline in Japan’s birth rate implies that Japan will have both a declining and an aging population. As seen in Figure 1, the decline in the “birth rate” is associated with a decline in the population growth rate. In fact, fertility rates have already fallen to such an extent that a declining adult population can be expected for much of the 21^st century—a development not anticipated in most industrialized countries. With lower fertility and smaller cohorts of new adults arriving in the future, the relative share of working age people will decline and the population’s average age will increase over time. The bottom panel in Figure 1 shows the dramatic rise in the ratio of Japan’s elderly dependents (age 65 and over) as a share of the adult population, based on the analytical model as well as projections by the Ministry of Health and Welfare.⁵ The sharp decline in fertility is expected to generate a more rapid aging of Japan’s population than in other major industrial countries (Table 1).

Table 1.

Old-Age Dependency Ratios: Comparative Projections¹

Source: United Nations, World Population Prospects,1950–2050, 1996 revisions.

¹Number of elderly (65 years and older) as percent of working age population (20–64 years of age).

Table 1.

Old-Age Dependency Ratios: Comparative Projections¹

	Canada	France	Germany	Italy	U.K.	U.S.	Japan
2000	20	28	25	28	27	21	27
2025	36	41	36	43	36	33	47

Source: United Nations, World Population Prospects,1950–2050, 1996 revisions.

¹Number of elderly (65 years and older) as percent of working age population (20–64 years of age).

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Table 1.

Old-Age Dependency Ratios: Comparative Projections¹

	Canada	France	Germany	Italy	U.K.	U.S.	Japan
2000	20	28	25	28	27	21	27
2025	36	41	36	43	36	33	47

Source: United Nations, World Population Prospects,1950–2050, 1996 revisions.

¹Number of elderly (65 years and older) as percent of working age population (20–64 years of age).

B. The State of Government Finances

As this demographic shock unfolds, Japan will face a substantially greater fiscal challenge than other countries. While most industrial nations have successfully reduced government deficits during the past decade, Japan’s fiscal situation deteriorated dramatically following the government’s efforts to resuscitate the economy during the past decade. Tax revenues receded strongly after the collapse of the asset price bubble in the early 1990s, and expenditures have been driven upward by economic stimulus measures, above all the strong increase in public works spending (Mühleisen 2000a). As a result, the general government deficit has reached an estimated 9 percent of GDP in FY 1999 (excluding the social security surplus), and even if Japan’s cyclical position is taken account of, the structural deficit remains worse than that of other G-7 countries (Table 2).

Table 2.

General Government Finances, 1999

(In percent of GDP)

Sources: IMF World Economic Outlook, April 2000; and staff estimates.

¹Excluding social security.

Table 2.

General Government Finances, 1999

(In percent of GDP)

	Canada	France	Germany	Italy	U.K.	U.S.	Japan
Actual balance	2.8	-1.8	-0.71	-1.9	0.3	0.01	-9.21
Structural balance	3.3	-0.8	-0.71	-0.5	0.1	0.21	-8.11
Net debt	56.7	49.0	52.4	108.8	39.0	50.6	38.1
Net debt, excluding social security	…	…	53.1	…	…	59.1	87.9

Sources: IMF World Economic Outlook, April 2000; and staff estimates.

¹Excluding social security.

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Table 2.

General Government Finances, 1999

(In percent of GDP)

	Canada	France	Germany	Italy	U.K.	U.S.	Japan
Actual balance	2.8	-1.8	-0.71	-1.9	0.3	0.01	-9.21
Structural balance	3.3	-0.8	-0.71	-0.5	0.1	0.21	-8.11
Net debt	56.7	49.0	52.4	108.8	39.0	50.6	38.1
Net debt, excluding social security	…	…	53.1	…	…	59.1	87.9

Sources: IMF World Economic Outlook, April 2000; and staff estimates.

¹Excluding social security.

Although Japan’s net general government debt still appears relatively small (at 40 percent of GDP in 1999), this figure includes assets owned by the social security system—accounting for 50 percent of GDP—which are more than offset by future pension claims. If social security assets are excluded, Japan’s debt situation is considerably worse than that of other industrialized countries. General government debt (excluding social security) has roughly doubled over the past decade, and markets have been concerned that the true level of public debt could be even higher, given the possibility that the government might have to cover contingent liabilities from loan guarantees and losses by public sector enterprises.

How will population aging affect government finances? Given the fact that the government currently finances roughly 20 percent of social security benefits, an increase in pension payments and costs of health services for the elderly will impact directly on the expenditure side, while revenue prospects would be affected by the slower economic growth. Chand and Jaeger (1996) estimated the present value of Japan’s net pension liabilities around 110 percent of GDP, and similar results were obtained by Leibfritz et al. (1995) and Roseveare et al. (1996).⁶ Broadly consistent with these findings, the Ministry of Health and Welfare (based on detailed actuarial assumptions) estimated that the main public pension system would need to raise contribution rates to 1½ times their current level over the next 25 years to remain viable.

Both the size of the current deficit and the demographic outlook indicate that the current fiscal situation is clearly unsustainable and requires strong adjustment measures in coming years. However, the problem for the authorities lies in addressing the fiscal imbalance in a way that will not jeopardize the nascent economic recovery. In 1997, the last attempt at fiscal consolidation had to be abandoned as a rise in the consumption tax rate and a cut in public works spending were among the factors contributing to the renewed economic downturn.

Although factors other than fiscal policy were at work on that occasion, the principle that fiscal consolidation needs to take account of evolving economic and financial conditions—including the robustness of the recovery—remains a valid one.

A. Age-earnings Profile

A key component to the analysis of demographic effects is the nature of the earnings profile over an individual’s lifetime, which typically has a hump-shaped pattern. Initially, as agents join the workforce, they can expect a rising path of earnings, reflecting productivity gains that come from work experience and seniority wages that reward past service. Eventually, labor earnings level off and decline as agents move into retirement. This life-cycle earnings profile is important in determining both supply and demand-side effects of population aging.

On the supply side, age-earnings profiles provide an indicator of the changes in relative productivity and labor supply that occur over an individual’s working life. To the extent that earnings differences are commensurate with differences in labor productivity, the income profile provides a measure of these life-cycle changes in labor supply (measured in efficiency units). Demographics changes in the population’s age-structure can thus affect aggregate labor supply through age differences in relative productivity and individual labor supply.

On the demand side, the anticipated path of labor income influences the saving plans of consumers over their lifetimes. Consumption/saving propensities vary by age as consumers choose to smooth consumption in the face of life-cycle income. Younger agents tend to be net borrowers, reflecting the fact that permanent income exceeds current income (see Jappelli 1990, Attanasio et al. 1995). Mature agents tend to be large net savers at the peak of their earnings potential and in anticipation of retirement. Meanwhile, the elderly—who consume largely out of asset income and transfers—also tend to save (albeit to a lesser degree), reflecting precautionary saving in the face of lifetime uncertainty (see Blanchard 1985, Faruqee and Laxton 2000).⁹ Changes in the demographic structure of the population can thus have important macro-economic implications for aggregate saving, stemming from these various life-cycle channels.

To calibrate the model according to the life-cycle pattern of earnings, empirical age-earnings profiles for Japan are estimated using cross-sectional data on wage-based salaries by age group for the period 1970 to 1997. The data are adjusted by labor force participation rates, reflecting the fact that the share of persons with zero earnings varies across age groups. The earnings profile thus represents the average earnings per person (not per worker) within each age category. The data are shown in Figure 2, normalized relative to per capita labor earnings of the youngest cohort.¹⁰ The relative earnings profiles have been stable over the sample period which suggests that the underlying institutional and structural features that implicitly underpin the variation in relative labor earnings across age groups—such as seniority wages and retirement age—have also been fairly stable historically.

Japan—Age-Earning? Distributions, 1970–1997

(relative to youngest cohort)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Japan Statistical Yearbook and IMF staff estimates

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Japan—Age-Earning? Distributions, 1970–1997

(relative to youngest cohort)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Japan Statistical Yearbook and IMF staff estimates

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Japan—Age-Earning? Distributions, 1970–1997

(relative to youngest cohort)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Sources: Japan Statistical Yearbook and IMF staff estimates

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For further analysis, the cross-sectional pattern between age and earnings that emerges from the data is taken as representative of the time-series pattern of an individual’s wage earnings over the course of his or her lifetime. The profile essentially summarizes the nature and timing of the rise and fall in relative earnings that agents can expect as they become mature workers and then move (gradually) into retirement. For simplicity, it is assumed that this historically stable profile remains unchanged in the face of demographic changes. However, with healthier seniors living longer and pension benefits possibly declining, older workers may decide to postpone retirement. This would tend to flatten the age-earnings profile and, hence, mitigate the economic impact of population aging.

To calibrate an agent’s life-cycle income profile, the following specification is estimated on the age-earnings data:

where ry denotes relative labor income, s and t represent cohort and time indices, respectively, and their difference t - s determines the age of a particular cohort. The restriction on the a_i coefficients reflects the normalization that the youngest cohort (i.e., when s = t) has relative income equal to unity. The exponential form is chosen for analytical tractability of the model, and the specific choice of three exponent terms—allowing for three inflection or turning points—is chosen to provide a reasonable fit of the data. The fitted values of this equation are shown by the solid line in Figure 2.¹¹

The estimated income-profile parameters from equation (1) enter the simulation in two distinct ways. On the supply side, the parameters directly affect the dynamics of aggregate labor supply—measured in efficiency units—since they reflect the relative productivity and labor supply of workers at different ages.¹² On the demand side, since consumption is (partly) based on permanent income, these income-profile parameters also affect consumption-saving plans through their impact on human wealth—i.e., the present value of future labor income streams (see Faruqee (2001)).

B. Pension System

To complete the analytical framework, social security needs to be modeled. An advantage of the multi-cohort approach is that social security transfers can be straightforwardly included. In particular, a pension system can be introduced into the framework as follows. Consider the simple case of a lump-sum transfer scheme:

where tr(s,t) represent the transfers paid or received by individuals, depending on their age relative to retirement age j. Younger generations pay into the system, while older agents or pensioners receive a benefit. For any transfer scheme, a full-financing condition can be written as follows:

where N(s,t) is the size of the cohort indexed by s. This general condition must hold for a transfer scheme to be deemed fully funded (i.e., no unfunded liabilities). In the case of lump-sum transfers, condition (3) requires that:

where ϕ(t) and 1 – ϕ(t) are the shares of elderly dependents and working-age persons in the adult population.¹³ Full-financing requires, as shown by equation (4), the well-known condition that the benefit-to-contribution ratio must equal the support ratio, defined as the number of working-age persons relative to elderly dependents.¹⁴ Otherwise, there would exist a financing gap that would need to be covered through other revenues or government borrowing. The amount of the financing gap is determined by:

A positive gap would indicate a shortfall of financing relative to benefits.

C. Fiscal Accounts

To provide a more detailed analysis of the fiscal accounts, the Multimod framework is further combined with a more-disaggregated fiscal model. Policy assumptions affecting general government and social security finances are first fed into the small fiscal model which—under given macroeconomic assumptions—provides a long-term projection of fiscal accounts.¹⁵ The results of the fiscal model are then fed into Multimod, which produces revised macroeconomic assumptions, and the process is repeated until a reasonable degree of convergence is achieved. However, “convergence” should not be understood in a mathematical sense, since Multimod is already a rather complex framework and adding a fully specified fiscal sector would have made the simulation unwieldy. Therefore, some macro parameters in the fiscal model were simulated independently, although projections for key variables, such as growth and saving, were obtained directly from Multimod.

A. Growth and Saving

The results of the Multimod simulations are summarized in Table 3. With a declining and aging population, the level of real GDP is projected to fall by about 20 percent cumulatively (relative to the reference scenario) in the long run:

• Initially, output and investment rise owing to the fact that effective labor supply is growing at the outset relative to the stationary population assumed in the reference scenario. Significant aging also does not occur till after 2015. An increase in effective labor supply—somewhat akin to a positive shock to labor productivity—tends to reduce the interest rate and boost saving and investment.

• Eventually, the decline in effective labor with population aging and contraction (similar to a negative productivity shock) leads to a rise in interest rates as saving and investment levels decline with output. Therefore, the decline in GDP largely occurs between 2025 and 2075, when the demographic changes are most pronounced. In growth terms, annual GDP growth on average is lower by about 0.5 percentage points per year, before the economy settles to a longer-run equilibrium with a permanently higher elderly dependency ratio.

Table 3.

Simulated Effects of Population Aging in Japan

(Percent deviation from scenario with stable demographics; unless noted otherwise)

¹Percentage point deviation from baseline; interest rates are long-term nominal rates.

²Deviation from baseline value in percent of baseline GDP.

Note: The table shows the impact of the shock on the Japan block of the model in isolation—i.e., treating world variables as exogenous and without further feedback. Adding demographic dynamics simultaneously for the other industrial countries would change some of the implications of the model, particularly for external variables, but the differences are small.

Table 3.

Simulated Effects of Population Aging in Japan

(Percent deviation from scenario with stable demographics; unless noted otherwise)

Variable	2001	2005	2010	2015	2025	2050	2075	2100
Real GDP	-0.7	1.4	1.6	1.7	-0.9	-11.2	-17.4	-18.4
Interest Rates1	-0.2	-0.2	-0.3	-0.5	-0.4	-0.2	0.0	0.0
Contribution to GDP:
Consumption2	-1.0	0.3	0.8	0.9	-0.9	-8.8	-13.9	-14.7
Investment2	0.0	0.4	0.3	0.4	0.1	-1.4	-2.4	-2.6
Net Exports2	0.3	0.7	0.5	0.4	0.0	-1.0	-1.1	-1.1
CPI Inflation1	0.2	-0.1	-0.0	-0.1	-0.1	-0.0	0.0	0.0
GPD per adult	-1.0	0.0	0.0	0.2	0.0	-1.4	-1.2	-1.5
Real Exchange Rate	-2.4	-2.6	-2.0	-1.6	0.8	7.7	10.5	11.2
C/A Balance1	0.2	0.4	0.4	0.5	0.5	0.3	0.2	0.4
Private Saving Rate1	0.5	0.6	0.5	0.6	0.6	0.5	0.4	0.5
Dependency Ratio1	0.0	0.0	0.1	0.7	2.0	5.1	4.0	2.5
Population Growth1	0.3	0.2	0.0	-0.1	-0.4	-0.3	-0.2	0.0

¹Percentage point deviation from baseline; interest rates are long-term nominal rates.

²Deviation from baseline value in percent of baseline GDP.

Note: The table shows the impact of the shock on the Japan block of the model in isolation—i.e., treating world variables as exogenous and without further feedback. Adding demographic dynamics simultaneously for the other industrial countries would change some of the implications of the model, particularly for external variables, but the differences are small.

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Table 3.

Simulated Effects of Population Aging in Japan

(Percent deviation from scenario with stable demographics; unless noted otherwise)

Variable	2001	2005	2010	2015	2025	2050	2075	2100
Real GDP	-0.7	1.4	1.6	1.7	-0.9	-11.2	-17.4	-18.4
Interest Rates1	-0.2	-0.2	-0.3	-0.5	-0.4	-0.2	0.0	0.0
Contribution to GDP:
Consumption2	-1.0	0.3	0.8	0.9	-0.9	-8.8	-13.9	-14.7
Investment2	0.0	0.4	0.3	0.4	0.1	-1.4	-2.4	-2.6
Net Exports2	0.3	0.7	0.5	0.4	0.0	-1.0	-1.1	-1.1
CPI Inflation1	0.2	-0.1	-0.0	-0.1	-0.1	-0.0	0.0	0.0
GPD per adult	-1.0	0.0	0.0	0.2	0.0	-1.4	-1.2	-1.5
Real Exchange Rate	-2.4	-2.6	-2.0	-1.6	0.8	7.7	10.5	11.2
C/A Balance1	0.2	0.4	0.4	0.5	0.5	0.3	0.2	0.4
Private Saving Rate1	0.5	0.6	0.5	0.6	0.6	0.5	0.4	0.5
Dependency Ratio1	0.0	0.0	0.1	0.7	2.0	5.1	4.0	2.5
Population Growth1	0.3	0.2	0.0	-0.1	-0.4	-0.3	-0.2	0.0

¹Percentage point deviation from baseline; interest rates are long-term nominal rates.

²Deviation from baseline value in percent of baseline GDP.

Note: The table shows the impact of the shock on the Japan block of the model in isolation—i.e., treating world variables as exogenous and without further feedback. Adding demographic dynamics simultaneously for the other industrial countries would change some of the implications of the model, particularly for external variables, but the differences are small.

In per capita terms, GDP per adult declines slightly in the long run (relative to the reference scenario) for the following reason. The percent decline in output is in line with the contraction of labor, measured in efficiency units. However, the percent decline in effective labor is larger than the fall in the number of workers, given the aging of the workforce and the differences in labor productivity and supply across age groups implicit in the age-earnings profile. Extending the simulation further out (i.e., closer to steady state) would show the decline in per capita GDP to be about 5 percent relative to the reference scenario, as the output-labor ratio returns to its baseline level.¹⁶

Investment and saving levels (relative to the reference scenario) also decline in the long run with GDP. The fall in investment reflects the desire to shed capital in the face of declining labor and output in the economy; the rate of investment (as a share of GDP) though is more or less unchanged. Saving rates, however, increase slightly as the population ages. Despite a higher proportion of elderly who tend to save less, the decline in the inflow of young agents (who tend to have high consumption propensities) and the increase in longevity act to raise saving rates.¹⁷ Consequently, the current account surplus increases, mainly reflecting the rise in private saving. Correspondingly, the real exchange rate would depreciate initially before appreciating in the long run with the accumulation of net foreign assets.

B. Fiscal Impact

The 2000 pension reform has reduced the government’s unfunded pension liabilities to some 60–70 percent of GDP but, this still implies that large contribution rate increases are necessary to prevent pension assets from being depleted. On the basis of the current benefit and transfer structure, the baseline simulation shows that contribution rates to the main employee pension system would need to rise from 17½ percent to close to 30 percent over the next 50 years (as opposed to 25½ percent currently projected by the government). Medical contribution rates would have to go up by a similar proportion, mainly as a result of the steep rise in old-age medical costs. Despite these increases, financial balance in the social security system would depend on a doubling of government transfers to more than 5 percent of GDP a year, which shows that the fiscal situation will become considerably more complicated as the demographic transition sets in.¹⁸

Accordingly, once the economy has recovered, the government is assumed to conduct fiscal consolidation before population aging intensifies after 2010. However, even if the government would manage to reduce its fiscal deficit to about 3 percent of GDP within a decade, net debt would only stabilize around 120 percent of GDP—a level that would leave public finances vulnerable to interest rate shocks and policy slippage. The need to cover contingent liabilities, e.g., those related to government guarantees or the Fiscal Investment and Loan Program, could further increase public debt levels.

Reducing public debt over the long run would require significant additional measures. Following the initial consolidation round, the room for further expenditure cuts appears limited as welfare obligations are likely to remain high, and payroll taxes will already be driven up by rising social security contributions). As a result, the consumption tax rate is projected to rise from the current 5 percent to about 25 percent over 50 years, which would be high but still comparable to today’s VAT levels in some industrial countries.¹⁹

It is clear that the policies assumed in this simulation—slow debt consolidation and gradual social security reform—would be a long-term drag on living standards as high social security contribution rates and indirect taxes would create economic disincentives. What could be gained by pursuing different policies and at what cost? To respond to these questions, the next section presents alternative policy paths—both for restoring the long-term viability of the social security system and for stabilizing government debt—and analyzes their impact on growth and welfare relative to this policy baseline.

A. How to Address the Aging Problem?

The debate over social security reform in Japan has focused mainly on two questions. First, to what extent should future benefits be cut, and second, how to finance the rise in social security expenditure? These questions are related as it is generally agreed that significantly higher payroll taxes (as in the baseline scenario) would have undesirable effects on work incentives and labor costs, which implies either a reduction in future benefit levels or an increase in government transfers:

• Benefit cuts. There have been various suggestions of how to cut net pension benefits, including through reductions in the gross replacement ratio, higher taxation of pension incomes, an increase in the retirement age, or a shift to privately-financed pension schemes. Potentially large savings could be achieved by shifting all remaining pension components from wage to price indexation (including National Pension benefits and entry levels of earnings-related pensions; Yashiro et al. 1997). An increase in the retirement age would also contribute to overall labor supply and output, but this effect is likely to be small as the participation rate of elderly Japanese in the labor force is already quite high.

• Higher government transfers. Maintaining high benefits at lower contribution rates would require an increase in government transfers to the social security system. These would have to be financed through indirect taxes to avoid the disadvantages associated with higher payroll taxes and to spread the burden of financing social security benefits over the general population (including pensioners themselves).

This debate is reflected in the following two simulations:

• First, one scenario assumes a reduction of social security benefits by 2 percent of GDP over a period of 20 years relative to the baseline scenario, which would allow a commensurate decline in social security contributions.

• The second scenario keeps social security benefits unchanged relative to the baseline, but assumes that consumption taxes would be raised to finance a reduction in social security contributions identical to that in the first scenario. In this way, the scenarios analyze the trade-off between the level of social security benefits and consumption tax increases that appears to be at the heart of the pension debate in Japan.

The results suggest that benefit reductions, coupled with a decline in social security contributions, would clearly offer the most beneficial reform alternative with regard to growth and economic welfare measures (proxied by private consumption and wealth; Figure 3).²⁰ The chart shows that both simulated reforms would result in higher long-term growth relative to the baseline, but the effects would be larger in the case of benefit reductions, where private saving increases.²¹ While benefit cuts would imply a short-term output decline (owing to a drop in consumption), the positive long-term effects on output would be substantially larger, owing to a fall in interest rates that would provide a boost to

Japan: Macroeconomic Effects of Social Security Reform

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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Japan: Macroeconomic Effects of Social Security Reform

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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Japan: Macroeconomic Effects of Social Security Reform

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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investment.²² In the case of the consumption tax increase, private saving would decline relative to baseline, since the pension financing would be partly shifted from workers to pensioners who generally have a lower marginal propensity to save. Higher growth over the long term would thus mainly be an effect of increased labor supply as a consequence of lower payroll taxes.

In contrast to benefit cuts, a reduction in social security contributions financed by a consumption tax increase would have mixed effects on private consumption and wealth. The initial decline in saving implies that interest rates rise and that there is less of a buildup in capital stock compared to the baseline (which translates into a valuation loss of financial assets and thus lower wealth). Moreover, the increase in interest rates leads elderly consumers—who are less liquidity constrained—to increase consumption, thus further reducing aggregate saving.²³ The resulting decline in the current account surplus also depresses financial wealth through a drawdown of foreign assets. Eventually, the fall in wealth would imply that consumption would drop relative to baseline, although this would only occur towards the end of the projection period.

Although the results may depend to some extent on the particular specification of the model, the main policy conclusion is that a reduction of social security benefits would generate lasting output and welfare gains, although at the risk of some small short-term output losses that would need to be minimized through careful phasing. As frequently pointed out in the literature, benefit cuts would also be the most equitable way of distributing the pension burden across generations. By contrast, financing social security through an increase in the consumption tax would also result in output gains relative to payroll tax financing, but welfare effects would not be permanently positive.

B. Speed and Composition of Fiscal Consolidation

In view of Japan’s long-term fiscal imbalance, any move to address the fiscal deficit will not only have a direct impact on aggregate demand, but will also effect on individuals’ current and future savings behavior. The choice of policies for stabilizing the fiscal situation is therefore important, especially if the government decides to pursue a somewhat faster pace of consolidation to reduce its exposure to fiscal risks. The potential benefits of such a policy include positive debt dynamics, higher public saving, and less need for precautionary saving on the part of individuals. However, as the 1997 experience has shown, there could be a drawback if strong fiscal adjustment measures would stall the recovery, making eventual fiscal consolidation all the more difficult to sustain.

To illustrate the macroeconomic trade-offs, the simulation framework has been used to compare the effects of policies that are assumed to stabilize general government debt over a period of five years compared to 10 years in the baseline. This is assumed to be achieved in turn through one of the following policy measures: (i) cuts in public investment; (ii) an increase in the consumption tax rate; and (iii) direct tax base broadening.²⁴ Faster consolidation would stabilize debt at a lower level than in the baseline, and it is assumed that this positive debt differential is maintained through the end of the forecasting period. All other assumptions (regarding social security parameters, etc.) remain unchanged from the baseline scenario.

As expected, faster consolidation would result in sustained gains to economic output over the medium-term, although at the cost of short-term losses (Figure 4). Real output would decline relative to the baseline scenario for the first 3–4 years of the adjustment process, but rise above baseline output for the rest of the forecasting period. The largest long-term gains would be achieved in the case of public investment cuts, but these would also entail the largest short-term output losses, with real GDP being 1¼ percentage points below baseline output in the first year of the adjustment process.²⁵ The cases of tax base broadening and consumption tax increases would imply a much smaller initial output loss, but long-term gains would also be smaller, owing to the distortionary effects of higher taxes.

Japan: Macroeconomic Effects of Fiscal Consolidation Strategies

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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Japan: Macroeconomic Effects of Fiscal Consolidation Strategies

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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Japan: Macroeconomic Effects of Fiscal Consolidation Strategies

(Difference to baseline scenario, in percent)

Citation: IMF Working Papers 2001, 040; 10.5089/9781451845976.001.A001

Source: Staff calculations.¹ Real financial assets plus discounted real income over the projection period.

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Long-term gains in private consumption and private wealth also highlight the beneficial role of public investment cuts. In the first scenario, both welfare measures improve strongly relative to the baseline scenario, whereas the other two strategies result in lower consumption for most of the time, and yield significantly smaller wealth gains.²⁶ The reason is that tax increases either directly reduce disposable labor income (in the case of direct taxes), or decrease future real incomes through an increase in consumer prices (in the case of consumption taxes).

Three main policy conclusions can be drawn from these findings:

• A shortening of the fiscal adjustment horizon implies short-term output costs—suggesting that sharp tightening measures should be held back until private demand has reached sustainable levels.

• The risk to short-term output growth is largest in the case of investment cuts, despite the fact that these also generate the strongest long-term welfare gains. From an economic perspective, tax increases would provide a less risky instrument to achieve fiscal consolidation in the initial phase of an upswing. Investment cuts should be phased in more gradually, depending on the progress of the recovery.²⁷

• In terms of taxation measures, the simulations indicate that a consumption tax increase would have somewhat less beneficial effects than a broadening of the direct tax base. This highlights the fact that the VAT—although generally considered to be close to an optimal tax—does carry distortionary effects as it introduces a wedge between producer and consumer prices. The model suggests that efficiency losses from base broadening (which could result from lower tax exemptions) are smaller, although only by a small margin.