Macroeconomic Effects of Japan's Demographics: Can Structural Reforms Reverse Them?
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Yes, partly. This paper studies the potential role of structural reforms in improving Japan’s outlook using the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) with newly-added demographic features. Implementation of a not-fully-believed path of structural reforms can significantly offset the adverse effect of Japan’s demographic headwinds — a declining and ageing population — on real GDP (by about 15 percent in the next 40 years), but would not boost inflation or contribute substantially to stabilizing public debt. Alternatively, implementation of a fully-credible structural reform program can contribute significantly to stabilizing public debt because of the resulting increase in inflation towards the Bank of Japan’s target, while achieving the same positive long-run effects on real GDP. If no reforms are implemented, severe demographic headwinds are expected to reduce Japan’s real GDP by over 25 percent in the next 40 years.

Abstract

Yes, partly. This paper studies the potential role of structural reforms in improving Japan’s outlook using the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) with newly-added demographic features. Implementation of a not-fully-believed path of structural reforms can significantly offset the adverse effect of Japan’s demographic headwinds — a declining and ageing population — on real GDP (by about 15 percent in the next 40 years), but would not boost inflation or contribute substantially to stabilizing public debt. Alternatively, implementation of a fully-credible structural reform program can contribute significantly to stabilizing public debt because of the resulting increase in inflation towards the Bank of Japan’s target, while achieving the same positive long-run effects on real GDP. If no reforms are implemented, severe demographic headwinds are expected to reduce Japan’s real GDP by over 25 percent in the next 40 years.

I. Introduction

After nearly three challenging decades, Japan’s economic prospects remain weak in the face of strong demographic headwinds. The economy has experienced almost three decades of sub-par economic performance since the 1992 bursting of the financial and property bubble, with weak real GDP growth and repeated deflationary episodes. There have been several attempts to reflate the economy prior to the ongoing “Abenomics,” but none were sustained. With the effectiveness of monetary policy constrained by the Effective Lower Bound (ELB) and repeated fiscal stimuli building an unprecedented increase in public debt, there is now less room to stimulate the economy. Moreover, structural bottlenecks in the labor market limit productivity growth and hamper the pass-through of demand stimulus to real wages and prices. Importantly, a rapidly shrinking and ageing population and labor force constitute severe demographic headwinds to future productivity and growth, with official projections anticipating that Japan’s population will decline by just over 25 percent in the next 40 years (Figure 1). Weak growth and inflation prospects, together with growing age-related government spending, pose serious challenges to fiscal prospects as well.

Figure 1.
Figure 1.

Japan: Impact of Demographic Projections (Baseline Simulation)

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Sources: GIMF simulations and IMF staff’s calculations.

Model simulations point to significant adverse effects on economic activity and further deterioration of government finances due to Japan’s unfavorable demographics. Simulations using the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) — incorporating the authorities’ demographic projections plus associated age-related health and pension spending projections — point to significant declines in real GDP, consumption, investment, and real wages, with a notable increase in the public-debt-to-GDP ratio and a deterioration of the external current account (Figure 1).2,3,4 For example, IMF staff simulations estimate that the level of real GDP will decline by over 25 percent in about 40 years due to demographics under current policies (with an average annual GDP growth rate of about -0.8 percent) relative to a projection where productivity and population grow at their recent pace. In response to a shrinking and ageing population, GDP growth declines not only due to the direct effect from the decline in labor inputs, but also because the capital stock declines in response to the shrinking labor inputs.5,6 As a result, private savings fall, leading to a deterioration of the current account which is further exacerbated by the reduction in tax revenues and increased government dissaving.7

This paper studies the potential role of structural reforms in lifting Japan’s outlook. Facing challenging economic prospects, Prime Minister Abe launched Abenomics at end-2012 to boost growth and inflation and bring government debt to a sustainable level. The economic plan of Abenomics is anchored on “three arrows”—bold monetary easing, flexible fiscal policy and structural reforms.8 Whereas the first two arrows were launched in earnest and met with initial success in 2012–13, the third arrow of structural reforms has yet to be fully implemented. In this paper we consider the set of structural reforms proposed by past IMF Japan Article IV Consultations and evaluate their impact on the economy.9 The set of studied reforms can loosely be classified into three broad categories: reforms to the labor market, reforms to product market and corporates, and international trade reforms.

This paper estimates the possible impact of structural reforms in Japan using GIMF, highlighting the importance of reform credibility. The analysis studies the conditions needed for structural reforms to maximize growth and inflation, while also stabilizing debt dynamics in the face of severe demographic headwinds. The paper therefore focuses on the nexus between structural reforms and debt sustainability, and as a consequence it highlights the effects on the level of GDP rather than GDP per capita. While the reform agenda has trade-offs and synergies, results show that some of the trade-offs can be eased when policy is coordinated and decisive (“fully-credible” scenario).10 The largest possible reform impact arises when efforts are fully credible, boosting the level of real GDP by about 15 percent in 40 years relative to the “current policies” scenario, while accounting for monetary accommodation and debt stabilization (with reforms mitigating 0.5 of the 0.8 percentage point drag to annual GDP growth from demographic factors).11,12 However, when the path of structural reforms is “not-fully believed” by agents, reforms deliver a smaller near-term GDP boost and lead to weaker improvements in inflation and public debt dynamics.

The paper first describes the proposed reforms and how these are implemented in GIMF, followed by a description of key results. Section II describes the proposed reform program and summarizes “off-model” estimates of the possible impact of the reforms on key variables (including labor productivity, labor supply, investment and trade costs) that serve as inputs into GIMF. Section III discusses the calibration strategy used and how the reforms are implemented in the model. Section IV presents the simulation results and emphasizes the differences between fully-credible and not-fully-believed reforms. It also describes the role that monetary and fiscal policies have in supporting the reforms. Section V concludes. Appendices cover: how mitigating labor market duality increases labor productivity; an overview of GIMF; detailed discussion of GIMF calibration and simulation strategies; a detailed decomposition of each of the labor and product market reforms; and the drivers of public debt reduction.

II. The Proposed Structural Reform Program

The studied structural reform package encompasses three broad categories of proposed reforms, taken from the IMF’s 2017 Japan Article IV Consultation: labor market reforms to address duality and boost labor supply; corporate and production sector reforms; and trade agreements (IMF, 2017a).

A. Labor Market Reforms

The proposed labor market reforms are designed to eliminate labor market duality over time and increase labor supply. Reforms to address labor market duality are designed to increase productivity by providing training and career opportunities across the workforce, while delivering balanced overall employment protection and compensation. Reforms that lead to an increase in labor supply are designed to partly offset the effects of an ageing and declining population and labor force. The labor supply expansion is predicated on an increase in labor force participation by female and older workers and by increased foreign human resources, whereas reforming the dual labor market proposes contract reform to boost overall productivity and real wages. More specifically:

  • a. Gradual replacement of regular and non-regular contracts by “intermediate” contracts to boost labor productivity.13 With employment protection for regular workers being relatively high in Japan, firms have made use of non-regular workers to contain wage costs and satisfy cyclical upsurges in demand.14 A consequence of the rapid increase in non-regular workers has been a decline in productivity as non-regular workers are subject to temporary contracts that typically result in less training, worse career prospects and reduced job security, relative to regular workers.15 We estimate that a gradual introduction of intermediate contracts (replacing regular and non-regulars over time), where intermediates are assumed to be as productive as regular workers, would boost the level of labor productivity (currently growing by around 1.5 percent per annum) by over 7 percent in the long-run (see Appendix A for details).16,17 This reform makes the crucial assumption that firms would provide training to intermediate workers as they do for regulars, to boost intermediates’ productivity to the same level as existing regular workers, thereby delivering an upper bound in terms of potential productivity gains. Meanwhile, the reform does not assume a significant change in workers’ bargaining power.

  • b. Increased labor force participation of females and older workers. While, by definition, there is a limit to the growth effect from higher labor force participation, research by IMF (2012b, 2013a) suggests that increasing female labor force participation from 2010 levels (63 percent) to the average of the G7 (equal to 70 percent when excluding Italy and Japan) by 2030 would increase potential growth by up to 0.2 percentage points per year. An additional increase to northern European levels (75 percent) would increase potential growth by an additional 0.2 percentage points. As the actual level of female participation in Japan is just shy of 70 percent in 2017, we assume that increasing female labor force participation towards northern European levels would lift potential growth by around 0.2 percentage points each year over 20 years (in line with Steinberg and Nakane, 2012). Older workers’ participation (those aged 60 and above) is already high in Japan relative to OECD levels, and it is assumed that a further 3 percentage point increase in participation would increase the labor force by around 0.5 percentage points, with a small impact on potential output growth. All in all, increased labor force participation of females and older workers is estimated to lift potential growth by 0.2 percentage points over 20 years.

  • c. Increased migration by one percent of the labor force. IMF (2012b, and 2013a) studies suggest that increased migration that lifts the labor force in Japan by 1 percent would increase potential growth by 0.15 percentage points over 10 years.

B. Corporate and Product Market Reforms

Three types of corporate and product market reforms are considered, designed to increase both productivity and investment. Product market and small and medium enterprise (SME) reforms will boost productivity and investment, while reforms to corporate governance will help unleash excessive cash holdings and use them for investment. More specifically:

  • a. Product market reform. These reforms envisage an easing of barriers to entry and removal of protections to incumbents in some industries (such as telecom and gas sectors), and deregulation of professional services (IMF, 2017b). These reforms are expected to increase productivity and investment. Egert and Gal (2017), building on the framework of Barnes (2014), suggest that a 20 percent reduction in product market regulation can deliver a 2.4 percent increase in multi factor productivity (MFP) after five years.18 It is therefore assumed that this reform gradually boosts MFP, resulting in a 2.4 percent improvement after five years.

  • b. Reforms to SMEs. Lam and Shin (2012) and IMF (2012b, 2013a) suggest that restructuring of the SME sector could lift the productivity of smaller firms, allowing it to increase to about 80 percent of that of large firms.19 This translates to increases in overall productivity (TFP), achieving a 2.5 percent improvement after ten years.

  • c. Corporate governance reform. Research by IMF (2013a), Aoyagi and Ganelli (2017) and Sher (2014) suggest that firms in Japan hold too much cash. Corporate governance reform, by allowing that surplus cash is used for investment, could boost the level of investment by 5 percent according to Sher (2014). Accordingly, we assume a reform that increases the level of investment by 5 percent after ten years.

C. International Trade Reforms

International trade reforms relate to two recently-agreed trade agreements: The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP or TPP-11) and the Japan-European Union (EU) trade agreement.20 To approximate the impact of the reforms, we consider a reduction of all tariff and non-tariff barriers between Japan and signature countries in CPTPP (Australia, Brunei, Canada, Chile, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam), and between Japan and the European Union.

We use the trade restrictiveness measures of Kee and others (2009) to compute the impact of the trade agreements. Kee and others (2009) estimate ad-valorem equivalents of all non-tariff barriers for nearly eighty countries, and they merged them with tariff measures to obtain an aggregate trade restrictiveness measure. The simulations assume that all trade measures are unwound over five years, such that all barriers on all goods and services between Japan, EU and the countries that signed the CPTPP vanish entirely.21 These barriers result in an equivalent reduction of tariffs of 9 percent by Japan and 6 percent for Europe, and around 10 percent by CPTPP countries; and reductions of non-tariff barriers by 23 percent in Japan, 6 percent in Europe and around 9 percent by CPTPP countries.

III. GIMF Calibration, Assumptions, and Scenarios

A. GIMF Calibration

The structural reforms are implemented in a six-region version of GIMF which allows for demographics and matches Japan’s stylized facts. The six regions comprise Japan, the United States, the Euro Area, Emerging Asia, Latin America plus the rest of the world.22 One salient feature of the Japan calibration is the high degree of nominal rigidity in the economy, which plays a key role in the estimated short-run impact of proposed structural reforms. Additional details on how GIMF is calibrated for Japan are provided in Appendix C.

To quantify the impact of the reforms in GIMF, the reforms are mapped to changes in GIMF’s structural parameters and shocks. Appendix C discusses details on how the reforms are mapped to the various shocks (total factor productivity shocks, labor supply, and investment and trade shocks), with guidance stemming from the “off-model” analysis that was presented in Section II. As Andrle and others (2018) note in a related exercise for Italy, several papers provide guidance on how to produce such a mapping in GIMF.

B. Assumptions

Different implementations of the reforms are considered, depending on whether economic agents fully believe the announced reform path (fully credible) or do not fully believe the announced reform path (not fully believed):23

  • When reforms are deemed fully credible, it is assumed that all (private sector) agents expect the reforms to be fully implemented over several years (i.e. there is perfect foresight of the path of the reform).24 Therefore, a fully credible reform program entails anticipation effects that support near-term economic activity and inflation because the implied demand boost (as firms and households increase investment and consumption due to higher expected capital returns and permanent income) exceeds the contemporaneous supply boost from the reform plan.

  • We compare the impact of fully-credible reforms with not-fully-believed reforms, in the sense that agents only believe the reforms at the time when these are implemented and realized (implying imperfect foresight of the reform path).25

Bank of Japan’s credibility: We assume that any persistent increase in inflation above the “perceived” inflation target (of one percent), improves the credibility of the Bank of Japan’s two-percent inflation target, thereby resulting in higher inflation in the long-run.26,27

Fiscal assumptions: Two sets of fiscal assumptions are used. First, all scenarios assume that age-related government spending grows with ageing while non-age-related government spending remains constant over time in per capita terms. This implies that overall government spending is the same under the baseline and under all reform scenarios. Second, all scenarios assume that all tax rates are constant (resulting in higher tax revenue due to structural reforms which is assumed to be used to reduce the public debt), except for one scenario where debt stabilization is achieved by a higher consumption tax rate (as proposed by McGrattan and others, 2018).

C. Four Scenarios

Four sets of simulation results are presented to show a range for the plausible effects of the various structural reforms. In the first case (labelled Case A), we consider the impact of the fully-credible reforms without monetary policy support or full stabilization of the public debt. To evaluate the impact of credibility, we next examine Case B where the reforms are not fully believed. In the final two cases we revert to the case of fully-credible reforms and allow for monetary policy accommodation (labelled Case C) and then add in full public debt stabilization (labelled Case D or “Abenomics Redux”).28 In all cases we discuss the impact on key macroeconomic variables such as GDP, consumption, investment, real wages, inflation, the nominal interest rate, the real exchange rate, the current account, and public debt.

IV. Results

A. “Plain Vanilla” Fully-Credible Reforms

Credible structural reforms boost GDP by over 10 percent above the baseline after ten years, and help inflation reach the Bank of Japan’s two-percent inflation target. Figure 2 presents the marginal impact of the structural reforms relative to the baseline from Figure 1 (or “current policies”). Each reform is layered on top of each other, starting with reforms to the labor market (blue), then the corporate/product market (red), and ending with the impact of trade agreements (black).29 We show the impact of the reforms on the level of GDP, consumption, investment, real wages, nominal interest rates, inflation, the real exchange rate, and both the current account and public debt as a percent of GDP. Appendix D further decomposes the impact of each of the labor and corporate/product market reforms.

Figure 2.
Figure 2.

Japan: Credible Structural Reforms

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Note: Reported effects are changes relative to the baseline reported in Figure 1.Source: GIMF simulations and IMF staff’s calculations. X-axis denotes years, LR=Long-run/steady-state (40+ years).

The main channels of Case A unfold in the near term as follows: Anticipating the prolonged nature of both labor market and product market reforms that boost the return to capital, firms immediately increase their investment to build up their capital stock.30 At the same time, in anticipation of higher permanent income, households increase consumption. The demand increase stemming from higher consumption and investment exceeds the increase in potential output, putting pressure on production costs (real wages, cost of capital) and hence inflation. The nominal interest rate increases as the central bank seeks to contain inflationary pressure in the near term. A relative increase in imports results in a deterioration of the current account balance relative to baseline in the first seven years. Public-debt-to-GDP declines in response to the GDP increase and in response to the reforms-generated higher tax revenue which is used to reduce the public debt.

Beyond the near term, consumption, investment and GDP continue to increase, but only gradually as potential output continues to expand. Inflation increases in the long run as the persistent inflationary increases result in increased credibility of the Bank of Japan’s inflation target.31 Public-debt-to-GDP ratio declines in the long run due to the interest savings from the reduced debt (on top of the reduced debt from primary surpluses) The current account improves in the long run as exports increase in response to higher potential output (leading to a real depreciation of the yen in the long run) and also, in response to the significant decline in public debt, households substitute domestic assets for foreign ones increasing the net foreign asset position.

Trade agreements also boost output and inflation. While tariffs are relatively low in Japan, there are important non-tariff restrictions according to Kee and others (2009). Removing both tariff and non-tariff trade barriers therefore results in a sizeable reduction to import prices which boosts investment (and hence potential output) and consumption.32 Accordingly, in response to the trade agreements, imports increase and the real exchange rate must depreciate to bring the trade balance back to equilibrium (by boosting exports and partly reducing imports).33 The current account, due to trade agreements, remains weakened in the long run (the difference between the black and red lines) given the large trade balance deterioration in the short run which lowers both the net foreign asset position and associated income flows from those assets.

Labor market reforms, driven primarily by reforms to the dual labor market, have the largest output effect, followed by the corporate/product market reforms (Figures 2 and 3). The significant impact from reforms to the dual labor market, which contribute almost 6.5 percent to the level of output, stems from the impact of the reform on labor productivity, as non-regular workers are gradually replaced by more productive intermediate workers. Increased domestic labor force participation has the second-largest impact of all other reforms, contributing 3.5 percent to the level of GDP. Within the product market/corporate reforms, the largest impact stems from reforms to the product market, closely followed by reforms to small and medium enterprises which yield output increases of 2 percent and 1.7 percent, respectively.

Figure 3.
Figure 3.

Japan: GDP Effect of Credible Structural Reforms

(Percent deviation from baseline)

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Sources: GIMF simulations and IMF staff’s calculations.Notes: X-axis denotes years and LR = long-run. Bars are stacked so that grey shows overall effect.

There is a range of uncertainties around such long-run model simulations. For example, there is uncertainty over the magnitude of the labor market reform estimates. Our results assume that the productivity of non-regular workers catches up fully with that of regulars and may therefore represent an upper bound to associated GDP gains. Previous research on labor market reforms that consider a reduction in job protection (e.g. IMF, 2016c; Duval and Furceri, 2018; Bassini et al., 2009) point to smaller gains driven by job protection reforms. However, the labor market duality reform studied in this paper is Japan-specific as it focuses on Japan’s potential productivity gains, not job protection reforms which have been the focus of the existing literature (see Appendix A). Nevertheless, to show the uncertainty associated with the reform, Figure 4 presents estimates that assume that only half of the productivity gap (between non-regular and regular workers) is closed, delivering a smaller real GDP gain (by about 3 percentage points in the long run).

Figure 4.
Figure 4.

Japan: GDP Effect of Credible Structural Reforms Under Full and Partial Labor Duality Reform

(Percent deviation from baseline)

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Sources: GIMF simulations and IMF staff’s calculations.Notes: X-axis denotes years and LR = long-run.

B. Not-Fully-Believed Reforms

Not-fully-believed reforms have a significantly lower impact on GDP in the near term, do not help inflation reach the Bank of Japan’s target, and result in less government debt reduction in the long run. The GDP, consumption, investment and real wage impact, in the long run, is nevertheless close to the fully-credible reform scenario. Figure 5 presents the marginal impact of the structural reforms relative to the baseline, with each reform layered on top of each other, starting with reforms to the labor market (blue), then to the corporate/product market (red), and ending with the impact of trade agreements (black).

Figure 5.
Figure 5.

Japan: Not-Fully Believed Structural Reforms

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Note: Reported effects are changes relative to the baseline reported in Figure 1.Sources: GIMF simulations and IMF staff’s calculations. X-axis denotes years, LR=Long-run/steady-state (40+ years).

The main channels of Case B unfold as follows: While consumption, investment and GDP are all higher, not-fully-believed reforms clearly result in a weaker short-term boost relative to Case A. The reforms have a lower impact in the near term because at that time both firms and households do not expect further reform efforts to materialize and hence do not expect their permanent income or the return to investment to be as high as in the fully-credible reform scenario. Subsequent reform “surprises” deliver only gradual increases in investment and consumption. Hence demand increases broadly in line with potential output through the period over which the reforms are implemented, which results in less inflationary pressure. The increase in GDP, brought about by increases in labor and capital, requires an exchange rate depreciation to export part of the additional output and to be able to bring the trade balance into equilibrium in the face of additional imports. In the long run, the impact of the reforms is very similar to the fully-credible case, except, importantly, for inflation and public debt. Without the sustained pickup in near-term inflation, the central bank is not able to increase inflation expectations towards the two-percent target, and inflation remains at one percent in the long run. As nominal GDP increases by less in this scenario (relative to Case A), the reduction in the public-debt-to-GDP ratio is lower.

C. Fully-Credible Reforms with Monetary Accommodation

Monetary policy accommodation, in addition to fully-credible structural reforms, results in stronger near-term activity which further boosts inflation. Figure 6 presents the marginal impact of structural reforms relative to the baseline, including monetary accommodation, again with each reform layered on top of each other. For Case C, when the monetary policy authority accommodates the structural reforms, the near-term real interest rate falls which further boosts activity by incentivizing households and firms to bring forward their consumption and investment plans. Additionally, the exchange rate depreciates in the near term in response to a lower near-term real interest rate. In response, inflation increases by more and public debt declines more rapidly. In the long run, the impact of the reforms is the same as in the credible simulations from Case A.

Figure 6.
Figure 6.

Japan: Credible Structural Reforms Plus Monetary Policy Accommodation

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Note: Reported effects are changes relative to the baseline reported in Figure 1.Sources: GIMF simulations and IMF staff’s calculations. x-axis denotes years, LR=Long-run/steady-state (40+ years).

D. Abenomics Redux: Fully-Credible Reforms with Monetary Accommodation and Public Debt Stabilization

Structural reforms together with monetary accommodation and public debt stabilization can partially offset demographic headwinds. To present simulation results for this final scenario (Case D), we add the estimated effects to the baseline or “current policies” scenario (summarized in Figure 1). This final scenario includes fully-credible structural reforms with monetary policy accommodation (as in Case C) but also increasing the consumption tax rate to stabilize public debt fully.34 This presentation of results (that include in the same figure the baseline together with Abenomics Redux) delivers an estimate for how much of the demographic headwinds can be undone via reforms. As before, all simulations are being added up in Figure 7. The blue line presents the baseline or “current policies” scenario that captures the effects from the demographic headwinds. The red line adds the impact of credible structural reforms together with monetary accommodation (from Case C). The difference between blue and red lines (and bars) shows how much of the demographic headwinds can be undone with both fully-credible structural reforms and monetary accommodation. The black line (Abenomics Redux) adds further fiscal consolidation, such that the difference between the red and black lines (and the bars) denotes the impact of the debt-stabilizing consumption tax increases.

Figure 7.
Figure 7.

Japan: Abenomics Redux Against Demographics

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Sources: GIMF simulations and IMF staff’s calculations. X-axis denotes years. LR = Long-run/steady-state (40+ Years)

In particular, simulations show that fully-credible structural reforms boost the level of GDP by about 15 percent in 40 years relative to the demographic headwinds from the “current policies” scenario (that showed a 25 percent decline), while accounting for monetary accommodation and debt stabilization.35,36 As expected, activity is lower in response to public debt stabilization (black versus red lines), with the increase in national savings increasing the current account (though it still shows a small decrease in the long-run). Inflation exhibits a similar boost as that from Case C (black versus red lines), with consumption rate hikes only slightly upgrading inflation. Overall, fully-credible structural reforms (plus public debt stabilization and monetary accommodation) are shown to undo much of the damaging demographic effects.

The stabilization of the public debt ratio under Abenomics Redux is achieved mainly through higher nominal GDP growth in the near term, with interest costs savings and primary surpluses also contributing in the long run. The drivers of the public-debt-to-GDP ratio reduction from Figure 7 are shown in Figure 8. The black line in Figure 8 shows the overall reduction in the public debt ratio brought about by the structural reforms and the fiscal consolidation via consumption tax rate increases, with the last period (bar) showing the consolidation effects in the long run. In the near term, higher nominal growth stemming from the structural reforms and monetary policy accommodation drive the reduction in the public debt ratio, with primary surpluses and lower debt interest costs also contributing to the reduction in the public debt ratio in the long run.37 Appendix E shows the derivation of each driver of the public-debt-to-GDP ratio reduction.

Figure 8.
Figure 8.

Japan: Public Debt Consolidation from Credible Structural Reforms and Consumption Tax Increase

Citation: IMF Working Papers 2018, 248; 10.5089/9781484384732.001.A001

Note: Reported effects are changes to the baseline reported in Figure 1. Sources: GIMF simulations and IMF staff’s calculations.

V. Conclusion

Japan’s economic prospects remain weak in the face of strong demographic headwinds. Baseline model simulations show that Japan’s demographics — the declining and the ageing of the population — are expected to reduce real GDP by over 25 percent in about 40 years under current policies, relative to a projection where productivity and population continue to grow at their recent pace.

This paper focused on the potential role of structural reforms in lifting Japan’s outlook using the IMF’s Global Integrated Monetary and Fiscal Model and highlights the importance of reform credibility. The analysis focused on the conditions needed for structural reforms to maximize growth and inflation, while also stabilizing debt dynamics in the face of severe demographic headwinds.

The upper bound for the estimated benefits of reforms arises when reform efforts are fully credible, boosting real GDP by about 15 percent in 40 years relative to the baseline scenario, while accounting for monetary accommodation and public debt stabilization. However, when the path of structural reforms is not-fully-believed by agents, reforms deliver a smaller near-term boost to real GDP and lead to weaker improvements in inflation and public debt dynamics. In practice, the impact of implementing all the outlined reforms is likely to lie somewhere between the fully-credible and not-fully-believed cases, given the difficulty in achieving full credibility of reforms. Therefore, higher consumption tax rates are likely to be needed to stabilize Japan’s public debt, relative to those rates estimated under the scenario with fully-credible reforms with monetary accommodation and public debt stabilization.

Macroeconomic Effects of Japan’s Demographics: Can Structural Reforms Reverse Them?
Author: Mariana Colacelli and Emilio Fernández Corugedo
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    Japan: Impact of Demographic Projections (Baseline Simulation)

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    Japan: Credible Structural Reforms

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    Japan: GDP Effect of Credible Structural Reforms

    (Percent deviation from baseline)

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    Japan: GDP Effect of Credible Structural Reforms Under Full and Partial Labor Duality Reform

    (Percent deviation from baseline)

  • View in gallery

    Japan: Not-Fully Believed Structural Reforms

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    Japan: Credible Structural Reforms Plus Monetary Policy Accommodation

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    Japan: Abenomics Redux Against Demographics

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    Japan: Public Debt Consolidation from Credible Structural Reforms and Consumption Tax Increase