After recovery takes hold: Implications of aging population will pose crucial policy issues for Japanese authorities Japan has option in addressing large deficit

In conjunction with its annual Article IV consultation with Japan, IMF staff prepared a background paper (Japan—Selected Issues) on a number of key topics. Two chapters of that paper dealt with the macroeconomic and fiscal implications of Japan’s aging population. The authors—Hamid Faruqee, an Economist in the Research Department, and Martin MÜhleisen, an Economist in the Asia and Pacific Department—speak with the IMF Survey about their findings.


In conjunction with its annual Article IV consultation with Japan, IMF staff prepared a background paper (Japan—Selected Issues) on a number of key topics. Two chapters of that paper dealt with the macroeconomic and fiscal implications of Japan’s aging population. The authors—Hamid Faruqee, an Economist in the Research Department, and Martin MÜhleisen, an Economist in the Asia and Pacific Department—speak with the IMF Survey about their findings.

IMF Survey: Over the past decade, industrial countries have grown more aware of the significant macroeconomic implications of aging populations, but Japan’s circumstances seem particularly urgent.

Faruqee: Population aging is a characteristic of most industrial countries. Societies that achieve higher living standards customarily see their mortality and fertility rates fall—something that is referred to as a demographic transition.

Where Japan differs from other industrial countries is in degree. The rate of increase of Japan’s elderly dependents is much higher than elsewhere. Ten years ago, Japan had the lowest share of elderly dependents among industrial countries; now it has the highest. Some studies have suggested that a relative lack of child care facilities has exacerbated the impact on family size of rising female participation rates in the labor force. Whatever the cause, the decline in fertility rates has been much more dramatic in Japan. The country expects to see a comparatively faster rate of aging and a greater increase in elderly dependents. The country can also expect an overall decline in its population—something that sets Japan apart. Among the industrial countries, only Italy comes close to Japan’s experience.

IMF Survey: Why is the IMF looking at the macro-economic implications of aging in Japan now, and what concerns were your studies designed to address?

MÜhleisen: Japan has long been known for its strong fiscal position. Like its people, the Japanese government has been fiscally conservative and traditionally has had little debt and relatively low expenditures. But the fiscal situation, like the demographic situation, has seen a marked reversal over the past decade. Japan has had to run very high deficits—including several large stimulus programs—to keep its economy afloat after the bubble period in the late 1980s. Within a few years, Japan recorded virtually the highest level of gross debt within the Organization for Economic Cooperation and Development.

Japan still has formidable assets, especially in its social security system, but it cannot continue indefinitely without raising concerns about the sustainability and financing of these deficits. The economy is still fragile, so this is not yet the time for fiscal consolidation. But a thinking process must begin; it is hoped this will lead to a strategy for addressing the fiscal problem before the aging problem really kicks in. A public debate is going on now, and the government has said that it wants to return to a more sustainable fiscal path as soon as the economy allows. Our papers are meant to contribute to this thinking process and help lay the basis for a strategy to address these issues.

Faruqee: The broader macroeconomic study, which I prepared, sought to quantify the impact of population aging on key macroeconomic variables. We asked ourselves what might happen to Japanese saving and investment rates and growth over the next half-century. We wanted some sense of how large the economic impact of aging would be and then use that information to help frame pertinent policy questions and strategies.

MÜhleisen: My paper looked more specifically at the fiscal side. Besides the question of how Japan could move away from its huge deficits in the coming years, we asked ourselves how Japan could address its long-term aging problem. Japan’s pension and health care systems are to a large extent publicly financed, with expenditures slated to rise considerably as the population ages. While the largest pension system for private employees is partly funded, it will run out of funds if Japan doesn’t do something in the next couple of years. So the question is what the Japanese authorities can do with the least harmful consequences for growth.

IMF Survey: What methodology did you use?

Faruqee: We extended the IMF’s own multicountry macrosimulation model—MULTIMOD—to bring in the impact of population aging and introduced a pension system with revenues generated from different avenues, including wage and consumption taxes. Conceptually, we tried to quantify the impact by looking at how various age groups differed, notably in wage earning. In Japan, as in most countries, you see young workers with rising income, middle-aged workers at an earnings peak, and senior workers and retirees with declining or little labor income. The age-earnings profile helped us characterize labor supply and productivity differences between age groups. And that feature helped us to quantify the impact of the changing composition of the population. The model then used this information to determine demand- and supply-side implications of population aging.

IMF Survey: What did the data tell you about the broader implications of Japan’s aging population?

Faruqee: On the supply side, Japan will have a shrinking workforce, with implications for investment. An aging population needs to shed capital as the size of the workforce declines. On the demand side, we found that saving levels also tend to decline with the overall size of the economy, but per capita saving rates tend to stay fairly stable. The fact that we did not find large declines in saving rates is a little different from the findings of previous studies on aging populations. In Japan, the aging comes from a fall in fertility rates and an increase in longevity. The elderly tend to save less than other age groups, but increasing longevity tends to raise saving rates across age groups, because the planning horizon is lengthened. Also, Japan’s sharp decline in fertility rates has led to a decline in youth dependency rates, which helps lessen the negative impact on saving rates.

The other main finding was that given a contracting workforce and a contracting population—and barring some change in productivity growth—Japan’s overall GDP growth could decline by about ½ of 1 percentage point over the next several decades, compared to a scenario with a stable population and workforce. In per capita terms, this is not necessarily a large decline, because income is declining in line with the number of people. But because the workforce becomes more elderly, you might also expect some decline in per capita incomes compared to a case where no aging took place.

IMF Survey: The second study looked at the fiscal situation in greater detail.

MÜhleisen: The most important question for the near term is whether Japan’s fiscal position is sustainable. The simulations tell us that the problem is manageable but will require serious consolidation in the next few years and a tight fiscal policy over the next couple of decades when the aging process kicks in.

But having said that, there is still some concern over the immediate future, since debt levels are going to rise even if Japan takes steps to turn its fiscal deficit of 8-9 percent of GDP into a primary surplus. On the basis of a realistic policy scenario that incorporates already approved social security reforms, we figure that net debt (excluding the social security system) is not going to stabilize until it reaches 120 percent of GDP by the end of the decade.

The options come in when we talk about the composition of adjustment measures. Japan has one of the largest public investment ratios among the Group of Seven countries, so there is some room to cut public investment. Moreover, while there is comparatively little room to cut current expenditure, Japan’s tax revenue ratio is rather small, and the authorities would need to either broaden the income tax base or raise the consumption tax rate.

Our policy analysis looked at the growth and wealth effects of these policy options. For example, cutting public investment a strong positive effect on growth over the longer term but would have sharply negative effects over the short term, since it reduces demand directly. It is not something we would recommend doing on a big scale right away, because Japan’s recovery remains weak.

The other two options for stabilizing debt—a consumption tax increase or a broadening of the tax base—tend to have somewhat lower long-term positive effect on growth but create fewer macro problems in the short term. Realistically, however, these measures would also need to be phased in gradually to avoid strong taxpayer resistance. So the policy response will need to be a balanced mixture.

IMF Survey: Once the fiscal situation has stabilized, what are the fiscal implications of the aging process?

MÜhleisen: In our simulations, we looked first at the finances of the social security system. The Japanese Ministry of Health and Welfare projects that under its currently envisaged pension reform plan, contributions to the major pension system would need to increase from a current level of 17½ percent on wages to 25 percent over 25 years. We found, using our own macroeconomic assumptions, that this would not be enough. We projected contribution rates of 30 percent, which would serve as an even larger disincentive for labor force participation.

We also looked at the fiscal implications of rising government transfers on the pension and health insurance systems. We found that once expenditure cuts and measures to broaden the tax base are implemented, additional adjustments will still be required on the consumption tax side. This is a politically sensitive issue, but in the end it is the main tool the authorities have to adjust the fiscal side. Right now, Japan has a relatively low tax rate of 5 percent. Under our baseline projections, the consumption tax rate would have to rise to 25 percent by the year 2050, when the age dependency rate is the highest. This estimate is not very precise, of course, since different assumptions on, say, the fertility rate or total factor productivity growth could lead to considerable variations in the end point for the consumption tax rates. Our estimates are in the range of 18 to 30 percent.

The main long-term question for Japan is really how it should finance the growing pension and health care burden. There are basically three options: maintain benefit levels roughly where they are, but raise contribution levels; keep the current level of benefits, but finance the gap through government transfers instead of contributions; or cut both benefits and contributions. These options have different growth and welfare effects. The baseline option of keeping benefits at current levels and raising contribution levels produces the worst results, because it discourages workforce participation. It is also proves to be the least equitable option, because pension costs would be entirely financed by the young, who are a shrinking proportion of the population.

Cutting both benefit levels and contributions produces the most positive effects. It offers an incentive for higher saving through private pension arrangements, has the least distortionary effects in terms of payroll taxes, and is the most equitable. The third option—higher benefit levels funded by consumption taxes paid by the elderly as well as the rest of the population—offers higher growth than the baseline scenario over the long term, but the welfare effects measured by real consumption and real private wealth tend to disappear over time. The main reason is that the model incorporates welfare losses caused by higher consumption taxes, owing to the wedge between consumer and producer prices. Our simulations conclusively indicate that cutting benefits and raising contributions is the preferred option, albeit a politically difficult one.

IMF Survey: What are the key issues, then, for Japan in the near term?

MÜhleisen: Let me emphasize that the first priority is ensuring a solid recovery. Debt reduction should be pursued in ways that least endanger the recovery. Our findings underscore the detrimental effects on growth that would initially result from severe public investment cuts.

Faruqee: Certainly, Japan’s current macroeconomic climate and persistent cyclical weakness argue that its short-term priorities lie elsewhere, but the prospects for population aging are well in place and thus pose serious policy challenges. Acting early, rather than later, gives the authorities the greatest degree of flexibility in the options they can consider. Acting only after the aging hits with full force would probably also necessitate a larger, more difficult adjustment. This paper hopes to encourage early action as soon as the strength of the recovery makes that feasible.

Copies of Japan—Selected Issues will be available shortly for $10.00 each from IMF Publication Services (see page 350 for ordering details). The two chapters discussed in this article are also being revised and will be released as an IMF Working Paper.