Fiscal Cost of Demographic Transition in Japan

This paper quantifies the fiscal cost of the demographic transition that Japan is projected to experience over the next several decades, in a life-cycle model with endogenous saving, consumption, and labor supply in both intensive and extensive margins. Retirement waves of baby-boom generations, combined with a rise in longevity and low fertility rates, will raise the old-age dependency ratio to 85% by 2050, the highest among major developed countries. The demographic shift will generate a significant budget imbalance as the government faces rising costs for public pension and health and long-term care insurance. In the long run, the labor income tax rate needs to rise by 13.5% or the consumption tax rate by 14.3% to balance the budget, assuming no other change in policies. The transition, however, involves more significant adjustments, and we simulate alternative pension reforms that can mitigate fiscal pressures.