Clarifying the Debate will Enable Productive Discussion on Pension System Reform

Fellow, RIETI

For months, Japan's pension debate has focused almost entirely on dealing with the negative fallout from the exposure of massive scandals ranging from missing pension records to embezzlement of premiums by government officials. Finally, however, constructive debate has begun on how to sustain and develop the nation's pension system.

Financing increasing costs to the government

At the center of the debate and of growing public concern is Basic Pension (BP), a universal scheme that constitutes the first tier of Japan's public pension system. More specifically, at issue is how to finance the additional costs to the government resulting from ongoing pension reform in which the share of national treasury-funded BP benefits is being gradually raised from the previous one-third to a target of one-half. Given the severe fiscal conditions, coming up with some \2.5 trillion in funds is an imposing task. Initially, talks were held on using the additional, or restored, tax revenue resulting from the scaling down and eventual elimination of fixed-rate income tax cuts. More recently, or I should say finally, calls are emerging for raising the consumption tax rate to cover the increasing share of government subsidies. Probably in tandem with this, some legislators in both the ruling and opposition blocs have begun to argue for the possibility of financing BP benefits not only partially but entirely with tax revenue. If realized, this could help prevent those entitled to little or no pension benefits from falling into poverty in their old age. Therefore, I do feel the idea should be given positive consideration. But national consensus must be sought on a number of issues.

Tax-based and premium-based pension systems look similar but are different

Japan's public pension system is primarily financed by premiums. In a premium-based scheme there is a moderate but recognizable quid pro quo relationship between premiums and benefits, with pensioners receiving benefits correlated to the premiums they have paid. Thus, when people pay pension premiums, the government implicitly promises the amount of benefits each individual will receive years later, as calculated using a formula based on the amount of premiums paid by that individual. With a tax-based pension system, however, there exists only a thin quid pro quo relationship between individual tax burden and pension benefits received. Pension benefits under this system are very much like financial assistance allowances. As such, BP benefits - even when referred to by the same name - differ greatly depending on their source of funding. It is difficult to change pension benefit amounts under a premium-based pension system, but it is somewhat justifiable for the government to change the amounts at its discretion under a tax-based system. Those arguing for restructuring the BP into a fully tax-funded system should clearly explain to then seek judgment from the public on the advantages and disadvantages of changing the funding method and the resultant changes to the benefits. The major advantages of a tax-based system are that it is easier on fiscal health because it enables the government to reduce pension benefits (for instance to high-income earners) and that it helps prevent low income earners from being left with little or no pension due to their inability to pay premiums. Its disadvantage is the insecurity it instills in beneficiaries as the amount of benefits could be reduced at any time. In this regard, the government needs to build broad public consensus. Without such consensus, if the government tries to limit the scope of discretionary changes in the amount of pension benefits by regarding as "quasi premiums" taxes that specifically fund the pension system (such as consumption taxes), it will need to clarify and refine the underlying concepts.

Making part-time workers eligible for EPI benefits

One major issue left unaddressed, though long recognized as important, is the need to expand the range of part-time workers eligible to join and receive benefits from Employees Pension Insurance (EPI), a second-tier plan for corporate employees. Restructuring the BP into a fully tax-funded system may significantly impact the expansion of EPI coverage. Under the current EPI scheme, the monthly premium is calculated by applying the prescribed premium rate to a "standard monthly income," not to the exact monthly income earned by individuals. Corporate employees are divided into 30 groups based on monthly income with each income group assigned a specific standard monthly income as the basis for premium calculation.

For instance, those with a monthly income of less than \101,000 are Class 1, the lowest income group. Anyone in this class is deemed as earning \98,000 per month, the Class 1 standard monthly income, meaning that the monthly premium is \98,000 multiplied by the premium rate. (Those with a monthly income of \605,000 or more are Class 30, the highest income group, with monthly premiums calculated by applying the premium rate to a standard monthly income of \620,000.) Based on the current rate, the Class 1 monthly premium under the EPI is \14,696 (including both employee and employer contributions), roughly comparable to the uniform premium of \14,100 under the National Pension (NP), a plan for the self-employed and those not covered by an employee pension scheme. (In terms of benefits, the EPI is advantageous as its beneficiaries are eligible for both salary-related and BP benefits.)

Thus, given the current level of the lower-end standard monthly income and the presence of Category 3 beneficiaries (dependent spouses of employees), the range of part-time workers who would benefit from expanded EPI eligibility criteria is very limited. Restructuring the BP into a fully tax-funded system would remove concerns about the balance between the EPI and NP or the treatment of Category 3 beneficiaries, and pave the way for sequentially expanded EPI eligibility covering a greater range of part-time workers by reducing the lower-end standard monthly income.

If realized, this would enable part-time workers - even those earning, theoretically, only \10,000 per month - to receive pension benefits in an amount corresponding to their actual income in working age. The question is whether the business community will agree to this. Strong opposition is expected, particularly from some industries that rely heavily on part-time workers. But things are different from the standpoint of the entire business community. When or if the BPs restructured into a fully tax-funded system, the corporate burden of pension payments will be reduced by an amount applicable to the BP (and it might be possible to keep the EPI premium rate unchanged from around 13%). This may provide momentum toward building consensus with companies as well as with households.

To what extent should income-related pensions cover the self-employed?

Most public pension systems - be it a two-tiered formula or a North European-style formula - have an income-related portion. Income-related pensions enable people to smooth out their consumption before and after retirement while mitigating risks such as economic fluctuations and uncertainty about lifespan. Thus, particularly for corporate employees with predetermined retirements, income-related pensions constitute a critical function of a pension system. (Some argue that the function of a public pension system should be limited to providing the minimum guarantee and basic pensions).

For instance, a system proposed by the Democratic Party of Japan would create and apply to all contributing beneficiaries (in other words everybody) an income-related pension plan equivalent to the second-tier portion of the EPI. This is an important idea. If both the self-employed and employees are covered by the same pension system, the amount of pension benefits is not affected by the type of work style during active working age. Thus changing from self-employed to employee or from employee to self-employed would not change the amount of pension benefits to which that person is entitled. This may work to induce entrepreneurial activities thereby boosting the still low number startups in Japan. The negative aspects of applying an income-related pension plan to the purely self-employed do also need to be taken into account. It may not make much sense to proactively try to provide income-related pension benefits to self-employed people to whom the notion of retirement is quite abstract.

Also, it should be noted that income-related public pensions are basically being financed on a pay-as-you-go (PAYG) basis. In a rapidly aging society, a PAYG pension system involves a "risk" associated with the working generation's capacity to bear burdens. Recent world trends in pension reform suggest that a typical approach taken by many countries is basically adopting a conventional PAYG system but curbing the expansion of PAYG plans and establishing a multi-tired pension scheme by partially incorporating elements of funded system, thereby diversifying risk. If Japan dares to buck world trends and expand its PAYG pension plans, it needs to do so with solid planning and discretion. Thus a broad range of issues should be discussed, including the possibility of expanding the existing National Pension Funds system.

Find rational common ground and explain to the people

Sweden's pension reform is often cited, not only in Japan, as a successful reform model. Years of efforts by both the regulatory authorities and the politicians lie behind Sweden's successful implementation of such remarkable reform. Government officials patiently worked to build national consensus while legislators - both from ruling and opposition parties - committed themselves to forming a rational consensus, keeping their respective interests in check so as to avoid conflicts. With the latest major reform in 2004, Japan undoubtedly made progress in improving the sustainability of its public pension system. In order to further ensure the sustainability of the system, I count on both the ruling and opposition parties to have productive discussion.

October 23, 2007

October 23, 2007

Article(s) by this author