Long- and Short-term Perspectives for Pension Reform and Options Left for Japan

KITAO Sagiri
Visiting Fellow, RIETI

The full-fledged launch of Japan's pay-as-you-go public pension system dates back to the 1960s. At the time, the average life expectancy was below 70 years, and the National Pension program that provides old-age benefits to those aged 65 and above was playing an insurance role against the risk of outliving the average. Based on a range of socioeconomic assumptions that included an ever-growing economy, an average household comprised of a married couple with the husband as the breadwinner and working a fulltime job and the wife as a mother and fulltime homemaker, lifelong employment and seniority-based pay systems, and a fertility rate above the replacement level and continuous population growth, the public pension system used to function effectively with the government offering insurance for items that were unable to be provided efficiently by the market. Now that each and every one of those underlying assumptions has failed, it is obvious that the system is unsustainable.

Average life expectancy has increased to about 85 years, and people have come to expect the public pension system to serve as longevity insurance and support their post-retirement lives spanning a couple of decades. The pension system must be reformed in accordance with changes in the socioeconomic structure. As another compelling reason, far greater fiscal challenges are awaiting in the medium-term future. As shown in Figure 1, the old-age dependency ratio, i.e., the ratio of people aged 65 and above to the working-age population aged 20-64, will rise rapidly over the coming several decades as baby boomers retire in increasing numbers and the working-age population declines due to persistently low fertility. The old-age dependency ratio, which was below 40% in 2010, is expected to exceed 70% in 2040 and reach 88% in 2080. It is predicted to remain high for the subsequent decades and will fall below 80% only after at least another century.

Figure 1: Old-Age Dependency Ratio (%) (Computed from fertility and mortality rate forecasts by the National Institute of Population and Social Security Research)
Figure 1: Old-Age Dependency Ratio (%) (Computed from fertility and mortality rate forecasts by the National Institute of Population and Social Security Research)

What it takes to avoid a consumption tax rate of over 40%

The public pension system is not the sole cause of the deterioration in the fiscal balance associated with an aging population. As payments under the public health and long-term nursing care insurance programs are mostly for elderly people, medical expenditures are bound to increase sharply with the aging of the population. If the current levels of pension and health insurance benefits are maintained, Japan must inevitably increase the burden on taxpayers drastically. Driven by interest in Japan as a country where the population is aging at an unparalleled pace, a number of research studies using general equilibrium models have been published in recent years.

According to a study by University of Southern California Professor Selahattin Imrohoroglu and his co-author, total tax revenue equivalent to 30% to 40% of consumption would be required if Japan is to achieve fiscal sustainability. My study using an overlapping generations (OLG) model found that the consumption tax rate required to achieve a fiscal balance would reach 40% in the 2050s and remain around that level for the following several decades, if the current social security system were to be maintained. R. Anton Braun of the Federal Reserve Bank of Atlanta and his co-author also found that Japan's consumption tax rate would have to be raised to above 45% if there is no reform to the public pension and health insurance systems.

The findings may appear unrealistic in Japan, where raising the consumption tax rate from 8% to 10% was such a big issue that it would rattle the dynamics of politics. However, those figures shown above should be taken as an indication of the magnitude of Japan's fiscal problem.

In order to avoid drastic tax hikes, the government needs to reconsider existing policies to adapt to changes in the social economic structure from a long-term perspective, while at the same time implementing measures to address a rapid rise in the proportion of the elderly population in the near future. As a possible long-term measure, shifting from the current pay-as-you-go public pension system to a funded system is an option worth considering. For instance, the government could introduce a mandatory funded pension scheme, whereby employees would be required to transfer about 9% of their salaries?i.e., an amount currently paid as employees' contribution to the Employees' Pension Insurance program?to the individual pension fund accounts. Employees then would manage funds in their respective accounts, investing them in relatively safe assets at their own risk, until they reach the pension age. This should apply to all without exception, whereby all individuals providing labor?regardless of gender, age, amount of income, employment status (whether fulltime permanent employees, agency workers, or casual workers), and company size?would have a certain percentage of their wages transferred to their pension fund accounts automatically. Since those pension fund accounts are personal accounts, job changes or losses would not result in a reduction in account balances or a complex procedure for switching from one pension plan to another. Although annual amounts funded would vary with fluctuations in wages, account balances would not decrease except when large investment losses are incurred, enabling people to receive a certain percentage of their lifetime earnings as pensions. As some people may not be able to accumulate enough funds to maintain the minimum standard of living after retirement, a portion of the current pension system?which is equivalent to the current old-age basic pension?should be kept in the form of a public pension plan.

According to my calculations, this scheme would enable the government to reduce its peak expenditure by an amount equivalent to a consumption tax rate of 20%. The shift from the pay-as-you-go scheme to the funded scheme would reduce the amount of payouts from the public pension system. In addition, investment of pension fund assets in individual accounts over a period of several decades would make an enormous amount of capital available for economic activity, leading to higher wages, production, and consumption, whereby an increase in tax revenue could be expected from sources other than the consumption tax. The scheme, which is primarily aimed at reducing social security expenditures, would also lead to the revitalization of the economy and welfare gains in the long run.

Short-term measures are needed aside from long-term measures

In the long-run, there is no option but to reduce the government expenditures or to raise revenues, through policies such as a gradual transition to a funded pension system, an increase in the pension eligibility age, and a reduction of pension benefits. In order to address immediate issues arising from a rapid increase in the proportion of the elderly population over the next several decades, a separate set of measures would be needed.

Suppose that the "macroeconomic slide" automatic benefit adjustment mechanism introduced in the 2004 pension system reform functions properly and successfully reduces benefit amounts by about 20%. Even then, it would be necessary to secure tax revenue equivalent to 30% of total consumption over the next 50 years or so if Japan's public pension system is to be sustained. If drastic reductions in pension benefits amounts are to be avoided for being undesirable from a welfare point of view or politically impossible, Japan needs to find a new source of tax revenue. Greater female participation in the workforce and the improvement of employment conditions?both of which are being promoted under the Abenomics economic policy?would help increase tax revenue, and thus can be counted among the new revenue sources. However, higher wages today translate into higher pension benefits in the future, meaning that raising total wages, although effective as a short-term revenue booster, would cause Japan's fiscal position to deteriorate in the long run as long as the public pension system remains unchanged. It is thus necessary for Japan to pursue two separate sets of measures?those based on the long-term perspective and those designed to increase tax revenue in a short-term period?in parallel and simultaneously. Allowing foreign nationals with certain skills to work for a designated period of time, just like under the H-visa program of the United States, is worthwhile of being considered as a potentially effective measure.

Being oblivious to the medium- to long-term problems for the sake of avoiding immediate pain is tantamount to exacerbating the problems and leaving them all to the future generations. We must get a clear and accurate picture of the fiscal problems facing Japan and begin concrete discussions into looking at options for solving the problems and their impact. We have no time to waste.

April 20, 2015

April 20, 2015