The Japanese Economy: Strategies to cope with a shrinking and aging population

Date February 1, 2023
Speaker Randall S. JONES (Professional Fellow, Center on Japanese Economy and Business (CJEB) at Columbia University / Former Head of the Japan / Korea Desk at the OECD)
Commentator KITAO Sagiri (Senior Fellow (Specially Appointed), RIETI)
Moderator SABURI Masataka (Director, PR Strategy, RIETI / Special Advisor to the Minister, METI)

Japan faces a demographic challenge. The falling population size and increasing share of the elderly in the population will make it more difficult for Japan to meet its commitment to provide universal health and long-term care and pensions to the elderly. Therefore, a comprehensive strategy is required that includes efforts to address the demographic situation and limit the decline in the labor force by making better use of women, older people and foreign workers. The government must also try to boost labor productivity from its current relatively low level, and reform the health and long-term care systems to make them more efficient. Alongside this, fiscal policies will also need to address government debt. This webinar explores Japanese demographic shifts in detail, including their contributing factors and associated issues, and offers suggestions on how to address these shifts moving forward.


Japan is a frontrunner in addressing demographic change, facing very rapid demographic transition. With the share of elderly increasing from 7% to 14% in the 24 years from 1970 to 1994, and then to 20% just 12 years later, the population is expected to fall by about a quarter, to about 93 million by 2060, with the elderly share of the population rising to 39%. While having fewer people means reduced pollution, greenhouse gas emissions and congestion, aging can make it difficult to maintain the social safety net. This starts with fertility, which for Japan was on a downward trend even pre-pandemic. Traditionally there is a negative relationship between fertility and GDP per capita, reflecting a quantity/quality tradeoff as parents get richer and invest more in quality, making it more expensive to have children. As wages increase and women become more educated and join the labor force, the opportunity cost of childcare rises, resulting in lower fertility. However, in recent years, fertility behavior in high-income countries has been increasingly driven by the degree of compatibility between women's careers and families. Without this compatibility, women choose to have fewer children. Improving the compatibility of women's careers and families requires greater emphasis on family policies, including public social spending, services, in-kind benefits, and tax benefits for children. Japan is at the low end of OECD countries in this regard, spending 1.6% of GDP compared to the OECD average of 2.4%.

Other relevant factors are social norms, gender roles, and labor market flexibility. Japan’s segmentation of labor markets into regular and non-regular employment can make it difficult for women to move from household responsibilities into the labor market. Every five years, the government polls couples on their ideal and intended numbers of children. The actual number of children falls short of both the ideal and intended numbers, prompting the question of how to remove the obstacles that are preventing these families from reaching their ideal or intended numbers of children. Such obstacles include high childcare and education costs, as well as the interruption to parents’ careers, associated health issues, and the lack of equal participation by both parents in childcare. OECD statistics show that women spend an average of 3 hours and 44 minutes daily on childcare and housework, while men spend about 41 minutes. This gap is exacerbated by long working hours and commutes. Japan has a generous parental leave policy, however the share of eligible men that take this leave was only 6% in 2018. Younger people also face financial challenges from debt, education and low salaries, leading them to delay marriage. In Japan only 2% of children are born outside of marriage, so this delay has a severe impact on the birth rate. To improve the birth rate Japan must first improve the financial situation for young people.

The Japanese Labor Force

In terms of labor force issues, Japan does not have a low rate of female employment. Since 2012, 2.9 million women have joined the labor force, with a rate of over 70% which is higher than the OECD average; however, Japan has the third highest gender wage gap in the OECD at 23%, driven by labor market duality. Women account for almost two-thirds of non-regular workers and therefore may not receive wage benefits such as seniority-based raises or substantial annual bonuses. Government polls show that non-regular employees are viewed by firms as a cheaper and more flexible workforce. Therefore, both employment flexibility and employment protection are key issues. The OECD recommends increased coverage of social insurance for non-regular work and training programs, and reduced employment protection for regular workers, with the goal of protecting people over jobs. Another issue is discrimination. Japan aimed for women to occupy 30% of leadership positions by 2020. As of 2018, this was still at 14%. In politics, just under 10% of Diet members are women, compared to rates of 30 to 40% in Europe.

There is also the issue of older workers. Both men and women commonly work past the age of 60, but there is still scope for increasing this figure. Many people want to work beyond 65 or 70, but most companies still set mandatory retirement at 60, despite Japan's long life expectancy. 2013 government initiatives for workers to continue with firms after age 60 ended up creating additional non-regular workers, as companies still ended the lifetime employment practice at 60. The share of men in non-regular employment positions increases from 10% in the 55-59 age group to nearly 60% afterwards, with their average wage dropping by about 40%. This is not an effective way to increase employment of elderly people because it disincentivizes work for the most qualified people in the age group. One way to help people extend their working careers is to abolish mandatory retirement, encouraging people to continue working, and to change the wage system to give less weight to seniority and more weight to job type and performance. Lifelong learning also needs to be increased to allow older people to adapt to a digital economy. Finally, a better work-life balance is necessary to prevent burnout and health risks associated with long hours.

The share of foreign workers in the Japanese labor force is about 2%, however there is much opportunity to increase this. In 2019, Japan introduced the specific skill work program, which allows foreign workers in 14 industries with labor shortages to work in Japan for five years. The government expected that this could have brought nearly 350,000 workers to Japan by 2023, however COVID-19 has made it difficult to bring workers in, and there is also increasing competition for foreign workers from Korea, Taiwan, Hong Kong and others, so Japan needs to ensure that it is an attractive opportunity.

Labor Productivity

Japan's labor productivity has fallen below the top half of OECD countries at about 28%, with large labor inputs, but relatively low productivity. As labor inputs drop with shorter working hours and a falling population and labor force, it will be essential to increase productivity. Japan has a polarized economy with a large gap (55%) between the productivity of small and medium-sized enterprises (SMEs) and large companies. Despite 72% of firms being classified as SMEs, highly dynamic small companies are rare, with 75% being over ten years old. Younger firms are key to increasing productivity because they grow through economies of scale and they also prevent non-viable firms from occupying space. A large number of Japanese SMEs purposely remain small in order to benefit from governmental support for smaller firms, including loans, lower tax rates and other policies. Additionally, nearly three-quarters of Japanese SMEs are in the service sector, and services make up about 65% of the Japanese economy, with this set to increase with aging. Manufacturing productivity has continued to develop in Japan since the 1990’s, but service sector productivity peaked in 2008 just before the world financial crisis but has basically stagnated since. Improving this through digital technology will be crucial to improving living standards and to sustaining economic growth. One of the problems in services and SMEs is the lack of innovation. The service sector provides two- thirds of economic output, but only 10% of Research and Development (R&D). Japan has many patent applications, especially in ICT and biotech, but international co-authorship and inventing are relatively low. Also, only 5% of R&D spending is in universities, where PhDs in STEM are located. A system where universities, government research institutes and business sectors work together cooperatively to advance technology would be ideal. Japan has a high level of ICT patents and investment, but this technology is not filtering down from big companies to SMEs.


Japan's healthcare system is very good. Healthcare spending has risen to about 11%, and aging accounted for two-thirds of a ¥12 trillion rise in healthcare spending from 2000 to 2016, with spending on people over age 65 about six times higher than for younger people. Technology advancement and adoption is also driving up costs and the government estimates that healthcare and long-term care spending will rise by another 5% of GDP by 2060, further increasing fiscal pressure. The average number of doctor consultations per year in Japan is very high at 12.8, reflecting Japan’s fee for service system. The average hospital stay is the highest in the OECD, reflecting social hospitalization where elderly people who need help with everyday living may end up in hospitals. Looking at hospital beds per capita by prefecture, prefectures that have a large number of beds per capita have larger numbers of people going to hospital, and higher healthcare spending. Reducing the number of hospitals and shifting towards long term elderly care facilities could be key, along with increasing the healthy lifespan to lower healthcare costs and raise employment rates for people 65 and over through healthy habits. Limiting the increase in healthcare spending is essential, and a performance-based fee structure, increased use of generic drugs and a shift towards home-based care could help achieve this.

Fiscal Concerns

The fiscal situation is also of increasing concern. In 1990, Japan's gross government debt was about 60% of GDP. This rose rapidly to around 150% in the 2000s, and 242% in 2020, with an OECD projection for 252% by next year. One reason for this is public social spending on healthcare, long-term care, pensions and social welfare. Government spending peaked in 2009 with efforts to offset the global financial crisis. There was then a gradual downward trend in government spending during Abenomics, with government revenue able to increase by about six points of GDP based on faster economic growth and tax hikes in 2014 and 2019. The deficit was reduced to around 3% of GDP in 2018 and 2019, despite an increased share of social spending, by squeezing other necessary categories such as education, science, national defense and infrastructure. This was not a long-term solution, with plans to double defense spending to 2% of GDP by 2027. In 2010, the government aimed to reach a small surplus by 2020, which was on track until it delayed the target to 2025 in 2018. With sharp increases in spending to deal with COVID-19, the OECD estimates that by 2023 the deficit will reach 6% of GDP, so achieving zero in just two years is not realistic. The government needs a realistic, achievable target to gradually put government debt on a downward trend.

As population density declines, capital spending increases. This will become a problem because Japan has many areas where the population is falling. It also increases as the share of elderly rises, contributing to continued pressure on government spending. The OECD measure of the replacement rate indicates that the Japanese pension system will provide relatively low benefits of about 37% of the working-age income. Elderly poverty (relative poverty defined as income below half the national median), is at about 20% in Japan and will likely rise. A sustainable pension system is needed to ensure the elderly do not fall into poverty. There are three options for fixing the pension system. One is to raise the contribution rate, which is already quite high at 18.3% of wages. You could also lower the benefits, but these are already quite low. So Japan’s plan to raise the eligibility age to 65 should go higher to 68 and then to 70. This extension of working life also increases the replacement rate.

While government debt is high, the Bank of Japan has kept interest payments low, and Japan spends only about 0.4% of GDP on net interest payments. On December 20th, there was an important decision at the Bank of Japan to widen the band for the zero target from 25 basis points up to 50 basis points. A further widening implies that the borrowing rate of the government could increase significantly in the near future. Japan is a low tax country, but it is not easy, either politically or economically, to raise tax revenue to solve these problems. The OECD ranks taxes based on their impact on economic growth, which suggests the best options are environment taxes, property taxes, and the consumption tax. Japan has high personal income tax rates, but low revenue, because the income tax base is very narrow. Social security contributions are high, and corporate-income tax rates have come down from 39% down to 29.84%. Broadening the tax base is recommended over raising the rate, in part to avoid negative effects on foreign direct investment. To raise 5% of revenue Japan’s 10% consumption tax would need to rise to the European average of 20%. A single rate would be preferable, because having two rates can lead to distortions. For personal income tax, the issue is that about 30% of wage income is excluded from taxation, with less than half of wage earnings taxed. Improved transparency through the “My Number” system is necessary to tax a broader base of income. Japan also has a relatively low share of environmental-related taxation. Given its targets for reducing greenhouse gas emissions and achieving carbon neutrality by 2050, it would be useful to raise carbon taxes as soon as possible.


KITAO Sagiri:
This thorough and comprehensive summary of issues facing an aging and shrinking Japan provides a very clear big-picture perspective supported by a wealth of data, and rich cross-country analysis against Japan’s peers in the OECD countries, with a comprehensive strategy targeting many aspects of the economy. The two main issues facing Japan are population decline, which must be mitigated through increasing either the labor force or productivity or both, and the increase in age-related expenditure. Effective fiscal policies must be implemented to stabilize this rising burden. I will take a macroeconomic approach to reiterate and corroborate some points. One issue is the labor shortage and female labor force participation, and the second is labor market dualism, which leads to inequality and future fiscal challenges. As Dr. Jones emphasized, Japan is not doing badly in terms of women’s labor force participation. However average earnings for women are low. Women stay in the labor force, but do not accumulate the same human capital as their male peers. Using a lifecycle model, myself and my co-author Minamo MIKOSHIBA examined women's labor market participation patterns to simulate policy reform and understand the effects. We focused on the effects of three policies, spousal deduction, social insurance tax exemption, and survivor's pension benefits, on women born in the 1960s. These policies were introduced and implemented with good intentions, to support low income or non-working dependent spouses in the 1960s and 1970s.

The data shows a decline in labor force participation for women in their thirties when they have children or get married. After that, the participation rate starts to rise, but there's a big decline in regular employment and an increase in nonregular work. When women come back to the labor force, they return as contingent workers. Employment types for single women do not show a change in the share of regular work, but married women switch from regular jobs to either not participating in the labor force, or to contingent work, with very different wages. Wage inequality amongst women is not determined by education or skill, but between whether they engage in regular and contingent work. Those who stay in nonregular jobs, including many women after they get married, don't see growth in their earnings. This brings us onto the goals of fiscal policy. Japan has a comprehensive social insurance system, with 30% of earnings paid equally between employer and employee. However dependent spouses who are married to covered individuals and earn less than the threshold of ¥1.3 million are exempted from social insurance tax payments, with additional survivor's pension benefits which allow for claiming a portion of the husband's pension. Labor income tax in Japan is individual-based, but there are spousal deductions. The husband can only claim this deduction in a full amount if the wife is not working. Therefore, the spousal deduction is a barrier for entry into work because women do not want the household to lose this exemption, and the premium exemption is a wall preventing the increase in women’s earnings. Once you go over this threshold, the tax liability of the household increases dramatically. Removing these spousal deductions in the life cycle model results in an increase in the participation rate, mostly from non-regular work. More women may start to work, but another obstacle they face is the exemption from social insurance taxes. Removing this ¥1.3 million threshold for the premium exemption leads to an increase in participation, largely in regular work. Without these barriers, women would participate more and accumulate human capital as regular workers, contributing to more earnings. When we removed these three policies in the model, employment rate increased by 12% and earnings by about 30%, representing a large increase in productivity. My second point is on labor market dualism. The share of nonregular work among men too has increased to more than 20%, resulting in increased inequality of earnings among younger households. We computed this change in earnings by age group, showing an increase in poverty in young households from increases in non-regular work. This is not just about earnings. These households are unable to accumulate wealth. The share of households in this situation has increased from about 5% to 10%. They are also likely not contributing enough to the social security system. In ten or twenty years when they reach retirement age, they may not have sufficient savings or social security benefits and the government will have to provide not only a pension, health insurance, and long-term care, but also increased social assistance expenditure. Therefore, we must address this quickly.

I agree with Dr. Jones’ comprehensive strategy, but at the same time, there are many policies that are no longer suited to the current reality. Policies, conventions of the seniority system and social norms need to be reexamined and must change.


What will happen to China when its population starts declining in a similar way to Japan? Regarding SMEs, how have political policies in other OECD countries been able to stay in effect while SMEs have voting power in elections exposed to market competition? Lastly, Japan's labor productivity is low among the OECD, but this fact does not reflect the high quality that comes with products produced in Japan. Do you somewhat agree?

Randall S. JONES:
I certainly agree that the quality of services is very high in Japan. Regarding the question related to SMEs, in the US, for example, SMEs are not viewed as a declining sector, as they include Silicon Valley and startups. Japan needs SMEs to become the driving force of the economy. The majority of Japanese SME owners will be over age 70 by 2025, so the consolidation of existing SMEs to make them bigger and more efficient, along with increased encouragement for startups and venture capital firms, would make a more dynamic economy. In Japan, people may be risk averse, but entrepreneurship is important to drive the economy forward. Finally, China is entering a new stage. They don't have as well-developed a safety net as Japan does. I would be less worried about their fiscal situation, and more about elderly poverty. With the one child policy, there will be an enormous burden of care on the working age population.

KITAO Sagiri:
What happens in China will have consequences in our economy as well. China has a limited social insurance system, so their saving rate is extremely high. If longevity continues increasing, and the number of children does not respond to policy changes, they will keep saving, and interest rates may fall leading to Chinese investment in Japan. Chinese Policy and the demographic changes will have some consequences on the Japanese economy through changes in capital flows.

Your knowledge related to America and the Western countries, and Korea and Japan as well, has provided us with a truly global point of view. Learning about Japan today was like getting a diagnosis from a doctor. Using a metaphor of an airplane with 4 engines, older men, younger men, older women and younger women, it sounds like other OECD countries are using all their engines, but Japan is only utilizing one engine: the older men. We are still flying, but if we had the other three, we could go further.

Randall S. JONES:
I'm very confident Japan will be able to make good choices and continue to be an outstanding and unique country.

*This summary was compiled by RIETI Editorial staff.