ACHIEVING FISCAL BALANCE IN JAPAN*

• Author: Selahattin İmrohoroğlu,Tomoaki Yamada,Sagiri Kitao
• DOI: http://doi.org/10.1111/iere.12150
• Published date: 01 February 2016
• Date: 01 February 2016

INTERNATIONAL ECONOMIC REVIEW

Vol. 57, No. 1, February 2016

ACHIEVING FISCAL BALANCE IN JAPAN∗

BYSELAHATTIN ˙

IMROHORO ˘

GLU,SAGIRI KITAO,AND TOMOAKI YAMADA1

University of Southern California, U.S.A.; Keio University, Japan; Meiji University, Japan

Japan is aging and has the highest government debt-to-output ratio among advanced economies. In this article, we

build a micro data-based, large-scale overlapping generations model for Japan in which individuals differ in age, gender,

employment type, income, and asset holdings, and incorporate the Japanese pension rules. Using existing pension law,

current fiscal policy, and medium variants of demographic projections, we produce future paths for government

expenditures and tax revenues, with implications for government debt and the public pension fund. Additional pension

reform, a higher consumption tax, and higher female labor force participation help achieve fiscal stability.

1. INTRODUCTION

Japan has the highest debt-to-GDP ratio among advanced economies and faces a fast and

large demographic transition to an older society. In addition, recent government plans call for

a continuation of primary deficits at least through 2020, renewing concerns over whether the

Japanese government bonds (JGBs) may become a global problem. In the absence of a robust

theory of government debt, it is difficult to evaluate statements regarding the massive quantity

of the JGBs, their prices, and if and when bond market participants will stop buying them. One

can, however, develop a model to measure what will contribute to the magnitude of the JGBs

and the underlying reasons, and that is what we do in this article.

We build a micro data-based, large-scale overlapping generations model for Japan in which

individuals differ in age, gender, employment status, income, and asset holdings and incorporate

the Japanese pension rules in detail. We estimate age-consumption and age-earnings profiles

from micro data and assume complete markets. We calibrate the model so that it matches main

macroeconomic and fiscal indicators for 2010. Using existing pension law, current fiscal policy,

and the medium variants of fertility and survival probability forecasts, we generate projections

of future government expenditures, tax revenues, the pension fund, and JGBs. In addition,

we decompose annual net borrowing requirements that integrate to the JGBs into nonpension

primary deficit, pension deficit, and net interest payments on JGBs net of the pension fund.

Our analysis highlights the following key quantitative findings:

(1) Under current policies and absent any further reforms or changes, large pension and

nonpension deficits will persist, with growing interest payments on government debt

∗Manuscript received April 2013; revised May 2014.

1We are grateful to Julen Esteban-Pretel, Fumio Hayashi, Ryo Kato, Tsutomu Miyagawa, Hajime Tomura, and

seminar participants at Hitotsubashi University, GRIPS, Gakushuin University, Hokkaido University, Kyoto Univer-

sity, 2013 Meetings of the Society for Economic Dynamics and the Society for the Advancement of Economic Theory,

Michigan Retirement Research Consortium Researcher Workshop, NYU Stern, and CIGS for many comments. We

gratefully acknowledge permission of the Statistics Bureau, the Ministry of Internal Affairs and Communications in

Japan to use the Family Income and Expenditure Survey and the National Survey of Family Income and Expenditure

for this project. Kitao acknowledges the financial support by a grant from the Abe Fellowship Program administered by

the Social Science Research Council and the American Council of Learned Societies in cooperation with funds provided

by the Japan Foundation Center for Global Partnership. Yamada thanks the Ministry of Education, Science, Sports,

and Culture, Grant-in-Aid for Young Scientists (B) 24730173 for their financial support. Please address correspondence

to: Selahattin ˙

Imrohoro˘

glu, Department of Finance and Business Economics, University of Southern California, Bridge

Hall 308 - 3670 Trousdale Parkway, Los Angeles, CA 90089-0804. Phone: 213-740-6546. Fax: 213-740-6650. E-mail:

selo@marshall.usc.edu.

117

C

(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

118 ˙

IMROHORO ˘

GLU,KITAO,AND YAMADA

becoming a serious burden. The ratio of debt to GDP reaches 210% in 2030 and 370%

in 2050.

(a) Pension and nonpension deficits contribute about the same, just about 4% of GDP

each, to new borrowing requirements over the next few years, with net interest on

debt playing a much smaller role, thanks to the low real interest rate on JGBs in the

current economic environment.

(b) With the consumption tax rate scheduled to rise from 5% to 10% in 2014–2015, there

is a significant improvement in the nonpension deficit and then a gradual rise of the

deficit over time as the ratios of nonpension transfers and government expenditures

to GDP start to rise.

(c) There is an initial, significant decline and, later, a smooth decline in the pension deficit

due to the pension reforms under way. However, in about 25 years the pension deficit

starts to rise again, eventually stabilizing at about 5% of GDP annually.

(d) Net interest payments on JGBs eventually dominate net borrowing requirements

despite the low 1% interest rate assumed in the baseline scenario; the stock of debt

becomes just too large.

(2) Among the outcomes and policies considered, three seem to have a large impact, although

none of them by itself is able to restore fiscal balance.

(a) Raising the retirement age to 70 and cutting pension benefits by 10% significantly

reduces the pension deficit.

(b) Raising the consumption tax to 20% produces a surplus in the nonpension balance.

(c) Raising the female labor force participation rates to those of males and having the

distribution of employment types converge to that of males impact the budget more

significantly; both pension and nonpension deficits are reduced.

In addition to the policy simulations, we present a number of sensitivity analyses on variables

that bring about changes in the deficit projections, including alternative assumptions on the

productivity growth, the interest rate on the government debt, and the returns on the asset

held in the pension fund. We also study various scenarios about how the female labor force

participation rates will evolve over time and investigate the impact of a guest worker program

to allow foreigners to supply labor in Japan. We note that outcomes and policies that are not

considered in this article, such as comprehensive tax reform and public health insurance reform,

may contribute to the solution of the fiscal problems, and these are left for future research.

The remainder of the article is organized as follows. We review the literature in Section 2

and present the model in Section 3. Details of the calibrated parameters are given in Section 4.

The benchmark results are discussed in Section 5, and Section 6 conducts a sensitivity analysis.

Policy experiments are presented in Section 7, and Section 8 concludes.

2. OVERVIEW OF THE LITERATURE

Our article contributes to a growing literature that relies on workhorse macro models to

shed light on the severity of fiscal adjustment Japan needs to make, the policy options that are

available, and the economic consequences of these alternative policy actions. We use Japan

as our economic laboratory because aging and fiscal imbalance are arguably most severe in

Japan among advanced economies. Therefore, a careful quantitative analysis of the impact of

outcomes and policies on the Japanese economy will allow us to discuss similar events for other

advanced economies.

The backdrop for this effort can be described as follows. The Japanese economy has essentially

been stagnant since 1990. The policy interest rate has been lowered to essentially zero for more

than a decade. Several rounds of fiscal stimulus packages since the early 1990s have resulted in

the highest debt-to-GDP ratio in the developed world. According to the OECD, Japan’s net

debt to GDP is about 116%, and its gross debt to GDP is above 200% by the end of 2010.

ACHIEVING FISCAL BALANCE IN JAPAN 119

2010 2020 2030 2040 2050 2060

40

45

50

55

60

65

70

75

Year

Millions of individuals

(

a

)

Working age population

2010 2020 2030 2040 2050 2060

30

40

50

60

70

80

90

Year

Percentage

(

b

)

Old-age dependency ratio

FIGURE 1

PROJECTED DEMOGRAPHICS: 2010–2060

In addition, Japan has the fastest aging population among the developed economies. There-

fore, Japan serves as a laboratory for (i) how severe demographic and fiscal challenges are, and

(ii) how various government policies and changes in economic environment may affect fiscal

sustainability. The expected aging of the population will raise pension payments as more and

more retirees will receive old age pensions, raising the transfers-to-output ratio.

Figure 1 shows the projected population in Japan at the working ages of 20 to 64 and the

old-age dependency ratio defined as the ratio between the population above age 65 and 20–64.2

With the increase in the fraction of 65 and older, the working age individuals will have to

increasingly support the elderly through some combination of higher taxes, lower leisure, lower

consumption, or lower future benefits for themselves, if current projections of future benefits

to current cohorts are to be maintained.

Using a neoclassical growth model, ˙

Imrohoro˘

glu and Sudo (2011a) examine the impact of a

rise in the consumption tax rate from 5% to 15% on the primary deficit-to-GDP ratio. Despite a

temporary improvement in the primary balance, their quantitative results indicate that a much

larger fiscal adjustment is needed to achieve fiscal sustainability. ˙

Imrohoro˘

glu and Sudo (2011b)

explore whether faster productivity growth can increase the tax base sufficiently to reduce debt

to GDP to manageable levels. They find that only a growth miracle, such as a 6% real growth

rate over 10 years, could achieve a fiscal adjustment of the size that Japan is facing.

Braun and Joines (2015) build an overlapping generations model that incorporates the de-

mographic transition and calculate economic projections for Japan. Their findings suggest that

in the absence of any reform, the consumption tax rate will have to rise to about 30%–45% in

order to achieve fiscal sustainability. They argue that a health-care reform that raises the co-pay

for the elderly to that for working age individuals, which is 30%, would contain the increase

in the consumption tax to 23%. Kitao (2015) uses a life-cycle model to quantify the fiscal cost

of demographic transition and shows that pension reform to scale down benefits and raising

the retirement age can significantly lower the required rise in consumption tax, assisted by a

significant increase in private saving and labor force participation.

Hoshi and Kashyap (2012) use a narrative to argue that zombie financing and very large

spending programs have significantly contributed to the already large projected fiscal burden

2Projections are based on the estimates of the survival rates and fertility rates by the National Institute

of Population and Social Security Research. For details, see the following Web site: http://www.ipss.go.jp/site-

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