Fiscal Sustainability in Japan: What to Tackle

Abstract

Japan leads all advanced economies in terms of aging and has the highest debt to GDP ratio. The public pension, medical and long-term care (LTC) expenditures are projected to far outpace revenues and create significant fiscal burdens. In this paper, we develop a detailed overlapping generations model that incorporates the social insurance programs in detail, use most recent estimates from Japanese micro data and government demographic projections to discipline the earnings and labor supply profiles of heterogeneous agents and their cohort shares, and simulate future paths of fiscal and macroeconomic indicators. Our numerical results suggest that absent any change in current policies, Japan will continue to run large pension, public health, LTC, and basic deficits and the debt to GDP ratio will continue to reach unprecedented highs, with interest payments on the debt becoming larger and larger. Although no single policy tool can address fiscal consolidation, a combination of policies is found to achieve sustainability: raise the retirement age to 67, cut pensions by 10%; raise copays of health and LTC insurances to 20%, and find policies to propel female employment and earnings to the levels of their male counterparts, and increase consumption tax rate to 15%. Under these changes, the debt to output ratio in 2050 would be lower than that in 2020.