Fiscal sustainability in Japan: What to tackle?

Abstract

Abstract Japan leads advanced economies in terms of the speed and magnitude of demographic aging and has the highest debt to GDP ratio. Furthermore, public pension, medical and long-term care (LTC) expenditures are projected to far outpace revenues and create even more severe fiscal burdens. In this paper, we develop an accounting model populated with overlapping generations of individuals and incorporate social insurance programs in detail, use most recent estimates of 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 growing interest payments. 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 at least 20% for all, and find policies to propel female employment and earnings and to narrow the gap with 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.