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Equitable and Sustainable Pensions
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Chapter 10. Pension Reforms in Japan: Options for Fiscal Sustainability

Author(s):
Benedict Clements, Frank Eich, and Sanjeev Gupta
Published Date:
March 2014
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Kenichiro Kashiwase, Masahiro Nozaki and Kiichi Tokuoka 

Introduction

Japan is taking the global lead in population aging. Life expectancy at birth in the country has increased to 83 years, which is the highest in the world. The postwar baby boom generation started retiring in 2007, meaning that the elderly population will continue to increase disproportionately in coming years. In addition, the fertility rate declined markedly during the past decades. As a result, Japan’s old-age dependency ratio is the highest in the world and is expected to rise from 38 percent in 2010 to 57 percent in 2030 (Figure 10.1).1

Figure 10.1Population Aging in Japan and Organization for Economic Cooperation and Development Countries

Sources: OECD (2011); and United Nations database.

Rising age-related public spending poses significant challenges for Japan. It makes fiscal consolidation—essential to reduce the country’s alarmingly high public debt burden—even more arduous. Social security reform, in particular for pensions, is critical for fiscal consolidation, but any reform should also preserve intragenerational equity, avoid worsening intergenerational inequity, and be growth friendly. Against this background, this chapter analyzes the impact of various pension reform options on fiscal consolidation, equity, and economic growth.

The chapter finds that the most attractive option is to increase the pension eligibility age in light of high and rising life expectancy in Japan. Such an increase would have a positive effect on economic growth in the long run by helping to raise labor force participation, and would be relatively fair in allocating the burden of fiscal adjustment between younger and older generations. Attractive options can also be put in place that promote intra- and intergenerational equity, including better targeting by clawing back a small portion of pension benefits from wealthy retirees, reducing preferential tax treatment of pension incomes, and collecting contributions from dependent spouses of employees eligible for the Employees’ Pension Insurance (EPI) program. These options, if implemented concurrently, could reduce the government’s annual pensions subsidy by up to 1¼ percent of GDP by 2020. Across-the-board cuts in the income replacement rate and higher pension contributions are less desirable options. Cuts in the replacement rate would undermine the pension’s role in alleviating old-age poverty, while higher contributions would discourage labor market participation and aggravate already large intergenerational imbalances.

This chapter is organized as follows: The next section describes the current public pension system and is followed by a section that discusses challenges to this system and reviews recent reform efforts. The subsequent section identifies reform options along with estimated fiscal savings and discusses the effect on economic growth as well as intra- and intergenerational equity.

Description of the Pension System

Japan has a universal, defined-benefit public pension system. Pension benefit spending was equivalent to 10.6 percent of GDP in 2010,2 consisting of old-age pensions (8.9 percent of GDP), disability pensions (0.4 percent of GDP), and survivor pensions (1.3 percent of GDP). The system’s main characteristics are shown in Figure 10.2.

Figure 10.2Japan’s Public Pension System

Source: Japanese government.

Note: EPI = Employees’ Pension Insurance; MAA = Mutual Aid Associations; NP = National Pension.

Participants. All residents ages 20 or older are obliged to participate in the system and are grouped into three categories. Category 1 participants are the self-employed and their spouses, and are covered by the National Pension (NP) program.3 Category 2 participants are employees of private sector enterprises and central and local governments, with private sector employees covered by the EPI program and government employees by the Mutual Aid Association (MAA) programs.4 Category 3 participants are dependent spouses of Category 2 participants.

Contributions. Category 1 participants pay flat rate contributions, while Category 2 participants contribute by paying payroll taxes (the payment is equally shared between employee and employer). The contribution rates are being raised through 2017 to ¥16,900 per month in 2004 prices (the rate was ¥15,020 per month in 2011) for Category 1 participants and to 18.3 percent of gross earnings (from 16.4 percent in 2011) for Category 2 participants, and will remain at these levels thereafter.5 Category 3 participants are not obliged to contribute. Total pension contributions from households and employers reached the equivalent of 6.5 percent of GDP in fiscal 2010.

Basic pension. All participants are eligible to receive a flat-rate basic pension benefit.6 This pension plays a substantial redistributive role by enabling a higher income replacement rate for poor retirees than for rich ones. The central government provides a subsidy to finance half of the basic pension benefit payment. The rest is paid by pension contributions collected by the program to which participants belong and by a drawdown from a reserve fund if contributions are temporarily insufficient to cover the payment.

Earnings-linked pension. Category 2 participants (in the EPI and the MAAs) receive earnings-linked benefits in addition to the basic pension benefit.7 Category 1 and Category 3 participants are not eligible for this benefit. The payment is fully financed by contributions paid by Category 2 participants and by a drawdown from reserve funds, if necessary.

Future Challenges and Past Reforms

Containing age-related spending, including pension benefits, is a key fiscal policy challenge in Japan. Age-related spending (mostly pension, medical, and elderly care spending) has been rising steadily and now accounts for nearly 55 percent of the total non-interest spending by the general government, reflecting the country’s rapid population aging (Figure 10.3). Although the increase in this spending will be moderate compared with other advanced countries (IMF, 2011; Clements, Coady, and Gupta, 2012), Japan needs to reduce both its fiscal deficit (10 percent of GDP in 2012) and debt (240 percent of GDP in 2012), which calls for rationalizing social security.

Figure 10.3Japan: Social Security Spending

Sources: Ministry of Health, Labor and Welfare (Japanese government); IMF staff estimates (panel 1); IMF World Economic Outlook database (panel 2).

Note: FY = fiscal year.

At the same time, social security reform should be designed to promote intra-and intergenerational equity and economic growth. To promote intragenerational equity, basic pensions help reduce old-age poverty in Japan, and are supported by a government subsidy. Nevertheless, women tend to receive smaller pension benefits than men because of lower wage rates and fewer years of labor force participation (Takayama, 2013). In addition, the share of nonregular employment (such as part-time and contractual employment) has been increasing, giving rise to a disparity in public pension coverage.8 Already large intergenerational imbalances (whereby younger generations bear a heavier fiscal burden than older generations) could be aggravated if reforms are delayed (Tokuoka, 2012). These tensions could be ameliorated if reforms promote economic growth.

An important step in coping with these challenges was Japan’s substantial pension system reform that took effect in 2004. The reform introduced an automatic adjustment of benefit levels based on changes in demographic structures—so-called macro indexing—although it has not been activated yet (Appendix 10A). As a result, aggregate pension benefit expenditures and contributions from households and employers will not increase as a percentage of GDP in the long term, despite rapid population aging (Figure 10.4).9

Figure 10.4Japan: National Pension and Employees’ Pension Insurance, Spending, and Contributions, 2010–2100

(Percent of GDP)

Sources: Official 2009 actuarial report; and IMF staff estimates.

Note: EPI = Employees’ Pension Insurance; NP = National Pension.

Reform measures recently proposed by the government address intragenerational equity issues, but are unlikely to generate fiscal savings. In line with the tax and social security reform plan adopted in February 2012, parliament in August 2012 approved laws to broaden eligibility to receive basic pension benefits by reducing the minimum number of years for which contributions need to be paid (to 10 years from 25 years); extending the coverage of the EPI to part-time workers; and integrating the EPI and the MAAs. On a net basis, these measures are not expected to reduce the fiscal burden. A bill to eliminate the past ad hoc nominal freeze of pension benefits by 2015 (the elimination is a precondition of macro indexing) was also approved by parliament in November 2012.

Reform Options

In broad terms, three reform measures are available to improve pension finances: increasing the pension eligibility age, reducing the pension replacement rate, or increasing contributions. There are trade-offs across these measures; for example, a higher retirement eligibility age can be combined with lower contributions without negatively affecting pension finances. These options, however, differ in their impacts on economic growth (see Appendix 10B) and intergenerational imbalances (Karam and others, 2010; Tokuoka, 2012; Kashiwase and Rizza, forthcoming).

Specific reform options and estimates of their potential fiscal savings are presented in Table 10.1. These potential fiscal savings would reduce the government subsidy to the basic pension.10 As discussed in detail later in this chapter, the most attractive option is to increase the pension eligibility age in light of the high and rising life expectancy in Japan. This would have a positive effect on economic growth in the long term by helping to raise labor force participation and would relatively fairly allocate the burden of fiscal adjustment between younger and older generations. Other attractive options from an equity-promoting standpoint include better targeting by clawing back a small portion of pension benefits from wealthy retirees, reducing preferential tax treatment of pension benefit incomes, and collecting contributions from dependent spouses of EPI-eligible employees. These options, if implemented concurrently, could reduce the government’s annual subsidy by up to 1¼ percent of GDP by 2020. Across-the-board cuts in the replacement rate and higher pension contributions are less desirable options. Cuts in the replacement rate would undermine the pension’s role in alleviating old-age poverty, and higher contribution rates would discourage labor market participation and aggravate already large intergenerational imbalances.

Table 10.1Japan: Options for Reducing Government Spending on Basic Pension
OptionAnnual Savings in 2020 (percent of GDP)
Raise basic pension eligibility age to 67¼
Reduce benefits for wealthy retirees¼
Eliminate preferential tax treatment for pension benefit income¼–⅓
Collect contributions from dependent spouses¼–½
Reduce replacement rate across the board by 3 percentage points½
Raise contribution (payroll tax) rate by 1 percentage point½
Reduce contribution (payroll tax) rate by 1 percentage point−½
Source: IMF staff estimates.
Source: IMF staff estimates.

Although the focus of this chapter is how to reduce the government subsidy, fiscal savings from pension reforms could also be used, for example, to reduce pension contributions (payroll taxes), which could improve incentives to work. Reform of the earnings-linked pension would not reduce the government subsidy because the benefit is fully financed by contributions, but it would complement reform of the basic pension, including by reducing the pension contribution rate, and could reduce the burden for employers and employees, thereby stimulating economic activity.

Raise Pension Eligibility Age

The pension eligibility age is being raised to 65. The pace of the increase differs between the basic pension and the earnings-linked pension, by program (the NP or the EPI), and by gender. The eligibility age for the basic pension is currently 65 for NP participants and male EPI participants (and by 2018 for female EPI participants). For the earnings-linked pension, the eligibility age is currently 60, and will be raised gradually to 65 for men during 2013–2025 (and for women during 2018–2030).

A higher eligibility age for the basic pension would generate substantial fiscal savings. An increase to age 67 for all categories of participants by 2020 would reduce the government subsidy to the basic pension by ¼ percent of GDP by then (compared with the base case projection included in the 2009 actuarial review). If it were raised further to 69 by 2030, the fiscal savings could reach ¾ percent of GDP in 2030.

Taking account of rising life expectancy, there is scope to increase the eligibility age. Life expectancy at birth is projected to increase from 85.2 years to 89.4 years for women (from 78.3 years to 82.4 years for men) during 2000–30. For participants in the NP, life expectancy at pension eligibility age is expected to increase by four years during this period, if the eligibility age remains constant at 65 (Figure 10.5). For participants in the EPI, life expectancy at pension eligibility age will decline reflecting the gradual rise in the pension eligibility age, but from a much higher base in 2010 compared with the NP. Moreover, elderly Japanese are expected to remain healthy and are less likely to be disabled, which would allow them the choice of working longer. Sanderson and Scherbov (2010) showed that the ratio of adults with disability to those without disability in Japan is projected to rise only marginally, to 13 percent by 2050 from 10 percent in 2005–10, despite the sharp rise in the old-age dependency ratio during this period.11

Figure 10.5Life Expectancy at Pension Eligibility Age, 2000–30

(Years)

Sources: United Nations Population Division Database; and IMF staff calculations.

Note: EPI = Employees’ Pension Insurance; NP = National Pension.

The gap between life expectancy and pension eligibility age is larger in Japan than in most other countries.12 As shown in the top two panels of Figure 10.6, three Organization for Economic Cooperation and Development (OECD) countries (Iceland, Norway, and the United States) had higher pension eligibility ages than Japan in 2010. By 2030, three other countries (Australia, Denmark, and the United Kingdom) will set their eligibility ages above 65. As other OECD countries also raise the eligibility age in line with longer life expectancy,13 the average pension eligibility age in those countries is expected to increase from 63.1 in 2010 to 64.3 in 2030. Although Japan continues to have the highest life expectancy in the world, the pension eligibility age remains capped at 65.

Figure 10.6Organization for Economic Cooperation and Development Countries: Pension Eligibility and Life Expectancy, 2010 and 2030

Source: OECD (2011).

Raising the pension eligibility age would also have a positive effect on economic growth and could be fairer from an intergenerational resource perspective. It would promote continued labor force participation of older workers and raise consumption through improved lifetime earnings (Appendix 10B). Unlike raising the contribution rate, the burden would be more equally shared between younger and older generations (Tokuoka, 2012). Although a higher pension eligibility age for the earnings-linked pension would not reduce the government subsidy, it would bolster long-term economic growth (by encouraging labor market participation), lessen intergenerational imbalances, and complement the planned reform of the basic pension.14 It would also allow for a reduction in the contribution rate, thereby lowering labor costs and increasing household disposable income.

An increase in the pension eligibility age should be accompanied by an expansion of the safety net to prevent an undue burden on those with disabilities. Total spending for disability pension benefits amounted to 0.4 percent of GDP in Japan, which is low compared with other advanced countries (Momose, 2008). Disabled retirees will become vulnerable as macro indexing reduces disability pension benefits in the future. In the United States, about one-fourth of all workers in their sixties may find work difficult on account of disabilities or poor health (Munnell, Soto, and Golub-Sass, 2008). Although Japanese older than age 65 are relatively healthy and less likely to be disabled (as noted earlier), they should be protected by a well-designed disability pension and social assistance programs to ensure that an increase in the pension eligibility age does not raise old-age poverty.

Lower Replacement Rate

A lowering of the pension replacement rate is already planned under macro indexing. The rate is officially defined as the pension benefit for a representative couple divided by the average wage of the working-age population. The representative couple comprises a private sector employee covered by the EPI and a spouse who does not work. The 2009 actuarial survey projects that the replacement rate is set to decline to 57 percent by 2020 and to 50 percent by 2038.

Although cutting the replacement rate further, beyond macro indexing adjustments, could reduce the government subsidy to the basic pension, doing so could worsen old-age poverty. This effect is especially probable given the limited role of private or voluntary pension schemes in Japan.15 An across-the-board reduction in the replacement rate of 3 percentage points would reduce the government subsidy by ½ percent of GDP by 2020. This option could have a positive effect on economic growth similar to the higher pension eligibility age (Appendix 10B), and would help correct intergenerational resource imbalances by placing a larger fiscal burden on older generations than on younger ones. However, with the current level of the basic pension benefit (¥66,000 per month) barely covering basic consumption needs (food, housing, and utilities) of a retiree, an across-the-board cut would undermine the pension system’s ability to contain old-age poverty (see Appendix 10D). Moreover, the fiscal savings would be offset by higher demand for social assistance spending.16

International comparisons also suggest that Japan’s pension benefits, on average, are on the low side. The replacement rate for a representative couple, of about 50 percent, is below the median and mean for OECD countries (Figure 10.7). More broadly, gross pension wealth measures the value of retirement incomes over a lifetime (OECD, 2011). This indicator takes account of life expectancy, the pension eligibility age, the replacement rate, and the way in which retirement benefits are indexed. Japan’s gross pension wealth is also low compared with other OECD countries.

Figure 10.7Pension Benefit Income Replacement Rates for Single-Earner Couples

(Percent)

Source: Organization for Economic Cooperation and Development (2011).

1 Countries with public defined-benefit or notional defined-contribution pensions. From OECD pension models based on 2006 parameters and rules. Replacement rates for a worker who enters the system today and retires after a full career.

A more targeted reduction in the replacement rate, therefore, would be appropriate from an equity standpoint, as opposed to across-the-board benefit cuts. In the current pension system, the government subsidy finances half of the basic pension benefit payments, regardless of the income level of retirees. Alternatively, the subsidy could be targeted toward poorer retirees and reduced for wealthier retirees by introducing a clawback, similar to that adopted in Canada. For example, a 10 percent clawback of the pension benefit for the wealthiest 10 percent of retirees (those with annual pension benefits equivalent to ¥2.5 million or more per person) would reduce the government subsidy by ¼ percent of GDP in 2020.17 In reality, a clawback could be applied more broadly, for example, to the wealthiest one-fourth of retirees, which would either generate larger fiscal savings or allow for higher average benefits than currently planned for lower-income retirees.

Raise Contribution Rates

A higher contribution rate would generate fiscal savings. In 2017, Japan’s pension contribution rate (for the EPI, levied on payroll) will be close to the average of advanced countries (Figure 10.8). Raising the contribution rate for the basic pension by 1 percentage point would increase contributions by ½ percent of GDP in 2020, which could be used to reduce the government subsidy to the basic pension.

Figure 10.8Pension Contribution Rate, 2009

(Percent of gross earnings)

This option, however, would have a detrimental effect on growth and aggravate intergenerational imbalances. Empirical studies find that a higher pension contribution rate has a negative effect on labor supply (see Appendix 10B).18 A higher contribution rate also increases the burden on younger generations disproportionally because pension contributions are paid by the working-age population.

Reduce Preferential Treatment

Eliminating the preferential tax treatment of pension income would also generate sizable fiscal savings and promote intragenerational equity. At present, a substantial part of the public pension benefit (basic and earnings-linked combined) is deducted from taxable income when calculating personal income tax liability.19 For those ages 65 or older, public pension income is fully exempt from tax up to ¥1.2 million per year. As a result, even for the wealthiest 2 percent of retirees, 40 percent of pension income is exempt from income tax. On an aggregate level, about three-fourths of pension income is exempt from taxable income. Eliminating this preferential treatment or tax expenditure would reduce the government subsidy by an estimated ¼–⅓ percent of GDP. Some other countries, such as France and New Zealand, do not exempt pension income from taxable income (OECD, 2011).

Collecting pension contributions from dependent spouses could also contribute to fiscal savings while ensuring equal treatment of beneficiaries. Under the current system, dependent spouses of employees covered by the EPI (Category 3 participants) receive basic pension benefits even though they do not pay contributions. They comprise 15 percent of the total working-age participants in the public pension system. Because benefits for Category 3 participants are paid out of contributions from both single and married employees, they are effectively cross-subsidized by single employees. This preferential treatment also creates a disincentive to work because a spouse can be qualified as a Category 3 participant only if his or her annual earnings are lower than ¥1.3 million. The government subsidy would be reduced by ¼–½ percent of GDP in 2020 if all Category 3 participants contributed to the NP.

Conclusion

This chapter analyzes various reform options for Japan’s public pension system, reviewing the size of fiscal savings and the impact on intra- and intergenerational equity and economic growth. The most attractive option would be to increase the pension eligibility age in light of high and rising life expectancy in Japan. Raising the eligibility age would have a positive effect on economic growth in the long term by helping to raise labor force participation and would be relatively fair in allocating the burden of fiscal adjustment between younger and older generations. An increase in the eligibility age should be accompanied by an expansion of the safety net, to avoid undue hardship for those with disabilities. Other attractive options that would promote intragenerational equity include better targeting by clawing back a portion of pension benefits from wealthy retirees, reducing preferential tax treatment of pension benefit income, and collecting contributions from dependent spouses of EPI-eligible employees. These options, if implemented concurrently, could reduce the annual government subsidy by up to 1¼ percent of GDP by 2020. Across-the-board cuts in the replacement rate and higher pension contributions are less desirable options. Cuts in the replacement rate would undermine the pension’s role in alleviating old-age poverty, while higher contributions would discourage labor market participation and aggravate already large intergenerational imbalances.

Appendix 10A. How does Macro Indexing Work?

This appendix explains the macro indexing of pension benefits introduced in 2004 in a simplified framework. To maintain the sustainability of pension finances, macro indexing will cut benefit levels automatically in accordance with population aging, while contribution rates are moderately increased to reach a constant level in 2017. The reform was a major shift from pension reforms before 2004, which had not resorted to benefit cuts.

The pension system’s financial balance B at time t equals

in which c is the pension contribution rate, W(t) is the average wage earned by the working age population, L(t) is the number of participants of working age, P(t) is the pension benefit per person, and N(t) is the number of retirees. The reserve fund outstanding, R(t), increases by the rate of return i(t) and the financial balance:

Macro indexing adjusts pension benefits P downward in line with changes in the number of working-age participants and life expectancy, until period t*:

in which Δ indicates a growth rate, for example, ΔW(t) = (W(t)−(W(t − 1)) / W(t−1). The variable μ is an estimated rate of increase in life expectancy, which is fixed at 0.3 percent. With ΔL(t) expected to be negative owing to a decline in the working-age population, the adjustment improves the financial balance. The end period of adjustment, t*, is determined such that pension finances achieve sustainability (i.e., the reserve fund outstanding is sufficient to cover benefit payments 100 years from now). That is,

The replacement rate, P(t) / W(t), will decline until t*, and remain constant thereafter.

The 2009 actuarial review projects that the macro index adjustment will continue until 2038. The replacement rate (for a representative single-earner couple) is projected to decline from 62 percent in 2009 to 50 percent in 2038, and remain constant thereafter.

The adjustments are restricted in several cases. First, the replacement rate should not decline below 50 percent. If such an event is envisaged to occur in the next five years, a system overhaul is called for. Second, macro indexing is suspended during periods of deflation. More precisely, benefit levels will never decline over time in nominal terms because the benefit adjustment is calculated as follows:

Third, macro indexing has not started yet, although the 2009 actuarial review presumed it would begin in 2012. Ad hoc suspension of price indexation during deflation early in the first decade of the 2000s raised the pension benefit from the level resulting from the original indexation rule. Elimination of this discrepancy is the precondition for macro indexing to begin.

Appendix 10B. Growth Impact of Pension Reform Options

Containing pension benefits could have a positive impact on output:

  • Raising the pension eligibility age. From a theoretical standpoint, using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model, Karam and others (2010) show that raising the pension eligibility age could boost the level of U.S. GDP by 3 percent in the long term by encouraging longer working lives. With a longer working period, households increase consumption because their lifetime incomes are higher. Similarly, using an overlapping generations model with an explicit life cycle,20Cournède and Gonand (2006) report that, in Europe, fiscal consolidation involving raising the pension eligibility age would boost labor supply and would be more growth friendly than tax-based fiscal consolidation. The point that fiscal consolidation involving a higher pension eligibility age could be less costly is confirmed by running a lifecycle overlapping generations model for Japan (see Figure 10B.1).21

    Empirical findings are consistent with these theoretical observations. Internationally, labor force participation is positively correlated with pension eligibility age (e.g., see Gruber and Wise, 1998, 1999, 2002).

  • Reducing the pension replacement rate. Qualitatively, reducing the pension replacement rate would have a positive impact on output similar to raising the pension eligibility age. The GIMF simulation by Karam and others (2010) shows that reducing the pension replacement rate would also boost output in the long term, although the positive impact would be less because in their setup, the incentive for increasing labor supply is weaker.22

    International empirical evidence shows that labor force participation is strongly and negatively correlated with the generosity of pension benefits, which is determined by the pension replacement rate and the pension eligibility age. This outcome may occur because the generosity of pension benefits functions as an implicit tax on work (Gruber and Wise, 1998).

Figure 10B.1Reform Measures and Output

Source: Authors’ calculations.

1 For all options, fiscal savings that improve the structural primary balance by 0.5 percent of GDP are assumed.

2 Investment rate = (GDP—consumption—tax payments—social security contributions)/GDP.

Raising the pension contribution rate would have a detrimental effect on output. Theory shows that higher pension contribution rates have both substitution and income effects because pension contributions are proportional to earnings, as with personal income tax. Although these effects have opposite impacts on labor supply, simulation analysis typically concludes that the substitution effect is dominant, and a higher contribution rate reduces labor supply and thus output (see Figure 10B.1 and Karam and others, 2010).

Data also show that growth is negatively correlated with the burden from social security contributions and personal income tax (Figure 10B.2). More formally, Arnold (2008) reports cross-country regression results that indicate that a higher personal income tax, the impact of which on output is similar to that of higher social security contributions, reduces GDP growth (for a comprehensive literature review, see OECD, 2010).

Figure 10B.2Organization for Economic Cooperation and Development Economies: Growth versus Social Security Contributions Plus Employees’ Income Taxes

Sources: Organization for Economic Cooperation and Development; and IMF World Economic Outlook database.

Appendix 10C. Methodologies for Calculating Fiscal Savings from Reform Options

Raise Basic Pension Eligibility Age To 67

Savings are calculated by multiplying the projected number of pension benefit recipients ages 65–66 and the level of basic pension benefits in 2020. The number of recipients is estimated by the official population projection by gender. The ratio of age 65–66 population to age 65 and older would be 9.5 percent for male and 7.7 percent for female in 2020. The level of basic pension benefits in 2020 reflects macro indexing as envisaged in the official 2009 actuarial report. If the eligibility age for the basic pension becomes 67 for all recipients (i.e., Categories 1–3 and both male and female) by 2020, aggregate basic pension spending would be reduced by ¼ percent of GDP, compared with the status quo of the current schedule of eligibility age increases. The calculation also takes account of early retirement.

Reduce Benefits for Wealthy Retirees (Clawback)

Data on the distribution of old-age pension benefits are available for the NP and the EPI.23 They indicate that the wealthiest 10 percent of retirees (i.e., those who receive a large amount of pension benefits) received about 25 percent of aggregate old-age pension benefits in 2010 (the basic and the earnings-linked pension benefits combined). If 10 percent of benefits are reduced, or clawed back, for such retirees, aggregate old-age pension benefits would be reduced by 3.1 percent or by ¥1.1 trillion (US$11 billion, ¼ percent of GDP). For 99.8 percent of retirees, monthly pension benefits were less than ¥300,000 (US$3,000) in 2010; thus, the benefit clawback would be less than ¥30,000 on an individual basis (i.e., less than 50 percent of the basic pension benefit). If an aggregate clawback rate of 3.1 percent is applied to aggregate old-age pension benefits in 2020, pension benefit spending would be reduced by ¼ percent of GDP.

Eliminate Preferential Tax Treatment for Pension Benefit Income

Data on the distribution of old-age pension benefits are available for the NP and the EPI.24 Using these data, income taxes collected from pension benefit recipients are estimated for 2010, assuming that pension income is their only source of income. Based on the current schedule of income tax rates, elimination of preferential tax treatment of pension benefits would have increased tax collections by ¥1.4 trillion, 0.3 percent of GDP). The calculation incorporates the basic deduction of ¥380,000 from annual taxable incomes (applied to all income tax payers), but does not take account of deductions for spouses because data for the marital status of retirees are not available.

Collect Contributions from Dependent Spouses

According to the official 2009 actuarial report, the monthly contribution rate for the NP would be ¥19,728 in 2020 (in 2020 prices), and the number of Category 3 participants would be 8.9 million. Thus, if all Category 3 participants contribute, contributions will increase by ¥2.1 trillion or 0.4 percent of GDP).

Reduce Replacement Rate across the Board by 3 Percentage Points

According to the official 2009 actuarial report, the average monthly wage in 2020 is expected to be ¥459,000. To reduce the replacement rate by 3 percentage points, monthly basic pension benefits for a retiree and a spouse need to be reduced by ¥13,770, or ¥6,885 per individual. If this reduction is applied to all retirees, excluding those who receive basic pension benefits of less than ¥6,885, aggregate basic pension spending would be reduced by ¥2.7 trillion, ½ percent of GDP).

Raise Contribution (Payroll Tax) Rate by 1 Percentage Point

According to the official 2009 actuarial report, EPI participants’ annual wages will total ¥201 trillion in 2020. Therefore, a 1 percentage point increase in the contribution (payroll tax) rate would raise contributions by ¥2 trillion. This translates into a monthly contribution increase per person of ¥4,322 (¥2 trillion divided by Category 2 participants in the EPI and Category 3 participants). If the higher contribution rate of ¥4,322 is applied to Category 1 participants and Category 2 participants in the MAAs, contributions will increase by ¥0.8 trillion. Thus, the total increase would amount to ¥2.8 trillion, ½ percent of GDP).

Appendix 10D. Old-Age Poverty in Japan and the Role of the State

Despite the low income replacement rate, Japan’s pension reforms have helped reduce the relative poverty rate25 among elderly persons. When the poverty rate is measured based on a threshold (50 percent) of median household income, Japan’s old-age poverty rate has been about 20 percent in recent years, which is high compared with other OECD countries (OECD, 2011). In the absence of the old-age pension, however, this rate would increase threefold (Abe, 2011). Pension benefits alleviate relative poverty among the elderly and help maintain their consumption levels during retirement. When relative poverty is measured by consumption expenditure, which is financed partly by assets, instead of household income, the rate falls to less than 15 percent and has come down quite significantly since the 1980s (Ohtake, 2005). Because past pension reforms often set benefit levels at a sufficient standard of living, Japan’s public pension system helps attain a more equitable consumption level (Shikata, 2010; Yamada, 2010).

The relative poverty rate among the elderly is disproportionately high for women. Across different household types, elderly people who live alone face a particularly high poverty rate, followed by the household of a retiree who lives with his or her daughter (Abe, 2011). Because Japan’s typical household structure is expected to change,26 and women typically live longer than men, future pension reforms may need to be supplemented by a safety net program targeted to those who are vulnerable.

More analysis of the distribution of income and wealth data would be necessary to develop a well-designed safety net program. For example, if a household with a large amount of assets invests the majority of its assets in bank deposits, its income could be low in the current low interest rate environment but such a household can still enjoy a high level of consumption. Therefore, cash transfers solely based on income levels might provide financial support to wealthy households. Identifying those really in need would require information not only on income but also on assets.

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The Republic of Korea is the only country in which population aging is advancing more rapidly than in Japan.

This refers to fiscal year 2010, which began in April 2010 and ended in March 2011.

In 2007, it became clear that the government had lost track of some pension contribution records, which led to a loss of public confidence in the public pension system. Partly reflecting this, participation in the NP has been on a declining trend and fell from 64 percent in fiscal 2007 to 60 percent in fiscal 2010.

There is also an MAA for teachers in private schools.

In mid-2013, 1 U.S. dollar was approximately equal to 100 Japanese yen.

Those who have paid contributions for 25 years or more and have reached age 65 are eligible for basic old-age pension benefits. The benefit depends on the number of years during which contributions were paid.

The earnings-linked benefit is calculated using an individual’s lifetime average earnings and an accrual rate. The accrual rate for those who were born after April 1946 is 0.5481 percent per month.

The share of nonregular employees (such as part-time workers and contractual workers) in total salaried employees increased from about one-fifth in the early 1990s to one-third in 2012. For women, non-regular employees now comprise more than half of total employees. Many nonregular employees are not eligible to participate in the EPI. Moreover, about 5 percent of nonregular employees do not participate in the public pension system, while nonparticipation of regular employees was only 0.8 percent.

In addition, the 2004 reform increased the ratio of the government subsidy to the basic pension benefit from one-third to one-half. Consequently, the subsidy increased from 1½ percent of GDP in 2008 to 2 percent of GDP in 2009 and is expected to remain about 2–2½ percent of GDP in the medium and long terms. Although this helped put Japan’s pension system on sustainable footing, it has added to the spending pressure on the government.

See Appendix 10C for data and methodologies.

Life expectancy across regions differs somewhat: in 2010, among 47 prefectures, the highest was 80.9 years (Nagano) and the lowest was 77.3 (Aomori).

The pension eligibility age is defined here as the age at which people can first draw full benefits, that is, without actuarial reduction for early retirement (OECD, 2011).

During 2010–30, Australia will raise the pension eligibility age from 63.5 to 66, Denmark from 65 to 67, the United Kingdom from 62.5 to 66, and the United States from 66 to 67. Austria, the Czech Republic, France, Greece, Hungary, Italy, Korea, the Slovak Republic, and Switzerland will also increase their retirement ages. Iceland and Norway expect to keep the retirement age at 67.

The government plans to reform the pension system into a simpler two-tier system: a noncontributory flat-rate pension and an earnings-linked pension with a payroll tax rate of 15 percent. The latter has features of a notional defined-contribution system (such as the one adopted in Sweden); that is, contributions are accumulated in an individual account with a notional rate of return and the pension benefit is calculated by dividing the pension wealth by remaining life expectancy at retirement. This would make the choice of retirement age actuarially fair because it does not penalize late retirement. The risk of higher longevity would also be transferred from younger generations to retirees, helping alleviate intergenerational imbalances.

The government offers Category 1 participants access to a voluntary pension scheme, but only 3 percent of them participate. More generally, participation in private pension plans declined during the past decade; a survey showed 23 percent of households participated in them in 2012, down from 29 percent in 2000. Also, contributions to private pension plans per household declined by 25 percent during this period.

The social assistance system pays the difference between the guaranteed minimum income and own-source incomes of the poor. The minimum income level for individuals is determined by area and age, and ranges from ¥63,000 per month to ¥81,000 per month for an individual who is 65 years old.

In Canada, a clawback of 15 percent is applied to retirees with annual incomes equivalent to US$70,000 or more.

At the individual level, the clawback amount under this scheme will be less than the government subsidy (except for the richest 0.2 percent of retirees, for whom the clawback amount would exceed the government subsidy).

Some euro area countries are considering a revenue-neutral shift from social contributions toward a VAT to improve export competitiveness. Such a reform has been known as “fiscal devaluation.”

In Japan, pension contributions (and investment returns on the reserve fund) are tax exempt, and pension benefit incomes above a threshold are added to taxable incomes.

The GIMF is also an overlapping generations model, but it makes stylized assumptions about the life cycle (for example, a constant rate of decline in productivity over the life cycle, a constant probability of death). An overlapping generations model with an explicit life cycle (for example, with a hump-shaped wage profile) could produce results of a different magnitude.

For details about simulation assumptions, see Tokuoka (2012).

This partly reflects the assumption in the model that the size of the labor force (length of work life) is exogenously determined. In a model in which the size of the labor force is endogenously determined by the level of pension benefits, a reduction in pension benefits could have a larger positive impact on labor supply.

Unlike the absolute poverty rate, which measures the share of the population below the minimum standard of living, the measure of relative poverty draws an inference about underlying income inequality.

A family of parents with adult children living together in a given household has been the norm in Japan for decades, and accounted for 30–42 percent of all households during 1980–2005. Based on the most recent projection by the National Institute of Population and Social Security Research (2008), single-person households are expected to become the largest share among all household types, reaching 37.4 percent in 2030 from 29.5 percent in 2009. With population aging, most of this increase comes from single-person households consisting of those 65 years of age or older.

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