What is the cost of delaying welfare reforms? Lessons from ageing Japan

A large body of literature exists that studies the effects of social security reform in an ageing economy, and much of it examines the economic and welfare consequences of pension reform. Studies assume, however, that individuals know the path of policy and fully anticipate economic dynamics associated with alternative policies.

In reality of course, we face a great deal of uncertainty regarding the timing of reform and the structure of a new system. Much less is known about the effect of such fiscal uncertainty and the cost (and benefit) of delaying needed reform of a social security system until later years.

Many developed countries established a pay-as-you-go public pension system decades ago, which guarantees benefits once an individual reaches a retirement age. Given the recent rise in longevity of life, coupled with retirement waves of baby boom generations expected in the coming decades, governments will face a significant challenge to keep the system sustainable.

The case of Japan: An economy with the most rapid ageing

Japan is a notable example. The old-age dependency ratio, defined as the ratio of individuals at age 65 and above to those aged 20-64, is projected to rise from less than 0.4 in 2010 to 0.6 by 2030 and above 0.8 by 2050. Studies have found that actions must be taken soon to prevent a crisis. Hansen and Imrohoroglu (2015) use a neoclassical growth model to argue that a 30-40% increase in consumption taxes is needed to stabilise debt. Braun and Joines (2015) build an overlapping generation model and predict a fiscal crisis with a partial default before 2040, if no major reform is implemented. In Kitao (2015), I show that consumption tax will reach 48% to balance the government budget at the peak of the dependency ratio if current transfer systems are to be maintained.

The Pension Reform of 2004 included a scheme known as the ‘macroeconomic slide’, which reduced benefits in response to a decline in the working-age population and a rise in life-longevity. The slide, however, has been triggered only once in the last 12 years because the adjustment is conditional on sufficient inflation, which has not been a common observation in Japan. There is much uncertainty as to the effectiveness of the macroeconomic slide, and surveys indicate that individuals, especially the young, are not expecting to receive the level of pension benefits guaranteed to current retirees.1

Roles of policy uncertainty: Who loses from a reform delay and by how much?

In recent work (Kitao 2016), I show that uncertainty about the timing and structure of social security reform could generate a significant effect on the life cycle decisions of households. Instead of knowing that benefits will begin to decline in a given year, if they anticipate the same reform but do not know the exact timing, the demand for precautionary savings is strengthened. Caliendo et al. (2015) build a continuous-time life cycle model calibrated to the US economy and argue that the welfare cost of uncertainty, relative to an economy without uncertainty, is large for non-savers but minimal for savers. I add a general equilibrium channel through which uncertainty affects household decisions and welfare.

As time goes by, the longer the reform is delayed and postponed, the greater the gains for elderly individuals, in exchange for higher taxes and welfare deterioration of young and future generations. In the case of Japan, a reform delay can result in additional consumption taxes of about 10 percentage points at the peak for every ten years of delay.2 Younger cohorts will be worse off and those who were born in 2010, for example, would lose by an amount equivalent to about 1.5% of lifetime consumption for each ten-year delay.

The analysis suggests that early action to implement reform and remove uncertainty could be a policy that balances the welfare consequences across generations and have them share the fiscal cost of demographic aging.

Author's note: The main research on which this column is based first appeared as a discussion paper of the Research Institute of Economy, Trade and Industry (RIETI).

References

Braun, A R and D H Joines (2015) “The implications of a graying Japan for government policy,”Journal of Economic Dynamics and Control 57, 1-23

Caliendo, F N, A Gorry and S Slavov (2015) “The cost of uncertainty about the timing of social security reform,” Working Paper

Hansen, G D and S Imrohoroglu (2015) “Fiscal reform and government debt in Japan: A neoclassical perspective,” Review of Economic Dynamics, forthcoming.

Kitao, S (2015) “Fiscal cost of demographic transition in Japan,” Journal of Economic Dynamics and Control 54, 37-58.

Kitao, S. (2016) “Policy Uncertainty and the Cost of Delaying Reform: A case of aging Japan,” RIETI Discussion Paper, 16-E-013.

Endnotes

[1] According to a survey of new adults conducted by Macromill, Inc. in 2015, more than 90% report they are unsure whether they can receive public pension in future and about 40% disagree that the pension system is sustainable.

[2] In Kitao (2016), I consider reform to reduce benefits by about 35% gradually over a 30-year period, while adjusting consumption taxes to balance the government budget and compare paths, where the reform begins in 2020, 2030, or 2040, respectively, as a result of the resolution of uncertainty.