Aging and Capital Flows in Japan and Korea. April Robert Dekle Department of Economics USC Los Angeles, CA 90089

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1 Aging and Capial Flows in Japan and Korea April 2001 Rober Dekle Deparmen of Economics USC Los Angeles, CA Prepared for he Asian Developmen Bank Insiue Conference: Aging and Capial Flows. I hank Professors Cook, Shin, Io, Horioka, and Takayama for helpful commens.

2 2 I. Inroducion. The saving raes of Korea and Japan are among he highes in he world and hese raes have played a valuable role in he developmen of hese wo counries. The high saving has provided he funds needed o finance corporae invesmen in plan and equipmen, and helped mee capial shorages abroad. The high invesmen raes allowed Korea and Japan o incorporae he laes echnologies ino he producion process, and has raised living sandards hrough beer public infrasrucure, boh in ciies and in rural areas. Over he nex hree or four decades, he populaions of Korea and Japan will be aging rapidly. In Japan, he populaion aging will be occurring earlier; projecions imply large increases in he elderly in he nex 20 years; by 2015, 25 percen of he populaion will be 65 or above. In Korea, he populaion aging will accelerae afer 2025; by 2040, around 30 percen of he populaion will be 65 and above. In boh counries, he main reason for his aging is he fall in he oal feriliy rae (birhs per family). In his paper, we revisi he issue of he impac of demographic change on he savinginvesmen balances and he curren accouns of Korea and Japan. There is widespread belief ha aging will lead o major shifs in he saving-invesmen balances, and he curren accouns of he wo counries. We show ha his belief is largely rue. Using he laes governmen demographic projecions, we show ha he aging of he populaion underway will seadily lower Japan s oal saving (privae and governmen) rae from he curren 30 percen of GDP o 19 percen of GDP in Japan s oal invesmen (privae and public) rae will decline from 28 percen of GDP oday o abou 22 percen of GDP in Given ha he decline in oal saving is larger han in oal invesmen, Japan s curren accoun will seadily narrow from is curren

3 3 level, and urn o defici around We also show ha he aging of he populaion will worsen Japanese governmen finances, as healhcare and social securiy spending soar. Unless Japanese governmen fiscal balances improve from he curren minus 7 percen of GDP o almos plus 5 percen of GDP over he nex decade or so, he curren Japanese governmen deb is no susainable. We forecas fuure Japanese governmen spending from projeced demographics. Given he forecased governmen spending, large ax increases will become necessary for he curren Japanese governmen deb o be susainable. In fac, we show ha axes as a percenage of GDP will need o be raised from he curren 28 percen o almos 50 percen by For Korea, we show ha he populaion aging will lower boh oal saving (privae and governmen) and oal invesmen (privae and public) raes--especially drasically afer Unil someime afer 2025, however, Korea is expeced o mainain relaively high oal saving raes, and run curren accoun surpluses, hus, accumulaing exernal asses on ne. In Japan, oal (privae and governmen) saving raes are expeced o sar falling around In Korea, oal saving raes will sar falling abou 20 years laer, since in Korea, he demographic ransiion declining feriliy raes happened wo or hree decades laer han in Japan. Alhough afer 2025, Korean saving raes are gradually expeced o dip below invesmen raes, he exernal asses accumulaed earlier should provide enough capial income so ha Korea is projeced o run sligh curren accoun surpluses even afer We leave he invesigaion of he impac of aging on Korean governmen finances for he fuure. However, wha is remarkable abou our projecions is ha conrary o he usual pos-ww II paern, Korea will be supplying inernaional capial o Japan from around 2025 o perhaps around 2040 a very

4 4 surprising urn of evens! This paper is organized as follows. In Secion II, we briefly review he lieraure on, and pas rends in, Japanese privae and governmen saving raes and privae and public invesmen raes. In Secion III, we review he deerioraing Japanese governmen fiscal posiion in he 1990s. In Secion IV, we summarize he demographic changes undergoing in Japan, and presen he Japanese governmen s laes governmen projecions. In Secion V, we simulae he impac of demographic change on he fuure Japanese saving and invesmen raes, governmen deficis, and he curren accoun. In Secion VI, we briefly review he lieraure on, and pas rends in Korean oal saving and invesmen raes. In Secion VII, we briefly summarize he demographic changes undergoing in Korea. In Secion VIII, we simulae he impac of demographic change on he fuure Korean saving and invesmen raes. Secion IX concludes. Japan II. Japanese Saving and Invesmen. I is well-known ha he pos-war Japanese economy is characerized by very high saving and invesmen raes. In fac, Japan s saving raes are among he highes in he world only Ialy, Singapore, and Taiwan have higher saving raes. However, hese high Japanese saving and invesmen raes are primarily a pos-war phenomenon in fac a pos 1955 phenomenon. If he period of he Korean War is excluded, Japan s saving rae did no make i ino he double digis unil 1955, a full 10 years ino he pos-war period. Thus, we can immediaely rejec he view ha Japan s high saving rae is he resul of culural facors such as naional characer or Confucian and Buddhis eachings, because alhough culural facors were sronger in he pre-

5 5 war period, he saving rae was lower. The rends and flucuaions in Japanese saving and invesmen closely mirror he rends and flucuaions in Japanese GDP (Figure 1). For boh saving and invesmen raes, here is clear posiive associaion wih he growh in GDP, especially unil The broad rends in pos-war Japanese privae and governmen saving raes, invesmen raes, and he ne expor surplus GDP raios, are depiced in Table The privae saving rae rose seadily beween 1955 and he mid-1970s, peaking (firs) in Subsequenly, he rae fell unil he early 1990s, when i rose (again) o reach is pos-war peak in There is a voluminous lieraure ha seeks o explain he paern and level of Japanese pos-war privae saving. 3 The lieraure suggess ha he mos imporan reason for Japan s high privae saving rae is rapid economic growh. The permanen income/life cycle hypohesis can explain he posiive impac of income growh on he privae saving rae if income growh is faser han expeced. This hypohesis may have been valid unil he early 1970s. The surge in privae saving from he mid-1970s o he early 1980s is relaed o he wo oil crisis in he 1970s. The explanaion given is ha hese crisis added furher fuel o he already rampan 1 We depic gross saving and invesmen. Gross saving includes he depreciaion includes he depreciaion on capial. In his paper, we use gross, insead of ne saving because he laer requires daa on depreciaion. There is enormous conroversy regarding he proper measuremen of he capial depreciaion rae in Japan, and he use of gross savings allows us o sidesep his conroversy (Dekle and Summers, 1991; Hayashi, 1991; Horioka, 1995). 2 The privae secor includes households, privae unincorporaed non-financial enerprises, and corporaions. Corporae saving is small in Japan, and if households pierce he corporae veil, corporae saving can be considered par of household saving. The governmen secor includes he cenral, prefecural, and local governmens. Governmen saving excludes governmen invesmen. 3 See Horioka (1990), Dekle (1993), and Hayashi (1998) for a caalogue of reasons for Japan s high privae saving.

6 6 inflaion and precipiaed a recession, which in urn raised uncerainy abou he fuure and increased he perceived need o save for precauionary purposes. The fall in privae saving from he mid-1980s o he early 1990s is because of robus consumpion, simulaed by rising sock and land prices. In conras, he mid- o lae-1990s rise in privae saving is relaed o he recessionary economy, increases in unemploymen, uncerainy, and pessimism, all raising precauionary saving. Horioka (1991, 1992) finds ha he level and growh of Japanese GDP explains abou 65 percen of he variaion in he privae saving rae. 4 The lieraure suggess ha he second mos imporan reason or Japan s high privae saving rae is he favorable age srucure of he populaion. Unil he early 1970s, he proporion of he aged (over 65) o he working-age populaion (20-64) he so-called dependency raio was low in Japan. According o he life-cycle hypohesis, an increase in he dependency raio has a significan negaive effec on he privae saving rae. In addiion, mos oher models including hose wih dynasic households predic a negaive relaionship beween he dependency raio and he privae saving rae. Horioka (1991,1992) finds ha adding he dependency raio o he equaion already including he level and growh of GDP raises he proporion of privae saving explained from 65 percen o 75 percen. Moreover, he esimaes ha a 1-percenage poin increase in he dependency rae will cause he privae saving rae o decline by 1 percenage poin. These and similar esimaes sugges ha he 12-percenage-poin increase in he dependency rae beween 1975 and 1998 has depressed privae saving by abou 12 percenage poins annually. 4 Horioka s resuls, however, mus be inerpreed wih cauion, since he includes variables wih differen orders of inegraion, I(.), in he same esimaing equaion. His demographic variables are I(2), bu he level and growh of GDP are I(0), and I(1), respecively.

7 7 The governmen saving rae rose unil he mid-1960s, hen gradually fell o is hisorical low in Subsequenly, he rae rose (again) unil he early 1990s, when i sared o decline o (almos) is new low in The rend in Japanese governmen saving is also closely relaed o economic growh. Governmen saving surged unil he mid-1960s, as growh raes were consisenly above governmen projecions, leading o rising ax revenues. From he mid-1960s, however, he demand for governmen services increased, dampening he budge surpluses. The recessionary 1970s led o couner-cyclical measures and a furher drop in governmen saving. To hal he decline in governmen saving, he Japanese governmen in he early 1980s inroduced budge freezes and reformed he ax sysem. These measures and srong economic growh in he mid- o lae 1980s led o rising budge surpluses. However, as he economy slumped in he early 1990s, falling ax revenues and he need for expansionary fiscal policy again depressed governmen saving raes. The invesmen rae also rose seadily, peaking in Since hen, i has fallen slighly. Compared o household and governmen saving raes, he invesmen rae has remained comparaively sable. The main deerminan of Japanese invesmen has again been economic growh. 5 As GDP growh surged in he 1950s and 1960s, invesmen was able o grow o ake advanage of newly available echnologies. Since he early 1970s, he invesmen rae dipped somewha, bu has remained a a high level. The surge in invesmen raes in he lae 1980s is relaed o he cheap financing available o firms, owing o rising sock and land prices. Alhough privae invesmen has dipped in he 1990s, rising governmen invesmen owing o expansionary 5 Kiyoaki and Wes (1996) find ha Japanese privae plan and equipmen invesmen beween 1961 and 1994 can be well explained by he flexible acceleraor model, wih lagged oupu as he sole explanaory variable.

8 8 public works projecs in he mid- o lae 1990s has kep overall invesmen raes high. Japanese ne expors were in persisen defici unil he early 1970s, reflecing srong invesmen demand, bu inadequae saving. However, by he mid-1980s, he surge in saving and decline in invesmen pushed Japanese ne expors (as a percenage of GDP) ino record erriory. Subsequenly, as a resul of srong domesic consumpion in he lae 1980s and srong governmen invesmen in he 1990s, he ne expor surpluses (as a percenage of GDP) declined. III. The Japanese Fiscal Posiion in he 1990s. Governmen saving declined and public invesmen rose in he 1990s (Table 1). These rends in governmen saving and invesmen in he 1990s were caused by he recession, and also by srucural changes. The recession and he decline in he rae of economic growh lowered ax revenues. Srucural changes worsening governmen saving include ax reforms ha lowered ax elasiciies and ax revenues, and he aging of he populaion, which raised social securiy and healhcare expendiures. The deerioraion of governmen finances led o sharp increases in ousanding governmen bonds, raising concerns abou fiscal susainabiliy, and calls for fiscal reform. Governmen saving in he 1990s. Tax revenues declined because of he recessionary environmen of he 1990s. In addiion, governmen consumpion increased. Owing o he low cyclical variabiliy of Japanese unemploymen and social welfare benefis, however, governmen consumpion increases during he recession were capped. Governmen saving can be divided ino he full-employmen and

9 cyclical componens. We esimae ha during he period , Japan s full-employmen governmen saving was abou 2.6 percen, slighly higher han acual governmen saving of percen, leaving he cyclical componen of governmen saving a -0.6 percen. 6 Thus, much of he decline in Japanese governmen saving in he lae 1990s was no because of auomaic sabilizers, bu because of srucural facors, such as ax reducions. This low cyclical variabiliy of governmen saving is corroboraed in a recen IMF sudy showing ha a one-percenage poin increase in he oupu gap ranslaes ino an increase of he cyclical defici by abou a hird of 1 percen of GDP, which is abou half of he defici response in oher OECD counries (Muhleisen, 2000). Governmen saving declined since he early o mid-1990s, wih ax reducions supporing aggregae demand in he face of an unprecedened economic downurn. Paricularly in 1998, when he economy slipped ino recession, he governmen passed ax cu measures ha led o a subsanial decline in governmen saving in he following year. Marginal income and capial gains ax raes and healh insurance premia were cu, exempions for gif axes were raised, and ax deducions for home morgage holders were inroduced. The governmen also lowered corporae ax raes from 50 percen o 40 percen. Governmen saving can be broken down ino he social securiy surplus, he surplus in oher caegories, and healhcare expendiures (Figure 2). The social securiy surplus (benefis minus conribuions) fell from abou 2 percen of GDP in he early 1990s o abou 0.5 percen of 6 We esimae he full-employmen governmen saving by regressing governmen saving on he oupu gap and a consan. We inerpre he esimaed value of he consan; which is he governmen saving rae when he oupu gap is equal o zero--as full-employmen governmen saving.

10 10 GDP in 1999, owing o he recession (lowering conribuions) and increase in he elderly (raising benefis). Governmen healhcare expendiures rose from abou 3.6 percen of GDP in he early 1990s o abou 4.2 percen of GDP in he 1999, mainly owing o increase in he elderly, who use mos of he hospial services. However, he healhcare expendiure-gdp raio in Japan is smaller han in he U.S. (6.6 percen of GDP), or Germany (7.7 percen of GDP). The remaining caegory of governmen saving includes usual spending such as educaion, defense, and policing and firefighing. Saving in his caegory declined sharply from 9.5 percen of GDP o 4 percen of GDP, owing o he fall in (income and consumpion) ax revenues. Public Invesmen in he 1990s. Beween 1990 and 1999, he Japanese governmen passed 10 simulus packages, in an aemp o jump-sar he salling economy. The mos imporan componen of he governmen simulus packages were public works, which are included in public invesmen. However, as shown in Table 1, he acual increases in public invesmen in he lae-1990s were raher moderae, compared o he prominen and headline grabbing role of public works in he simulus packages. There are wo reasons why acual public works fell shor of he levels announced in simulus packages. Firs, during he 1990s, he cenral governmen assigned roughly wo-hirds of he increased public works spending o local governmens (wihou providing a commensurae increase in funding). The capaciy, however, of local governmens o expand public invesmen was affeced by heir poor financial siuaion, and he coninued rise in public invesmen has increasingly been financed hrough local bond issues. The amoun of ousanding local

11 11 governmen bonds increased from 12 percen of GDP in 1990 o 22 percen of GDP in Many local governmens surpassed he legally allowed hreshold of bonds-ousanding, and were pu under bond issuance resricions by he cenral governmen. Second, some of he public invesmen funds provided by he simulus packages remained unused, because of poor projec implemenaion. Ishii and Wada (1998) calculaed ha only percen of he simulus packages public works has ranslaed ino addiional demand during he mid- o lae 1990s. Governmen Deb and Liabiliies in he 1990s. The lae 1990s decline in governmen saving and rise in public invesmen led o sharp increases in governmen deb. Table 2 depics he fiscal balance-gdp raio, and several deb o GDP raios. The fiscal balance-gdp raio is lower han he difference beween he governmen saving-gdp raio and he public invesmen-gdp raio by abou 2 percen, mainly because of he inclusion of ne governmen land purchases in he fiscal balance. During he 1990s, he governmen bough significan amouns of land from he privae secor o prop up land prices. The fiscal surplus declined coninuously in he 1990s, reaching abou minus 10 percen in Correspondingly, he raio of deb o GDP has risen sharply. By inernaional sandards, Japan s gross deb-gdp in 1999 was he highes among he G-7 counries Ialy s was 115 percen, and he U.S. s was 62 percen. Because of he parly funded naure of he Japanese pension sysem, as well as he governmen s major role in financial inermediaion, he Japanese governmen holds significan asses, keeping ne deb-gdp a a moderae level, and lower han in oher G-7 counries. However, since he asses of he social securiy sysem are more han offse by fuure pension

12 12 obligaions, hey should be excluded when assessing Japan s deb siuaion. As a resul, Japan s ne deb excluding social securiy ne asses, a 85 percen, is significanly higher han in he U.S., 60 percen, and in Germany, 53 percen. The governmen s rue ne obligaions may be subsanially higher han he ne deb figures, because of unfunded liabiliies. There are hree main sources of unfunded liabiliies. The firs source are he fuure coss of governmen social securiy and healh schemes. Esimaes of fuure unfunded social securiy coss depend on demographic, economic growh, and ineres rae assumpions and range widely. In Japan, here are several social securiy schemes, bu he main scheme he Employees Pension Scheme derives one-hird of is (benefi) payous from governmen subsidies, and wo-hirds of is payous from payroll axes (conribuions). Given curren governmen subsidy and payroll ax raes, Chand and Jaeger (1996) esimae he presen (2000) value of Japan s unfunded social securiy liabiliies a 110 percen of GDP. Muhleisen (2000) esimae he presen value of ne unfunded liabiliies a 60 percen of GDP. Wih regards o governmen healh benefis, on average, governmen subsidies cover abou 1/3 oal public healh insurance benefis (2 percen of GDP), wih he res covered by healh insurance conribuions and co-paymens. Given ha he elderly are exemp from healh insurance conribuions, and pay only small co-paymens, he fuure aging of he populaion is expeced o significanly raise he proporion of healh benefis covered by governmen subsidies. The second source of unfunded liabiliies are poenial losses on governmen asses. A porion of he governmen s asses represen sof loans ha may no be repaid. Many large public or join public-privae infrasrucure projecs financed from he Fiscal Invesmen and Loan Program (FILP) loans generae less revenue han budgeed, which may imply significan

13 13 coningen liabiliies of he governmen. For example, much of he subsanial deb 3 percen of GDP--of he now privaized Japan Naional Railways is owed o FILP. Since mos of his deb will never be repaid, his deb will evenually have o be covered from he governmen budge. Oher public corporaions wih large accumulaed FILP deb include he Japan Highway (4 percen of GDP) and Housing and Urban Developmen Corporaions (2.5 percen of GDP). The hird source of unfunded liabiliies are he explici and implici governmen guaranees of privae secor lending. Explici guaranees are exended by FILP and oher governmen eniies o encourage lending by privae financial insiuions. Examples are guaranees of bank deposis by he Deposi Insurance Corporaion, and guaranees of lending by credi cooperaives o small- and medium-sized enerprises. Alhough hese guaranees do no enail fresh governmen lending, should he guaraneed loans no be repaid, he governmen mus cover he loans from he budge. The oal amoun of ousanding governmen-guaraneed bonds and loans amouned o abou 10 percen of GDP in Alhough hisorically, only abou 1 percen of governmen-guaraneed loans are never repaid, if he Japanese economy worsens, he percenage of unpaid loans could soar (Bayoumi, 1998). In addiion o he explicily guaraneed governmen loans and bonds, here are he implicily guaraneed governmen loans. Hisorically, he Japanese governmen has shown willingness o cover he irrecoverable problem loans of privae financial insiuions. For example, in 1998, he governmen auhorized 60 rillion yen (12 percen of GDP) in public funding o cover he irrecoverable loans of privae banks. 7 This willingness represens implici 7 The oal of public funds acually spen and included in governmen consumpion--in 2000 was abou 8 rillion yen (0.16 percen of GDP).

14 14 guaranees, and hese guaranees are coningen liabiliies of he governmen. In 2000, ousanding loans minus he capial and liquid asses of financial insiuions was abou 200 percen of GDP. If, as some bank analyss esimae, 10 percen of he loans are irrecoverable, hen he cos o he governmen of hese implici guaranees could be as high as 20 percen of GDP. IV. Aging and Suppor Raios in Japan. The economic consequences of populaion aging depend on he naure of underlying demographic change as well as on he relaionship beween he resource needs of individuals of differen ages. Figure 3 plos he Japanese governmen s projecions of he counry s populaion and he percenage of he oal populaion ha is elderly. 8 Japan s populaion is expeced o peak a close o 130 million in 2005, hen gradually decline o abou 100 million by abou The percenage of he populaion over he age of 65 has grown rapidly, especially since 1980, and now sands a abou 15 per cen. By 2020, ha percenage should approach 25 percen, and by 2050, 33 per cen. By 2030, he percenage of he very old (aged over 80) should exceed 10 per cen. These raes of populaion aging are much higher han in oher counries. For example, in he U.S., only abou 15 per cen of he populaion will be above he age of 65 by Declining feriliy is he principal source of he changing demographic paers (Takayama, 1998). In he years following he Second World War, he oal feriliy rae in Japan rose o abou 4 by However, feriliy declined sharply during he 1970s and 1980s. I was 2.1 per 8 The figures for were calculaed from daa presened in Japan s Saisical Yearbook. The figures from were calculaed from he medium projecions of he populaion by age group presened in he Minisry of Healh and Welfare (1998).

15 15 household in 1974, bu 1.4 per household by The oal feriliy rae is projeced o decline o abou 1.2 over he nex several decades. Moreover, Japan has allowed almos no immigrans, who, especially in English-speaking counries, have helped o keep he populaion young. These rends have imporan implicaions for he demographic srucure of he populaion over he nex half-cenury. The Suppor Raio. Demographic shifs affec he economy s consumpion opporuniies because hey change he relaive sizes of he self-supporing and dependen populaions. Following Culer, Poerba, Sheiner, and Summers (1990), we summarize hese changes by he suppor raio, denoed by α, which we define as he effecive labor force, LF, divided by he number of consumers, CON, α = LF / CON. The firs issue in measuring he suppor raio concerns he relaive consumpion needs of people a differen ages. We assume ha all people have idenical resource needs so ha: CON = 99 N i, i= 1 where N i is he number of people of age i. The second issue concerns he effecive labor force. The firs measure, LF1, assumes ha all people aged are in he labor force, while individuals 19 and under or 65 and over are no:

16 16 LF1 = 64 N i i= 20. This measure is used by he Japanese governmen in projecing he fuure labor force. The second measure, LF2, recognizes ha boh human capial and labor force paricipaion raes vary by age. We use daa on he average 1990 earnings of people of each age (measured in 5-year inervals) and sex ( W ij, where i is age, and j=m, male or F, female) along wih daa on age- and sex-specific labor-force paricipaion raes ( PR ). 9 ij 80 LF2 = ( W * PR * N + W * PR * N ) i= 15 im im im iw iw iw. This measure assumes ha earnings accuraely reflec a worker s human capial. If ageearnings profiles are hump-shaped, hen labor produciviy peaks in middle-age. Thus, his measure recognizes ha human capial of a sociey wih a high fracion of people in middle age is higher han ha of a sociey wih many older workers, whose earnings and labor-force paricipaion raes decline. The wo suppor raios using he wo measures of he labor force are repored in Figure 4. The wo suppor raios have very similar paerns, especially afer Using LF1, he suppor raio declines from 1 in 1990 o 0.80 in Using LF2, i declines o Beween 2005 and 9 The daa on earnings and labor-force paricipaion raes are from he Minisry of Labor (various years).

17 , he second suppor raio declines more han he firs, owing o he fall in high-earning, prime age males. Given he similariy in he wo suppor raios, for he remainder of his paper, we focus on he governmen measure, LF1. V. Demographic Change, Opimal Saving-Invesmen, he Curren Accoun, and Governmen Deficis in Japan. Here we simulae he impac of demographic change on fuure Japanese saving and invesmen raes, and governmen deficis, using he governmen s measure of he suppor raio, LF1. We adop he neoclassical framework and assume ha consumers maximize (lifeime) uiliy. Households base heir consumpion on boh curren and fuure income. Thus, consumpion can be deached from curren income; households adjus heir saving o keep consumpion growh consan ino he fuure. In our simulaions, we adop he sandard small-counry, open capial markes, Ramsey opimal-growh model (Barro and Sali-i-Marin, 1995, Ch. 3). Specifically, we closely follow Culer, Poerba, Sheiner, and Summers (1990) modificaions o he Ramsey model, in examining he impac of changing demographics on savings and governmen deficis. 10 Wih he model, we 10 The Ramsey model assumes ha households are dynasic hey care abou heir children s and grandchildren s welfare (uiliy) as much as heir own. Of course, an imporan implicaion of dynasic households is ha Ricardian equivalence holds; governmen deb does no affec he inergeneraional disribuion of wealh. There is a large lieraure esing wheher he dynasic model is applicable for Japan(for a review, see Horioka, 2001). The dynasic model can be conrased wih he life-cycle model, in which households do no care abou heir children. Thus, in he life-cycle model, households bring down heir wealh (dissave) in old age. On he whole, he empirical ess suppor he dynasic model, and rejec he life-cycle model. The Japanese elderly, on average, leave large bequess o heir children, and his appears o be moivaed by alruism owards he nex generaion.

18 18 can examine how a sociey can adjus is saving, invesmen, and governmen deficis in response o changes in demographic variables. We simulae he model using plausible parameer values; and he projeced fuure pahs of he suppor raio, and he growh in he populaion and he labor force. (i) Skech of he Simulaion Resuls. As consumers seek o smooh consumpion over ime, consumpion per capia grows a a consan rae. However, as he suppor raio falls, GDP per capia grows a a slower rae han consumpion per capia, which raises he consumpion-gdp raio. Tha is, as he number of workers relaive o populaion falls, here are relaively less people susaining oupu (GDP), while consumers remain relaively numerous, raising he consumpion-gdp raio. The rise in he consumpion-gdp raio lowers he privae saving rae. The privae saving rae is projeced o decline from abou 28 percen oday o abou 15 percen by 2020, and abou 12 percen in To reduce disorions, he governmen seeks o mainain a per capia ax level ha grows a he rae of per capia consumpion growh, implying a rising ax-gdp raio (given slower growh in GDP per capia). The ax-gdp raio is projeced o rise sharply from 28 percen oday o abou 45 percen in 2020, o reach almos 50 percen in Alhough aging raises social securiy and healhcare spending, increasing he governmen spending-gdp raio, he rise in he governmen spending-gdp raio is lower han he increase in he ax-gdp raio. Thus, he governmen saving rae gradually rises. The governmen saving rae rises from abou 2 percen of GDP oday o abou 10 percen in However, he decline in he privae saving rae is larger

19 19 han he rise in he governmen saving rae, leading o a fall in he oal saving rae, from 30 percen oday o abou 24 percen in 2020, and abou 20 percen in The rising governmen saving rae evenually offses oday s ousanding governmen deb-gdp raio; fuure governmen spending, and public invesmen. Consequenly, afer iniially increasing, he governmen deb-gdp raio sars o decline in abou As he labor force declines (in absolue number), he need o equip workers wih capial equipmen decreases, and boh privae and public invesmen raes fall, resuling in a decline in oal invesmen. The privae invesmen rae falls from 20 percen oday o abou 16 percen in 2040; he public invesmen rae falls from 8 percen oday o abou 6 percen in The fall in oal saving is sharper han he fall in oal invesmen, resuling in a decline in he curren accoun-gdp raio from 2 percen of GDP oday o -1 percen of GDP in 2020, and evenually o -3 percen of GDP in Thus, afer iniially increasing, Japan s ne foreign asses-gdp raio sars o decline around 2020 and approaches 0 by (ii) Behavior of Firms. We begin wih he producion funcion of a represenaive firm ha uses boh privae and public capial as inpus: y = k$ γ γ λ m$ α 1 e h (1) where y is gross oupu per populaion (capia), k $ is he privae capial sock per effecive populaion, $m is he public capial sock per effecive populaion, and h is he consan rae of labor augmening echnical progress. We assume consan reurns o scale in privae and public

20 20 capial, so ha ( 1 λ) = 2γ. In he above producion funcion, public capial is essenial for he produciviy of privae capial ie., public capial is no waseful. This goes agains convenional wisdom regarding he wasefulness of recen public invesmen in Japan. In our producion funcion, we are mosly concerned wih he produciviy of public capial over he long run (over decades), and public invesmen was cerainly producive in Japan in he pas (1960s and 70s), and may be producive again in he fuure. Noe ha when $k, $m and he suppor raios are consan, oupu per capia grows a a consan rae h. When he suppor raio is falling, however, oupu per capia grows a a slower rae han h. The supply of privae capial available o he firm depends on he global capial marke; he marginal produc of capial mus equal raes, and δ is he rae of depreciaion. We have: r + δ, where r is he gross inernaional real ineres 1 v 1 v k$ = ( r + δ)( avα λ ) m$, (2) and hus privae invesmen per capia is: i$ = k$& + ( n + h+δ) k $. (3) where n is he populaion growh rae Thus, he pahs of privae capial and privae invesmen are solely deermined by he real ineres rae, he raes of growh of he labor force and populaion, echnical progress, and he pah of public capial. The governmen adjuss he level of public capial by changing he public invesmen rae,

21 21 $ j : $ j = m & $ + m$ ( n + h+ δ) (4) (iii) Behavior of Consumers. The consumpion rae is deermined from forward-looking household behavior. Assume ha households wish o maximize heir lifeime uiliy, U, given by: U = 1 θ c n ee ( θ) 0 1 ρ d (5) where c is consumpion per capia, 1/θ is he ineremporal elasiciy of subsiuion, and ρ is he pure rae of ime preference. The budge consrain for households (in per-capia erms) is: a& = α w + ( r n) a τ q 2 τ 2 (6) where a is oal asses per capia, which is comprised of privae capial, governmen bonds, and foreign asses, which are perfec subsiues in inernaional porfolios; w are wages; and τ is he lump-sum ax imposed on each person each period by he governmen. This lump-sum ax

22 22 qτ 2 also imposes a deadweigh welfare loss of per person. 2 I can be shown (see Appendix) ha consumpion per capia always grows a h. Thus, while consumpion per capia grows a h, when he suppor raio is declining, oupu per capia ends o grow a less han h (see ii). The consumpion rae, c y is rising, lowering he privae saving rae. (iv) The Governmen Budge Consrain. Each period, he governmen issues governmen bonds of, &b o cover shorfalls in ax revenues: b& = ( r n) b τ + g + j (7) where b is governmen bonds ousanding per capia. The increase in governmen bonds per capia is higher, he larger is he primary fiscal defici, which is he difference beween ax revenues per capia, and he sum of governmen consumpion g and public invesmen j per capia. As in Culer, e. al. (1990), we assume ha g is deermined by age-specific paerns of

23 23 governmen consumpion. 11 Governmens spend differen amouns on people of differen ages. Spending on educaion benefi primarily children, while he elderly are he primary beneficiaries of healhcare and social securiy. Thus, even wihou changes in he srucure of governmen programs, demographic shifs can affec he level of g. We calculae per capia age-specific governmen spending paerns for Japan, focusing on he hree larges social expendiures: social securiy, healhcare, and educaion. For social securiy, we divide average social securiy expendiures in by he populaion over age 60. For healhcare, we allocae average healhcare spending in o differen ages, using he age-specific expendiure paerns repored in Ishi (2000). For educaion, we divide oal educaion spending in 2000 by he populaion beween ages 5 and 20. Demographic shifs can significanly aler governmen spending. Table 3 shows he projecions of oal governmen spending in 1995 yen and as a share of projeced GDP. We assume ha age-specific per capia expendiure paerns remain a he same real level beween 2000 and Consisen wih curren Japanese governmen objecives (Ishi, 2000), we are no allowing any real increases in age-specific healhcare and social securiy spending. Tha is, if he average 67 year old receives 190 housand yen in governmen healhcare in 2000, an average 67 year receives he same inflaion adjused amoun in Oher governmen spending, mainly defense, policing, and adminisraion, are assumed o always equal he average raio o 11 We also assume ha g eiher yields no uiliy o households, or ha governmen benefis do no affec he household s opimal choice of privae consumpion. 12 For social securiy, however, we assume ha he age of eligibiliy increases from 60 o 65 in 2015 (in accordance wih curren laws); alhough we assume ha per recipien benefis remain he same.

24 24 GDP of 5.6 percen. In our projecions, governmen spending rises from 25 percen of GDP in 2000 o 28 percen in 2015, and 33 percen in While educaion spending is projeced o decline, healhcare, and especially social securiy spending, are projeced o increase sharply, as he populaion ages. In paricular, in 2035, he populaion over 65 increases significanly (Figure 3), leading o sharp increases in social securiy and healhcare spending. I can be shown (see Appendix) ha he governmen will choose o levy a per capia lumpsum ax of ha grows a he rae of consumpion per capia growh, h. The governmen mus τ hen saisfy he following ineremporal budge consrain: τ 0 0 h e R d = b + ( g + j ) R d 0 0 (8) where b 0 is he governmen deb ousanding per person oday, and R is a discoun facor. This budge consrain says ha he presen value of ax revenues mus equal he presen value of governmen consumpion plus public invesmen. If governmen ax revenues are insufficien o cover governmen spending oday, hen in he fuure, ax revenues mus exceed governmen spending for he governmen o saisfy is ineremporal budge consrain. (v) Projecions of Opimal Privae and Governmen Saving, Privae and Public Invesmen. As in Clarida (1993), we assume ha he governmen maximizes lifeime household uiliy (5), wih respec o c and $ j subjec o he consrains. We simulae he model using plausible

25 25 parameer values, projeced fuure suppor raios (LF1), and fuure raes of populaion and labor force growh. In he simulaions, we allow suppor raios and raes of populaion and labor force growh o change every five years. Deails of he simulaion are given in he Appendix. For comparabiliy wih acual Naional Accouns Daa, we express our simulaions in erms of raios o GDP. We calibrae our model so ha he saring year (2000) corresponds o he average of he acual daa beween (he daa in Tables 1 and 2). For he iniial governmen deb-gdp raio, we use he raio of ne deb-gdp, inclusive of he social securiy ne asses (=45 percen of GDP). We accoun for ne fuure social securiy unfunded liabiliies by explicily incorporaing fuure social securiy benefis and conribuions ino our model. Of course, as alluded o earlier, here are oher unfunded and coningen liabiliies. Our saring year deb-gdp raio should be viewed as he lower bound. There is one excepion o his saring year calibraion exercise. Beween , he oal axes (including social securiy conribuions) colleced by he governmen averaged abou 27 percen of GDP. This ax rae was found o be simply oo low o be consisen wih our model s ax smoohing and he saisfacion of he governmen budge consrain, (4). This is anoher way of saying ha unless he governmen sars running primary fiscal surpluses, governmen deb will no be susainable. Thus, we depar somewha from ax smoohing, and allow axes per capia o gradually increase from he year 2000 rae of 27 percen. 13 The governmen s ineremporal budge consrain is sill saisfied, which means ha fuure ax raes mus be higher han when axes are perfecly smoohed. 13 Culer, e. al. (1990) show ha deadweigh losses arising from deparures from ax smoohing are small.

26 26 Table 4 presens our projecions. Privae saving raes decline a few percenage poins unil 2010, and hen declines rapidly from 2010 o This paern is a resul of shifs in he suppor raio and increases in ax raes, which reduces disposable income. Alhough consumpion per capia always grows a a consan rae of h (=1.2 percen), as he suppor raio falls, oupu per capia growh is lower. Essenially, consumers are seeking o smooh heir consumpion when income is growing very slowly by lowering heir saving raes. Under ax smoohing, axes per capia increase a a consan rae, while oupu per capia grows a a slower rae; hus he ax-gdp raio rises over ime. However, he acual ax rae in he saring year (average, ) a 28 percen of GDP, is lower han wha is necessiaed by ax smoohing (33 percen) and he saisfacion of he governmen s ineremporal budge consrain. Tha is, unless curren ax raes are increased, he governmen will no be able o saisfy is ineremporal budge consrain. We allow axes per capia o increase more rapidly beween 2000 o 2015, and hen smooh increases in axes per capia from 2015 onwards. The sharp increases in ax raes beween 2000 and 2015 also conribues o he decline in privae saving raes, by lowering disposable income. By 2040, ax raes need o increase o almos 50 percen of GDP, for he governmen o recoup is curren ousanding ne deb (45 percen), projeced fuure spending (Table 3), and projeced public invesmen (Table 4). Governmen saving raes rise from abou 1-2 percen of GDP in 2000 o abou 10 percen in 2020, owing o he increased ax receips. Governmen saving raes decline somewha in 2035, because he spike in he over 65 populaion (Figure 3). Privae and public invesmen raes gradually fall over ime, as he need o equip workers wih capial equipmen declines. Because of high governmen saving and falling public invesmen, he fiscal surplus (governmen saving

27 27 minus public invesmen) urns posiive afer Consequenly, he governmen ne deb-gdp raio increases unil 2020, and falls hereafer. The decline in he ne deb-gdp raio is fairly rapid beween 2020 and The decrease in privae saving is sharper han he increase in governmen saving, resuling in a fall in oal saving. The oal saving rae declines from abou 30 percen in 2000 o 24 percen in 2015, 21 percen in 2030, and 19 percen in Toal invesmen declines from 28 percen in 2000 o 25 percen in 2015, 23 percen in 2030, and 22 percen in Thus, he decline in oal saving is sharper han he decline in oal invesmen, leading o declining curren accoun surpluses. Japan s curren accoun surplus is projeced o become negaive in 2015, and negaive from hen onwards. Consequenly, Japan s ne foreign asses, afer peaking relaive o GDP in 2015, will sar o decline, and will approach 0 by Korea VI. Korean Saving and Invesmen. Korea is well known for is high saving, and even higher invesmen raes (Figure 5). Privae saving (he sum of household and corporae saving) increased sharply from abou 19 percen o over 33 percen in he lae 1980s and early 1990s, while governmen saving raes have remained seady a abou 4-5 percen (Table 5). Toal invesmen raes have been impressive, especially in he 1990s (Table 5). Household saving appears o respond mos direcly o income (GDP) gains, demographic facors, and real ineres raes. Household saving has risen relaive o income in rache fashion, suggesive of he permanen income model of consumpion (Collins and Park, 1989).

28 28 Economeric work has shown he imporance of high average growh raes of GDP as an explanaion for he impressive rise in household saving, and he large swings in real growh raes of GDP as an explanaion of he cyclical flucuaions of saving raes (Collins and Park, 1989). The high average real GDP gains of he 1970s and 1980s sharply raised household saving raes, while he sharp dip in real GDP in he 1990s (owing o he currency crisis), decreased saving raes somewha. The coninuous declines in he populaion growh raes, from 3.0 percen per annum in 1960 o 2.0 percen per annum in he 1970s, lowered dependency raios, helping boos household saving raes during he 1970s. The surge in domesic saving beween 1985 and 1995 was also aided by high domesic afer-ax real ineres raes. The developmen of non-bank financial inermediaries replaced he curb marke and offered high real reurns for savers. The governmen s policy of applying a low fla ax rae on mos ineres income raised afer-ax real reurns (Kim and Leipziger, 1991). Privae saving was also boosed by srong corporae saving. Corporae saving (no depiced) averaged around 7 o 8 percen in he 1970s and 1980s, boosed by a lower ax burden and a booming economy. In addiion, during he 1970s and early 1980s, corporaions were urged by he governmen o accumulae heir own invesmen funds, hrough managemen raionalizaion and he upward adjusmen of consumer prices (Kim and Leipziger, 1991). Governmen saving (exclusive of public invesmen) has remained high in Korea, because of low governmen expendiures, and buoyan ax revenues. A noable feaure of Korea s paern of governmen expendiure is he low proporion spen on wages and salaries. Tax revenues increased from 10 percen of GDP in he early 1960s o abou 20 percen in he mid-1980s, and hereafer. This growh was helped by he creaion of he Office of Naional Tax Adminisraion,

29 29 which was creaed for effecive ax enforcemen. The inroducion of he Value Added Tax in 1977 also boosed ax revenues significanly (Kim and Leipziger, 1991). Korean oal invesmen in he 1970s was aided by srong governmen infrasrucure spending, which averaged more han 1/3 of oal invesmen. Toal invesmen was also boosed by he Heavy and Chemical Indusry drive of he 1970s. No only were public resources direcly mobilized for Heavy and Chemical Indusry financing (so-called, policy loans ), bu even more significanly, banks were direced o lend o indusry, ofen a preferenial raes. The high invesmen raes in he lae 1980s o he early 1990s were driven by he chaebols sraegy of compeing for marke share in maure indusries; and of diversifying in new indusries, ofen unrelaed o he core business of he group. In his period, corporaions financed heir expansion mainly by borrowing in foreign currencies from domesic financial insiuions. Reflecing hese developmens in saving and invesmen raes, ne expor surpluses (as a percenage of GDP) were sharply negaive in he 1970s, posiive in he 1980s, and slighly negaive in he 1990s (Table 5). VII. Aging and Suppor Raios in Korea. Figure 6 plos he Unied Naion s projecions of Korea s populaion; and he percenage of he Korean oal populaion ha is elderly. The Korean populaion is expeced o peak a a lile over 50 million in 2025, hen gradually decline. The percenage of he populaion over he age of 65 is expeced o increase, from abou 5 percen in 2000 o over 15 percen in 2025, and

30 30 hen double o over 28 percen in As in Japan, declining feriliy is he principal source of hese changing demographic paerns. The suppor raio for Korea using he measure of he labor force ha assumes ha all people aged are in he labor force; while individuals 19 and under or 65 and over are no (LF1) increases from 0.63 in 2000 o 0.62 in 2025, and 0.53 in Compared o he populaion aging, he decline in he Korean suppor raio beween 2000 and 2025 is negligible. Alhough he fracion of hose over he age of 65 is rising, he fracion of hose under he age of 20 is falling, hus, keeping he suppor raio consan. VIII. Demographic Change, Opimal Saving-Invesmen Balance, and he Curren Accoun in Korea. For Korea, we will focus on projecing he oal saving and oal invesmen raes. Tha is, we will no separaely projec he governmen saving and public invesmen raes. The simulaion model for Korea is oherwise very similar o he one developed for Japan, excep ha we do no disinguish beween privae and public capial for Korea. We adop he neoclassical framework and assume ha consumers maximize (lifeime) uiliy, and firms maximize firm value. Households now base heir consumpion on boh curren and fuure income. Thus, consumpion can be deached from curren income; households adjus heir saving o keep consumpion growh consan ino he fuure. (i) Skech of he Simulaion Resuls. 14 For Korea, we only have labor force projecions for 25 years (2025), and 15 years afer ha (2040).

31 31 As Korean consumers seek o smooh consumpion over ime, consumpion per capia grows a a consan rae. However, as he suppor raio falls, GDP per capia grows a a slower rae han consumpion per capia, which raises he consumpion-gdp raio. Tha is, as he number of workers relaive o populaion falls, here are relaively less people susaining oupu (GDP), while consumers remain relaively numerous, raising he consumpion-gdp raio. The rise in he consumpion-gdp raio lowers he oal saving rae. However, given ha aging in Korea is very sligh unil 2025 (suppor raios decline from 0.63 o 0.62), oal saving raes remain roughly consan from he level, a 36 percen of GDP. As aging acceleraes afer 2005 (suppor raios decline from 0.62 o 0.53), Korean oal saving raes plunge from abou 36 percen in 2025 o abou 27 percen in As he labor force declines (in absolue number), he need o equip workers wih capial equipmen decreases, and oal invesmen raes fall. The oal invesmen rae declines from an average of abou 37 percen in o 35 percen in 2025, and 30 percen in Unil abou 2025, oal saving raes are slighly higher han oal invesmen raes, resuling in an increase in he curren-accoun-gdp raio o abou 2 percen of GDP. Thus, Korea s ne foreign asses-gdp raio rises from abou 8 percen in 2000 o abou 23 percen in Alhough Korean saving raes sar o dip below invesmen raes afer 2025, he ineres income from Korea s accumulaed ne foreign asses are sufficien o keep he curren accoun in slighly posiive erriory. Thus, Korea s ne foreign asses-gdp raio coninues o grow, o reach a peak of abou 70 percen in (However, Korea s ne foreign asses-gdp raio is projeced o fall rapidly afer 2040).

32 32 (ii) Opimal Invesmen Raes. We assume ha Korean firms maximize he presen discouned value of profis: V e r τ = [ Y w L$ adc ] dτ 0 (9) where Y is gross oupu, r is he world real rae of ineres, w is wages, L $ is he effecive labor force, and adc are adjusmen coss o changing he oal (privae and public) capial sock, such as reooling, downime, bureaucraic delay, ec. The producion funcion for Korea is: Y υ = KL$ 1 υ (10) where K is he oal capial sock; υ, he capial share of oupu is: 0.30 (Young, 1985). Effecive labor and oal capial grow according o: $ ( n + g) = L e 0 L (11) dk d = I δk (12) and adjusmen coss o changing oal capial are: adjcos = I *[ 1+ b / 2* I / K ], (13)

33 33 where he noaion is as before. We maximize (9), given he consrains (11), (12), and (13), and simulae he model, using plausible parameer values. For g we ake [=labor share (0.70)*TFP Growh (0.017)], for r, 0.06, and for δ, Labor-augmening echnical progress of 1.2 per cen implies a growh rae of oal facor produciviy of 1.7 percen for Korea s labor share of For he pah of n, we use values from he Unied Naions labor force projecions. Deails of he simulaion are similar o hose given in he Appendix. However, for Korea, we only have labor force projecions for 25 years (2025), and 15 years afer ha (2040). Thus, we assume ha n remains consan wihin hese inervals. Table 6 depics he projeced Korean invesmen raes from 2000 o The values for he invesmen raes are normalized so ha he invesmen rae for 2000 is equal o he average value of invesmen beween 1990 and From Table 6, we can see ha oal invesmen raes remain close o heir curren level unil The invesmen rae is projeced o fall more sharply afer 2025, as labor force growh rae declines sharply. In general however, he invesmen rae is no very sensiive o changes in labor force growh raes, alhough i is quie sensiive o changes in real ineres raes (which is assumed consan). A fall in he labor force growh rae lowers boh oupu and he capial needed o equip workers, leaving he capial-labor raio seady. Wih a seady capial-labor raio, he invesmen rae is also seady. (iii) Opimal Saving Raes. As wih he case wih Japan, he Korean saving rae is deermined from forward-looking