NBER WORKING PAPER SERIES FINANCING CONSUMPTION IN AN AGING JAPAN: THE ROLES OF FOREIGN CAPITAL INFLOWS AND IMMIGRATION.

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1 NBER WORKING PAPER SERIES FINANCING CONSUMPTION IN AN AGING JAPAN: THE ROLES OF FOREIGN CAPITAL INFLOWS AND IMMIGRATION Rober Dekle Working Paper hp:// NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachuses Avenue Cambridge, MA Sepember 2004 Presened a he Trio Conference in Tokyo, December 8 and 9, Forhcoming in he Journal of Japanese and Inernaional Economies, December I hank he paricipans of he conference, my discussan Professor Ihori, an anonymous referee, and he edior of he journal, Takeo Hoshi, for very helpful commens. The views expressed herein are hose of he auhor(s) and no necessarily hose of he Naional Bureau of Economic Research or he IMF by Rober Dekle. All righs reserved. Shor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full credi, including noice, is given o he source.

2 Financing Consumpion in an Aging Japan: The Roles of Foreign Capial Inflows and Immigraion Rober Dekle NBER Working Paper No Sepember 2004 JEL No. F2, F3, F4 ABSTRACT We projec he impac of demographic change on Japanese capial flows by simulaing he impac of populaion aging on Japanese saving and invesmen raes. As aging depresses saving raes, in our baseline projecions, we show ha by 2015, foreign capial inflows will comprise abou 15 percen of Japanese oupu. A disinguishing feaure of his paper is ha we compare he capial flows ha occur wihou immigraion o he capial inflows ha would occur wih immigraion of 400,000 people annually. Wih he larger labor force from immigraion and he larger induced capial accumulaion, oupu will be 22 percen higher by 2020, and 50 percen higher by The higher oupu means ha less capial needs o be impored; by 2015, Japan will be imporing only 8 percen of is oupu. Rober Dekle Deparmen of Economics USC Los Angeles, CA dekle@usc.edu

3 2 1. Inroducion. Over he nex several decades, Japan s populaion will be aging rapidly. In 1955, only 5.5 percen of he populaion was 65 years or older; by 1998, 16.2 percen were elderly. Projecions imply large increases in he elderly in he nex 20 years; by 2015, 25 percen of he populaion will be 65 or above. Declining feriliy is he principal source of he changing demographic paerns (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 household in 1974, bu 1.4 per household by The oal feriliy rae is expeced o remain a abou 1.4 over he nex several decades. 1 Moreover, Japan has ypically allowed only a small number of immigrans, who, especially in Englishspeaking counries, have helped o keep he populaion young. A key quesion is how consumpion in an aging populaion can be susained. The elderly consume, bu do no supply he labor ha leads o higher oupu. Thus, as he populaion ages, he share of consumpion in oupu increases. If domesic oupu is insufficien o susain consumpion in an aging populaion, capial mus be impored. In his paper, we revisi he impac of demographic change on Japanese capial ouflows and inflows. We show ha he aging populaion will decrease boh saving and invesmen raes, bu he decline in saving raes will be more severe, leading o curren accoun deficis and foreign capial inflows. In our baseline projecions, we show ha by 2015, foreign capial inflows will comprise abou 15 percen of oupu. We projec he impac of demographic change on Japanese capial flows by simulaing 1 All demographic projecions of his paper are from he Populaion Projecions for Japan: , which is based on he 2000 populaion census.

4 3 he impac of aging on Japanese saving and invesmen raes. In our simulaions, we adop he sandard small-counry, open capial markes, Ramsey opimal growh model. Specifically, we follow Culer, Poerba, Sheiner, and Summers (1990) modificaions o he Ramsey growh model, in examining he impac of changing demographics on saving and invesmen. Our main innovaion is ha while Culer e. al. s work focused on he closed-economy, we focus on he open-economy, so ha capial inflows ino Japan can be explicily modeled. Pas work projecing he impac of demographic change on Japan s saving-invesmen balance are voluminous; see for example Horioka (1991, 1992), Oishi and Yashiro (1997), Auerbach e. al. (1989), Miles and Cerney (2001), McKibbin and Nguyen (2001) and many ohers. The disinguishing feaure of our work is ha in our projecions, we compare he capial flows ha will occur wihou immigraion, o he inflows ha occur wih immigraion. Consisen wih he Unied Naion s recommendaions, we assume ha from 2005 o 2040, Japan will allow 400,000 immigrans annually. Wih he larger labor force from immigraion and he larger induced capial accumulaion, oupu in 2000 will be 22 percen higher by 2020, and 50 percen higher by The higher oupu means ha less capial needs o be impored. In our projecions wih immigraion, by 2015, Japan will be imporing only abou 8 percen of is oupu. To he bes of our knowledge, our paper is he firs paper o simulae he effec of increased immigraion ino Japan, on ha counry s saving-invesmen balances. The benefis of immigraion ino Japan are a holy debaed opic. While in recen cenuries, Japan has virually allowed no immigrans, immigraion has been massive in some previous cenuries. Some anhropologiss believe ha he impor of we-rice culivaion, and of iron and bronze ools and implemens from China and Korea during he Yayoi period (400

5 4 B.C. o 300 A.D.) were accompanied by massive or a leas modes immigraion from hose wo counries (Seki, 2000). Japan s populaion a he beginning of he Yayoi period was esimaed o be beween 75 and 250 housand; he populaion grew 70-fold during he Yayoi period. Some anhropologiss also believe ha during he Kofun period (300 A.D. o 700 A.D.), Korean, bu no Chinese, immigraion was exensive (Diamond, 1998). These Korean immigrans brough Buddhism, wriing, horseback riding, and new ceramic and meallurgical echniques. Our simulaion model also requires ha we projec governmen finances. We show ha he aging of he populaion will worsen governmen finances, as healhcare and social securiy spending soar. In our baseline simulaions, we show ha Japanese axes would need o increase from 28 percen of GDP o almos 50 percen of GDP by 2040 o cover he curren Japanese governmen ne deb, and he fuure governmen spending. Wih immigraion, social securiy and healhcare spending as a percenage of GDP will be lower, meaning ha fuure ax increases can be lower. We show ha wih immigraion, he Japanese ax-gdp raio would need o increase o only 45 percen by This paper is organized as follows. In Secion 2, we summarize he demographic changes undergoing in Japan, and presen he Japanese governmen s demographic projecions. We hen show how Japan s fuure demographic profile would improve when 400,000 annual immigrans are allowed. In Secions 3 and 4, we digress briefly o describe he insiuional characerisics of he Japanese social securiy sysem. We show ha in pracice, he Japanese social securiy accouns are inexricably inerwined wih he general budge of he Japanese governmen; and ha i is difficul o separae he Japanese social securiy accouns from he

6 5 general governmen budge. This jusifies he assumpion in our model ha here are no dedicaed social securiy payroll axes; and ha all axaion can be summarized by a lump-sum disorionary ax. In Secion 5, we simulae he impac of demographic change on fuure Japanese saving and invesmen raes, governmen deficis, and ne capial inflows, boh wihou and wih immigraion. Secion 6 concludes. 2. Aging, Immigraion, and Suppor Raios. Figure 1 plos he Japanese governmen s projecions of he counry s populaion and he percenage of he oal populaion ha is elderly. 2 Japan s populaion is expeced o decline from he 2000 peak of 124 million o 122 million by 2010, and hen gradually decline o abou 100 million by abou The labor force (age 20-64) is projeced o fall from 75 million in 2000 o 50 million in 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 28 percen, and by 2050, 33 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 Immigraion ino Japan. 2 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 (2002).

7 6 Beween 1970 and he mid-1980s, Japan annually allowed beween 20 and 30 housand immigrans. 3 During he lae 1980s and early 1990s, because of he severe shorage of labor, annual immigraion increased o abou 70 o 90 housand, bu ha number declined in recen years. In erms of socks, Japan s immigran populaion numbered 1.5 million, or 1.2 percen of he populaion, wih perhaps anoher 500 housand in illegal immigrans in This is conrased wih he Unied Saes, which in he same year, had a sock of 26 million legal immigrans, or 9.7 percen of he populaion. Annual flows of legal immigrans o he U.S. is abou 1 million (0.4 percen of he populaion), wih an addiional esimaed illegal immigran flow of 1 million. The Unied Naions Populaion Division (1998) projecs ha o keep he size of he Japanese populaion consan a oday s level of 125 million, Japan would need an average of 400,000 immigrans per year beween 2005 and In our projecions of he Japanese populaion srucure wih immigraion, we assume ha 200 housand men and 200 housand women immigrae annually. They are assumed o be equally divided beween he age groups of and We also assume ha all year old immigran couples have 2 children each wihin 5 years of heir arrival in Japan. Under hese assumpions, Figure 2 depics he oal populaion and he populaion over age 65, wih immigraion. Wih immigraion, he populaion peaks a 2015 a 135 million and says a abou ha level. 4 The labor force is kep robus wih immigraion. The labor force is projeced o fall from 79 million o abou 74 million in The daa on immigraion are from Papademeriou and Hamilon (2001) 4 Our populaion projecions are somewha higher han he Unied Naions projecions, because we assume higher immigran feriliy raes.

8 7 By 2050, he immigrans and heir decedens will comprise abou 18 percen of he oal populaion of he counry. As immigrans reach age 65 afer 2040, he elderly populaion increases somewha. The proporion of hose over he age of 65 reaches 25 percen in 2020, and 29 percen in Thus, even wih his immigraion, he populaion of Japan will be considerably older han in he Unied Saes. 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. We assume simply ha all people

9 8 aged are in he labor force, while individuals 19 and under or 65 and over are no 5 : LF = 64 N i i= 20. This measure is used by he Japanese governmen in projecing he fuure labor force. Figure 3 plos he suppor raios wihou (LF) and wih immigraion (LFIM). 6 As he populaion falls, he suppor raio declines under boh scenarios, bu he decline in he suppor raio is seeper wihou immigraion. Wihou immigraion, he suppor raio falls from 1.0 in 2000 o 0.86 in 2025 and 0.80 in Wih immigraion, he suppor raio falls from 1.0 in 2000 o 0.89 in 2025 and 0.86 in Aging and he Japanese Social Securiy Sysem. The Japanese social securiy sysem is wo-iered. The firs-ier is he universal pension, which provides a fla basic pension, currenly averaging abou 50 housand yen. Enrollmen is mandaory for all Japanese residens, including immigrans, beween he ages of 20 and 60. An 5 This is obviously a heroic assumpion. The labor force paricipaion rae of year olds is abou 75 percen, because of coninued aendance in college. Also, a significan fracion of women beween he ages of 25 and 64 (abou 30 percen) are no in he labor force. In an earlier paper, (Dekle, 2000), I calculaed a labor force measure ha recognizes ha boh human capial and labor force paricipaion raes vary by age and gender. I compared he suppor raios using he wo labor force measures, and found ha he suppor raios have very similar paerns, especially afer 1995 (Dekle 2000; Figure 3). Given he similariy of he wo suppor raios, we focus on he simpler suppor raio above. 6 As he referee correcly poins ou, he qualiy of he immigrans may be low. Given he lower qualiy of immigrans, more immigrans may be necessary. On he oher hand, we have shown above ha differences in human capial do no significanly affec paerns in he suppor raio. Since in our model, he effec of demographics is enirely summarized by he suppor raio, he lower human capial of immigrans may no grealy impac our simulaion values.

10 9 ineresing feaure of he universal pension plan is ha 1/3 (½ by 2004) of he benefis are paid from he general budge of he governmen. The second-ier covers mos employees, and conribuions are wage relaed. Presenly, conribuions are 13.6 percen of annual income, shared equally beween employee and employer. Average monhly benefis are abou 180,000 yen. The Japanese social securiy sysem has buil up a sizable rus fund abou 30 percen of GDP bu is essenially a pay-as-you-go sysem. Problems wih he Japanese Social Securiy Sysem. Inergeneraional Inequaliy. One characerisic of pay-as-you-go social securiy sysems is ha when he populaion ages, he elderly receive more from he sysem han hey pay ino he sysem. In urn, younger generaions pay more ino he sysem han hey receive from he sysem. The main reason why pay-as-you-go social securiy leads o inergeneraional inequaliy is ha when populaion growh raes decline, axes mus increase or benefis mus decline o keep social securiy inakes approximaely equal o payous. Thus, in he face of an aging populaion, he Japanese governmen has repeaedly raised payroll axes and cu social securiy payou raios in an aemp o keep he fuure sysem inac. 7 These policy changes have hur fuure generaions. Takayama and Kiamura (1999) idenified large inergeneraional imbalances in Japan, wih fuure generaions expeced o pay abou 3-4 imes more in ne axes and social securiy conribuions han he generaion currenly in reiremen. Haa and Oguchi (1999, p. 5) calculae ha people born in 1935 receive abou 7 For example, social securiy payroll axes as a percenage of income was 3 percen in 1979, and 17.4 percen in I is projeced o be 26.2 percen of income in 2035.

11 imes wha hey paid; and people born in 2010 receive only abou 60 percen of wha hey paid. Unfunded Social Securiy Liabiliies. Anoher consequence of slowing populaion growh under pay-as-you-go social securiy is he accumulaion of unfunded governmen liabiliies. Alhough he governmen has in recen years--especially in raised payroll axes and reduced fuure benefis, unfunded liabiliies have coninued o accumulae. The governmen bases is fuure projecions of he social securiy balance on assumpions regarding fuure demographics, income growh, and ineres raes. Based on hese assumpions, he governmen deermines is projeced payroll axes and benefis; so as o keep he annual flows of social securiy inakes and payous approximaely equal. However, some analyss have argued ha he governmen s assumpions are over-opimisic, and ha he projeced payroll axes and benefis will lead o annual deficis (Nishizawa, 2003; Chand and Jaeger, 1996). The presen value of hese annual deficis do no appear on he governmen s balance shees, and are called unfunded social securiy liabiliies. Chand and Jaeger (1996) esimae he presen (2000) value of Japan s unfunded social securiy liabiliies as 110 percen of GDP. Haa and Oguchi (1999) esimae he presen value of unfunded liabiliies as 140 percen of GDP. On an opimisic noe, he IMF esimaes ha he 1999 governmen pension reforms have reduced governmen unfunded social securiy liabiliies o abou 30 percen of GDP (IMF, 2000). There are several reasons for he coninued accumulaion of unfunded liabiliies.

12 11 Firs, he governmen s demographic projecions have consisenly underesimaed he pace of fuure populaion aging; because of rapidly declining feriliy raes, and lenghening life-spans. The oal feriliy rae has declined from 2.1 per household in 1975 o 1.33 per household in Meanwhile, male life expecancies have increased from 72 in 1975 o 78 in Since demographic projecions are based on curren feriliy raes and life-spans, adverse movemens in hese variables make demographic projecions over-opimisic. Based on hese demographic projecions, ax raes have urned ou o be oo low, and benefis, oo high, resuling in large unfunded liabiliies. Second, is governmen s inabiliy o ge a good ineres rae on he social securiy rus fund. The governmen s projecions assume a 4.5 percen ineres rae on he social securiy rus fund. Since here were relaively few aged unil now, he social securiy sysem ran persisen surpluses, and he rus fund reached 150 rillion yen (30 percen of GDP) by end Unil 2001, hese funds were by law invesed in governmen invesmen projecs hrough he fiscal invesmen and loan program; and earned he ineres rae on governmen bonds, which recenly yielded abou 0.7 percen. Since 2001, he social securiy rus fund has been allowed o inves in financial markes, alhough asse allocaions have been legally prescribed. 8 Given he weakness of Japanese financial markes, he fund earned a minus 2.5 percen in I appears unlikely ha he governmen will be able o earn raes of reurn approaching 4.5 percen, which means less income from he social securiy rus fund; and larger unfunded liabiliies. Finally, here has recenly been a sharp increase in non-paymens of social securiy 8 The prescribed asse allocaions are 68 percen domesic bonds; 12 percen domesic socks; 7 percen foreign bonds; 8 percen foreign socks; and 5 percen domesic deposis.

13 payroll axes and oher social securiy conribuions. As in oher counries, paricipaion in he 12 social securiy sysem in Japan is mandaory. 9 However, Nishizawa (2003, p. 63) calculaes ha nearly 40 percen of hose required o paricipae in he social securiy sysem fail o pay axes or conribuions. These non-payers include he unemployed, he self-employed refusing o pay conribuions, and hose wih incomes so low ha hey are excused from paying conribuions. The exisence of hese non-payers resuls in a increase in unfunded liabiliies. Recenly Enaced or Proposed Social Securiy Reform Measures. Recen social securiy reform measures have focused on reducing he inergeneraional inequaliy, and unfunded social securiy liabiliies. In 1999, he Japanese governmen enaced heir laes social securiy reform measures. These reforms: 1) cu he fuure level of benefis across he board by 5 percen in real erms ; 2) scheduled a gradual increase in he age of eligibiliy of social securiy benefis from 60 oday o 61 in 2013 and 65 by 2030; and 3) eliminaed he auomaic indexing of social securiy benefis o increases in he real wage. Japanese auhoriies have claimed ha wihou hese reforms, payroll axes would need o increase o 35 percen by 2025; bu wih he reforms, payroll axes would need o increase o only 28 percen. Many privae secor analyss have argued ha hese measures do no fundamenally resolve he problems of he social securiy sysem. As poined ou above, he governmen s demographic assumpions appear over-opimisic; wih more realisic assumpions, payroll axes 9 However, no everyone paying conribuions is eligible o receive social securiy benefis. Curren law says ha if he oal paymen period is less han 25 years, he paricipan is no eligible o receive full benefis

14 13 will have o increase subsanially, leading o greaer inergeneraional inequaliy, and larger unfunded social securiy liabiliies. Overwhelmingly, privae secor analyss recommend a shif from he curren pay-as-you-go sysem o a fully-funded sysem. Haa and Oguchi (1999) are perhaps he sronges proponens of his shif o a fullyfunded sysem. In shifing from he curren pay-as-you-go sysem o he fully-funded sysem, hey recommend he following process. They firs recommend ha he governmen fully fund he amoun of unfunded social securiy liabiliies by issuing bonds. Their reasoning is ha he funding of hese liabiliies are no jus he responsibiliy of fuure wage earners, bu also he responsibiliy of all ciizens. In fac, hey recommend ha hese bonds be covered by increased consumpion axes, which would be levied on he elderly as well. Nex hey recommend ha he benefis of fuure reirees be cu by 20 percen; and ha fuure payroll axes be lowered o make he sysem acuarily fair. The porion of he benefis of he curren reirees ha should have been paid by payroll axes on he currenly working are hus unfunded and should be covered by increased consumpion axes. 4. Social Securiy and Overall Governmen Spending in Our Model. Our approach differs from he radiional approach in modeling he Japanese social securiy sysem. Firs, unlike in Haa and Oguchi (1999), Nishizawa (2003), Japanese Minisry of Welfare and Labor (2001) and ohers, we do no esimae he amoun of unfunded social securiy liabiliies. To do so would require separaely projecing social securiy benefis, and in paricular, dedicaed social securiy payroll axes. Thus, in our model, we do no differeniae beween dedicaed social securiy payroll axes and oher forms of axaion. Our view is ha in

15 14 pracice, Japanese social securiy accouns canno be separaed from he overall Japanese governmen budge. Some of he social securiy benefis, and much of he excess social securiy payroll axes (i.e., social securiy rus fund) are oday inexricably inerwined wih he general governmen budge. As noed, as much as 50 percen of he benefis of he basic pension will be (from 2004) subsidized from he general governmen budge. In addiion, mos analyss expec ha as unfunded liabiliies moun, his rae of subsidy will increase. For example, as menioned, Haa and Oguchi (1999) recommend ha all of he currenly projeced unfunded social securiy liabiliies should be paid for by he general governmen budge (consumpion axes). Moreover, par of he social securiy rus fund (abou 80 percen) is mixed in wih oher governmen borrowing-- like posal saving deposis--o finance he massive Fiscal Invesmen and Loan Program. Hoshi and Doi (2003) esimae ha over 50 percen of governmen funds in FILP are irrecoverable, which means ha some of he social securiy rus fund is irrecoverable. Money o replace hese irrecoverable loans mus come from he general governmen budge. Second, unlike in Haa and Oguchi (1999) and Takayama and Kiamura (1999), we will no be concerned wih he redisribuive effecs of he social securiy sysem, and he inergeneraional inequaliy ha arises from he sysem. In our model, we assume ha Japanese households are Ricardian. If he elderly raise heir bequess o compleely offse he coss o he young of he higher burden of social securiy, hen he higher burden of social securiy has no redisribuive effecs. Our model only requires ha we projec overall governmen spending paerns by age group. In our projecions, we focus on he hree larges social expendiures: social securiy,

16 15 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 he ages 5 and 20. For healhcare and educaion, we assume ha age-specific expendiure paerns remain a he same real level beween 2000 and For social securiy, we assume ha he age of eligibiliy gradually increases from 60 o 65 in 2030, bu once eligible, he age-specific benefis remain he same as oday in real erms (in accordance wih he 1999 reform). Tha is, if he average 67 year old receives 180 housand yen in social securiy benefis in 2000, an average 67 year old receives he same inflaion adjused amoun in Oher governmen spending, mainly defense, policing, and adminisraion, are assumed o always equal he average raio o GDP of 5.6 percen. Demographic shifs can significanly aler he paerns and overall levels of governmen spending. Tables 1 and 2 depic he projecions of oal governmen spending in 1995 yen and as a share of projeced GDP wihou and wih immigraion. Wihou immigraion (Table 1), 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, leading o sharp increases in social securiy and healhcare spending. Wih 400,000 annual immigrans (Table 2), governmen spending rises from 25 percen

17 16 of GDP in 2000 o 27 percen in 2015, bu falls hereafer o 22 percen in Governmen spending as a proporion of GDP falls, because while immigraion raises he level of governmen spending somewha, immigraion sharply booss he level of Japanese GDP, resuling in a fall in he raio of governmen spending o GDP. The immigraion-induced increase in he labor force and in capial accumulaion raises he projeced Japanese annual real GDP growh rae beween 2000 and 2040 from 0 percen wihou immigraion o 1.1 percen wih immigraion. These growh raes mean ha oupu in 2020 will be 22 percen higher by 2020, and 50 percen higher by 2040 wih immigraion. Wih immigraion, he absolue levels of healh care and educaion spending increase, as immigrans also require healhcare and especially, educaion services for heir children. The absolue level of social securiy spending increases afer 2035 as some of he immigrans sar o reire. 5. Demographic Change, Governmen Deficis, and Opimal Capial Flows. Here we simulae he impac of aging and of immigraion on fuure Japanese saving and invesmen raes, and governmen spending and deficis. 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 can examine how a sociey can 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.

18 adjus is saving, invesmen, capial inflows, and governmen deficis, in response o changes in demographic variables, summarized by he suppor raio. 17 (i). 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 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 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.

19 18 70s), and may be producive again in he fuure. 11 Noe ha when $k, $m and he suppor raios are consan, oupu per capia also grows a a consan rae h. When he suppor raio is falling, however, oupu per capia grows a a slower rae han h. The supply of privae capial available o he firm depends on he global capial marke; he marginal produc of capial mus equal raes, and δ is he rae of depreciaion. We have: r + δ, where r is he gross inernaional real ineres 1 v 1 v k$ = ( 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, $ j : 11 I is difficul o predic he fuure efficiency of public invesmen. Japan, however, lags behind he U.S. in public research and developmen ( R & D), including R & D in universiies. Branseer and Nakamura (2003) argue ha greaer public R & D spending can boos Japanese growh. Thus, fuure governmen public capial, especially R & D ha is embedded in public capial, may be producive.

20 19 $ j = m & $ + m$ ( n + h+ δ) (4) (ii) 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 12 : 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, 12 In an insighful paper, Barro (1974) showed ha Ricardian equivalence can prevail in he overlapping generaions model wih bequess, even hough each individual is moral. Even hough each individual cares direcly only abou his immediae descendan, his is enough o link him o all fuure generaions. Obsfeld and Rogoff (2002, p ) presens he exac condiions ha are required o collapse he overlapping generaions model o he single represenaive agen model, as in our paper. Thus, he infinie-horizon uiliy funcion, (5) is consisen wih our earlier definiion of he suppor raio, in which agens die when hey reach 100 years.

21 20 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 qτ 2 ax also imposes a deadweigh welfare loss of per person. 2 I can be shown (see Appendix) ha consumpion per capia also 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. (iii) The Governmen Budge Consrain and Governmen Behavior. 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

22 21 capia. As in Culer, e. al. (1990), we assume ha g is deermined by age-specific paerns of governmen consumpion, as presened in Tables 1 (wihou immigraion) and 2 (wih immigraion). 13 I can be shown (see Appendix) ha he governmen will choose o levy a per capia lump-sum ax of ha grows a he rae of consumpion per capia growh, h. The governmen τ mus 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. 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 parameer values, projeced fuure suppor raios wihou immigraion, LF, and wih immigraion, LFIM, and fuure raes of populaion and labor force growh wihou and wih 13 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.

23 22 immigraion. 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 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. (iv) Projecions of Opimal Governmen Deficis and Capial Flows: Wihou Immigraion. Table 3 presens our projecions wihou immigraion. Privae saving raes decline abou 10 percenage poins unil 2010, and hen decline rapidly from 2010 o This paern is a resul of shifs in he suppor raio and increases in ax raes, which reduce 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. This raises he consumpion rae and lowers he privae saving rae. 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

24 23 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 of 45 percen of GDP, and o cover is increased fuure spending. Governmen saving raes rise from abou 1-2 percen of GDP in 2000 o abou 11 percen in 2040, owing o increased ax receips. 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 minus public invesmen) urns posiive afer Consequenly, he governmen ne deb-gdp raio increases unil 2020, and falls hereafer. The decrease in privae saving is sharper han he increase in governmen saving, resuling in a fall in oal saving beween 2000 and The oal saving rae declines from abou 30 percen in 2000 o 10 percen in 2015, and hen rises o 15 percen in 2040, as he governmen saving rae rises. The oal invesmen rae 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 larger curren accoun deficis. Japan s curren accoun surplus is projeced o become negaive in 2005, and sharply negaive from hen onwards. Par of Japan s domesic consumpion will be financed from inernaional capial

25 24 inflows from abou By 2015, foreign capial inflows are projeced o be 15 percen of Japan s GDP. This raio declines o abou 8 percen by 2040, as governmen saving increases.. (v) Projecions of Opimal Governmen Deficis and Capial Flows: Wih Immigraion. Table 4 presens our projecions wih immigraion of 400,000 people a year. Privae saving raes decline abou 8 percenage poins unil The decline in privae saving beween 2010 and 2040, however, is milder wih immigraion han wihou, owing o improvemens in he suppor raio, especially afer By 2040, privae saving raes decline o abou 7 percen of GDP. Wih immigraion, he growh in GDP is higher, and projeced governmen spending as a percenage of GDP is smaller, meaning ha ax raes can be lower. However, even wih lower ax raes, he acual ax rae in he saring year (average, ) a 28 percen of GDP, is below wha is necessiaed by ax smoohing (33 percen), and he saisfacion of he governmen s ineremporal budge consrain. Thus, again, we allow axes per capia o increase more rapidly beween 2000 o 2015, and hen smooh increases in axes per capia from 2015 onwards. By 2040, ax raes need o increase o only 45 percen of GDP-- insead of almos 50 percen wihou immigraion--for he governmen o saisfy is ineremporal budge consrain. Governmen saving raes rise from abou 1-2 percen of GDP in 2000 o abou 12 percen in 2040, owing o increased ax receips. Privae and public invesmen raes gradually fall over ime, bu he decline is less rapid wih immigraion, as he labor force says roughly consan from The governmen ne deb-gdp raio increases unil , and falls

26 25 rapidly hereafer. The decrease in he privae saving rae is larger han he increase in he governmen saving rae, resuling in a fall in he oal saving rae beween 2000 and The oal saving rae declines from abou 30 percen in 2000 o 16 percen in 2020, bu bounces back o 19 percen by 2040, as governmen saving rises. Toal invesmen declines from 28 percen in 2000 o 24 percen in The curren accoun defici, while worsening o 10 percen of GDP in 2020, improves o a defici of only 5 percen of GDP by 2040, as he governmen saving rae increases. 6. Conclusion. Many previous papers (Horioka (1991, 1992), Oishi and Yashiro (1997), Auerbach e. al. (1989), Miles and Cerney (2001), McKibbin and Nguyen (2001) and ohers) have projeced he impac of demographic change on he Japanese saving-invesmen balance and on capial inflows, alhough papers projecing fuure Japanese governmen budge balances are fewer. Despie he variey of mehodologies and modeling assumpions, mos earlier papers like our paper projec declining saving and invesmen raes, wih saving raes declining faser han invesmen raes, leading o curren accoun deficis and capial inflows. On he whole, he previous papers predic deerioraing governmen budge balances, unless here is drasic fiscal reform. The proposed fiscal reforms in he previous papers range from ax increases o cus in social securiy benefis and public invesmen. In our paper, we have focused on ax increases. A unique feaure of our work is ha we also examine scenarios in which he governmen allows sizable immigraion (400,000 immigrans per year from 2005 o 2040) ino Japan. We

27 26 show ha wih immigraion, Japan s projeced capial inflows as a percenage of GDP will be much smaller, since he higher labor force will be able o raise Japan s GDP, o help susain is growing elderly populaion. Wih he larger labor force from immigraion, Japanese oupu in 2020 will be 22 percen higher by 2020, and 50 percen higher by Finally, wih immigraion, social securiy and healhcare spending as a percenage of GDP will be lower, meaning ha fuure ax increases can be smaller.

28 27 Appendix: For convenience, we carry ou he analysis in erms of effecive populaion. The daa for he populaion, n and he labor force, z (and herefore, α ) are available only every 5 years. Thus, we assume ha n and z discreely change only every five years; wihin any 5-year inerval, say 2005 o 2010, n and z are assumed o be consan. From 2050 onwards, we assume ha he values for 2050 hold. From (1), real wages per effecive populaion are: w$ = ( 1 γ )$ y In addiion, we assume ha here are adjusmen coss o adjusing public capial, reflecing poliical lobbying coss, and bureaucraic implemenaion lags, j adjcos s $ χ $ = j ( 1+ ( )) 2, (A1) m$ where χ reflecs he coss of adjusmen. The governmen (or opimal planner) maximizes (5), in erms of effecive populaion, wih respec o (4), (6), (7), (8), and (A1). Opimal Consumpion. The opimal pah of consumpion per effecive populaion is: c$& c$ 1 = *( r ρ θg) θ.

29 To preven consumpion per effecive labor from approaching zero asympoically, we 28 assume ha r = ρ + θg, so ha consumpion per effecive populaion is fla, or ha consumpion per capia grows a rae h. For h, we ake, (from Jorgenson and Nishimizu, 1978). Consumpion per effecive populaion a ime 0, c0 $( ), (in our case, he year 2000), depends in a complicaed way on he parameers of he lifeime uiliy funcion, and he enire fuure pahs of n, α,$ τ, g$, $ j, w$, he parameers r, h, and he saring values, $a 0,and b0 $. Raher han calculaing c0 $( ), we assume ha he acual level of consumpion per capia beween 1996 and 1999 (in he daa) was a or near he opimal level. (Of course, we are no assuming ha he Japanese economy was in seady-sae beween ; we are only assuming ha consumers were opimizing in ). Opimal public and privae invesmen, oupu. The opimal pah of public capial per effecive populaion is: m$& m$ 1 φ = ( ( 1) ( n + h+ δ )), (A2) χ µ where µ is he marginal uiliy of oal asses, and φ is he marginal uiliy of public capial. Invesmen in public capial raises uiliy by raising oupu; on he oher hand, invesmen in public capial lowers uiliy because oal asses decline. Thus, φ µ represens he shadow value

30 29 of public invesmen. µ and φ evolve according o: µ & = ( r n h) µ (A3) & dy$ φ = ( h+ δ + n) φ ( + dm$ φ ( 1) µ 2χ 2 ) µ (A4) dy$ dm$ where, afer subsiuing he expression for $k, (2), is a funcion of only $m. To deermine he opimal pah of $m, we discreize (A2), (A3), and (A4), and simulae he pah of $µ, φ $, and $m forward, for plausible parameer values. For he parameers used in he simulaions, we ake values culled from he lieraure. For γ, h, δ, r, and χ, we use 0.20, 0.012, 0.13,0.05, and 6. These values are fairly sandard, excep ha since we have no empirical daa for he adjusmen speed of public capial, we ook he value 6 from he privae capial adjusmen cos lieraure (Hayashi, 1982). Our simulaion sraegy is o sar from 2000 (from he acual values in he daa, ), and simulae forward using he values of n and α. We imposed he condiion ha φ ( 0) = µ ( 0), and chose a value of φ ( 0 ) so ha he pah of $m did no vary much from

31 m0 $ ( ). As menioned, we assume ha he demographic variables change discreely only every 30 5 years. As i urned ou, given our parameer values, new seady saes for $m, φ, and were reached in abou 5 years for all and. µ n α Finally, from he pah of $m ; $ j (from (4)), k $ (from (2)), $ i (from (3)) and $y (from (1)) can be calculaed. Thus, we can calculae he privae and public invesmen raes, which are depiced in Tables 3 and 4. Opimal Governmen Taxes. I can be shown ha c0 $( ) is maximized when $τ is consan (Barro, 1979). Tha, is, he governmen maximizes he pah of consumpion (and of uiliy) when lump-sum ax axes per effecive populaion are consan, or ha axes per capia are growing a he rae h. Saisfacion of he governmen s ineremporal budge consrain (8) means ha he presen value of lump-sum axes per effecive populaion is equal o he presen value of governmen spending per effecive populaion: τ= $ b$ + grd $ + $ jrd 0 0 Rd 0 0, (A5)

32 31 where he discoun rae, R = exp( ( r h n ) dv) 0 v. From (A5), we calculae he opimal value of $τ, from our esimaed (exogenous) pah of $g (from Tables 1 and 2), and our simulaed pah of $ j (from above). In pracice, we runcae he inegral a 2050, since beyond ha, $g and $ j are discouned o he exen ha hey are negligibly small. By dividing $τ by $y, we obain he ax rae. Finally, from $c (above), $g, $ j, $y and $τ, we can calculae he privae and public saving raes ha are depiced in Tables 3 and 4.

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36 Fig. 1: Populaion and Elderly Projecions Populaion (Millions) Percenage Elderly Year Populaion Over