The Choice of Japan toward the Construction of a Sustainable Social Security System *Yasushi Iwamoto **University of Tokyo

August 2008

Abstract
This paper discusses how future population aging will affect the finances ofhealth and LTC (long-term care) insurance sectors by using an updated version of the
HLI (Health and Long-term Care Insurance) model, which was first developed by Fukui
and Iwamoto (2007). Since the burden of social contributions will significantly increase
under the current scheme, the younger generation will bear a heavier lifetime burden.
One possible option to moderate the disparity in the financial burden faced by thedifferent generations is by creating a shift to a prefunding scheme, which raises thepremium rate immediately and then accumulates a fund that will pay for future benefits.
One serious barrier in implementing the prefunding scheme is the “double burden;”when shifting to a prefunding scheme, the working generation should contribute thepremium that finances not only their social costs but also those of the older generations.
Our policy simulation finds that even the generations that suffer from the
double financial burden will be better off under the prefunding scheme. Maintaining thestatus quo does not apparently create a double burden, but the rising financial burden
under the current system will impose a heavier burden on future generations. Therefore,
the double financial burden cannot be the reason for which the prefunding scheme isrejected as an alternative to the current system.
JEL classification numbers: H55, I10
Keywords: social insurance; pre-funding; health insurance; long-term care; long-termcare insurance*This paper has been prepared for the International Conference on “Public
Finance/Social Security System and Intergenerational Issues in De-population Society,”
June 3, 2003. I would like to thank Yoshibumi Aso and Tadashi Fukui for theirinsightful comments.
**
Professor, University of Tokyo.

1. Introduction

The latest annual estimation reports that the total population of Japan in 2007
was 127.8 million. Post-World War II, Japan’s population was growing at a rate of morethan 1% up until the 1970s. Population growth has slowed down recently, and is expected
to decline steadily in the future due to the low fertility rate. According to official
projections, in 2055 the population of Japan will be less than 90 million. Moreover,
40.5% of the total population would fall under the age group of 65 and above.
The impending change in the population structure will have a critical impact on
the social security programs that pay benefits mainly to the elderly and collect social
contributions mainly from the working generation. In particular, health insurance andLTC (long-term care) insurance benefits are expected to grow faster than the national
income. Financing those costs is a very difficult challenge for policy makers.
The purpose of this paper is to analyze how future population aging will affectthe finances of the health and LTC insurance sectors. This paper uses an updated versionof the HLI (Health and Long-term Care Insurance) model, which was first developed by
Fukui and Iwamoto (2007). 1
This model estimates the future health care and LTC service costs, and simulates
the financial situations of social insurance and the burden faced by different generations
under different policy scenarios. Since the financial burden of social contributions will
significantly increase under the current scheme, the younger generation will bear aheavier lifetime burden.
One possible option to moderate the disparity in the financial burden faced by
the different generations is to establish a shift to a prefunding scheme, which raises thepremium rate immediately and then accumulates a fund that will pay for future benefits.
The prefunding scheme has been proposed by Suzuki (2000) for the health insurance
sector and by our previous studies (Fukui and Iwamoto, 2007; Iwamoto and Fukui, 2007)
for the health insurance and LTC insurance sectors. However, one serious barrier in
implementing the prefunding scheme is the “double burden;” when shifting to a
1

Iwamoto and Fukui (2007) and Iwamoto (2008) use several versions of this model. The
details are explained by Iwamoto and Fukui (2008).
-2-

prefunding scheme, the working generation should contribute the premium that finances
not only their social costs but also those of the older generations, who will not be
participating in the prefunding scheme and thus will not be contributing.
A notable finding in this paper is that even generations who suffer from the
double burden will be better off under the prefunding scheme. Maintaining the status quodoes not apparently create a double burden, but the rising financial burden under thecurrent system will impose a heavier burden on future generations. Therefore, the double
financial burden cannot be the reason why the prefunding scheme is rejected as analternative to the current system.
This paper is organized as follows: Section 2 discusses the effects of the change
in the population structure on economic growth and on the financial status of the social
security system. Section 3 presents the simulation results. Section 4 presents theconcluding remarks.

-3-2. Challenges of Population Aging

2.1 The Effects on the Economy and Social Security Programs
Many people worry that population aging and the impending decline of the total
population will adversely affect the Japanese society and economy. Since the Japaneselabor force will decline in the future, future economic growth rate will be inevitably
lower than the current level. As shown in Figure 1, the Ministry of Health, Labor andWelfare projects that if the labor force participation rates of each age group remain
constant, the labor force will decrease by 10.7 million between 2006 and 2030. The labor
force will decline by 4.8 million even if future labor force participation rates increase
substantially.

Figure 1 Projections of Future Labor Force
7000
60.4

59.9

6657

58.0
6628

6800

59.4

59.4

56.4
6556

6600

53.7

6426

million

6400
6217

6180

6200
6000
5800
5584

5600
5400
2006

2012

2017

Labor force (lest scale, pessimistic)
Labor force participation rate (right scale, pessimistic)

62.0
60.0
58.0
56.0
54.0
52.0
50.0
48.0 ％
46.0
44.0
42.0
40.0
38.0
36.0
34.0

2030

Labor force (left scale, optimistic)
Labor force participation rate (right scale, optimistic)

Source: The Report of Employment Policy Workshop at the Ministry of Health, Laborand Welfare (December 2008).

However, the per capita income will grow if the Japanese economy does not
suffer from a sizable decline in the technological growth. Although the Japanese economy
was stagnant in the 1990s, the yearly technological growth rate during that period was-4-more than 1%. Thus, a conservative estimate of the future yearly technological growthwould be 1–2%. This growth rate is enough to offset the negative effects of labor force
decline. The total size of the economy is therefore likely to grow. Population aging is nota crucial problem for the economy.
The biggest challenge for the Japanese economy is the fiscal impact ofincreasing social costs. The figures in Table 1 are taken from “the Projection of Social
Security Benefits and Burdens,” which was complied by the Ministry of Health, Laborand Welfare in May 2002. The social security benefits in the Fiscal Year 2025 will be
33.5% of the National Income at factor cost; this proportion is 10 percentage points larger
than that in FY2002. Among the various categories under benefits, public pension, healthcare, and LTC will increase.

Table 1 Projection of Future Social Security Benefits and Burdens(May 2002)

Social security benefits
Public pension
Health careWelfareof which: Long-term care
Social security burdens
Social security contributions
Government subsidies

2002

2005

2010

2025

22.5
12.1
7.1
3.3
1.4
22.5
15.9
6.6

22.0
11.6
6.8
3.4
1.4
21.0
13.8
7.2

24.6
12.9
7.8
3.8
1.8
23.2
15.0
8.3

33.5
16.0
11.4
6.1
3.8
34.3
22.1
12.2

Note: Percent of National Income at factor cost.
Source: Projection of Future Social Security Benefits and Burdens,
Ministry of Health, Labor and Welfare, May 2002.

The last two rows show the two types of financial sources for social security
programs. Both social security contributions and government subsidies financed withtaxes will increase. The growth rate of government subsidies is greater than that of social
security contributions. This is caused by the fact that subsidies concentrate on the healthcare costs for the elderly and the LTC costs that, in turn, concentrate on the elderly, as-5-well. In the future, the proportion of the elderly in the total population will increase
dramatically. Therefore, government subsidies will grow dramatically.
The government has recently implemented several measures to cut the current
and future social security expenditures in the 2004 public pension reforms, 2005 LTC
insurance reform, and the 2006 health system reforms. As a result of these reforms, futuresocial security benefits will be cut substantially. A newer projection, which was compiledin May 2006, takes account of these reforms. As shown in Table 2, social security
benefits in FY2025 are projected to be 26.1% of the national income, an absolutedecrease of 7.4 percentage points (more than 20%, proportionally) vis-à-vis the 2002
projection. The social security burden for FY2025 is not very high as compared to thecurrent levels of this burden in some advanced countries with generous social security
systems. In light of this fact, it may appear that the social cost problem in Japan becomesmanageable. However, the government intends to further reduce social security costs; theIntegrated Reform of Expenditures and Revenues plans to cut the social security costs
between FY2007 and FY2011 by 1.1 trillion yen in the national budget and by 0.5 trillion
yen in the local budget. The national budget for the FY2008 plans to cut 220 billion yen

Table 2 Projection of Future Social Security Benefits and Burdens(May 2006)(Percent of National Income)

2006

2011

2015

2025

Social security benefits
Public pension
Health careWelfareof which: Long-term care
Social security burdens
Social security contributions
Government subsidies

23.9
12.6
7.3
4.0
1.8
22.0
14.4
7.7

24.2
12.5
7.5
4.2
2.0
23.3
14.9
8.4

25.3
12.8
8.0
4.5
2.3
24.8
15.9
8.9

26.1
12.0
8.8
5.3
3.1
26.5

Note: Percent of National Income at factor cost.
Source: Projection of Future Social Security Benefits and Burdens,
Ministry of Health, Labor and Welfare, May 2006.

-6-through downward revisions of the officially determined medical service price scheduleand a reduction of government subsidies toward health insurance for employees in smalland medium-sized businesses. The Ministry of Finance proposes a further cut through theintroduction of a deduction, an increase in the coinsurance rate of LTC insurance, andother measures.
The government plan may give rise to three issues.
First is the feasibility of cutting the future benefits. The government plan may
face strong objection just before implementation. Since the plan shrinks the coverage ofsocial security, people will be exposed to risks that are no longer covered by social
security programs. A low-income earner may have difficulty bearing those risks. The
government places emphasis on preventing diseases and disability, and expects a decline
in health and LTC expenditure. However, there is no firm, scientific evidence to support
that preventive measures indeed reduce these costs.
The second problem is that population aging will not stop in 2025. Figure 2

Figure 2 The Ratio of the Elderly (65 and Over) to the Total Population, 2005-2055(Percent)
45

40

35

30

25

20
2005

2015

2025

2035

2045

2055

Year

Source: Population Projections for Japan: 2006–2055, National Institute of Populationand Social Security Research, December 2006.

-7-

depicts the ratio of the elderly (aged 65 and over) to the total population, indicating that2025 is just at the midpoint of the aging process. Since the dominant part of social
security benefits is financed by the burden of the working generation, the fiscal
conditions of social security programs will be much worse after 2025.
Finally, there is a point of contention as to whether or not the future benefits
should be cut. Since health care and LTC care are indispensable services to consumers,
the welfare state is then responsible for providing the necessary level of these services.
Quite ironically, however, the government tries hard to reduce the spending on these
services.

2.2 How to Finance Social Costs?
Let us consider the ways in which social security costs can be financed in an
aging society. At the outset, the following needs to be tackled: The fiscal condition ofsocial security programs deteriorates when the ratio of the elderly to the working age
population grows.
There are three ways to alleviate this problem. The first is to raise thedenominator through a policy that raises the fertility rate. However, this has proved to beineffective, and the fertility rate has been continuously declining. The second approach isto reduce the numerator by improving the health status of the elderly and reducing thedemand for health and LTC services. As already mentioned, however, the effect of theabove approach is uncertain. The third approach is to make social security independent of
population structure. One way in which this is possible is the introduction of a funded
scheme in the social insurance programs. This paper focuses on this policy option.
If individual savings can finance health care and LTC costs after retirement,these costs need not be cut. However, the idea of prefunding has garnered very little
support, for several reasons. First, since the above costs are currently largely financed bysocial security programs, people do not recognize these as necessary expenses in theirretirement plan. Second, the future costs cannot be projected accurately. Such a risk
cannot be insured by individual savings. Third, since the political process tends to createa deficit, the government is not a good saver. The Japanese government currently runs a
sizeable budget deficit.

-8-

Although the idea of funded social insurance faces several problems, it is aserious alternative. The other approaches by which we can make social insurance
sustainable are not easy to implement. The next section will present some simulation
results that examine how the shift to funded health and LTC insurances changes thefinancial burden of the present and future generations.

-9-3. Policy Simulations

This section presents policy simulations of the introduction of a prefunding
scheme in the health insurance and LTC insurance sectors. These simulations are a joint
work with Professor Fukui of Kyoto Sangyo University. The model used here is an
updated version (April 2008) of the HLI model, which was originally developed by Fukui
and Iwamoto (2007). The details of this model are described in Fukui and Iwamoto(2008).
Our analysis treats both health care and LTC services. Since LTC costs
concentrate heavily on the latter period of people’s lives, prefunding these costs requiresa large amount of savings. We have to take account of both health and LTC insurance, if
we want to understand the future financial problem of the social insurance program. Our
analysis of the financial burden faced by different generations is spiritually similar to
generational accounting, a concept dealt with in the pioneering work by Auerbach,
Gokhale and Kotlikoff (1991). However, our analytical framework is somewhat different
from that of generational accounting. We specify the future policy variables and calculate
the financial burden under the specified policy scenario. Our simulation has a longer time
horizon than the government’s official projection. The policy simulation is from FY2007
to FY2105. We calculate some variables beyond FY2105 because we need to calculate
the lifetime burden of future generations.
We assume that people work from the age of 15. Our setting of labor supply
replicates the labor force participation rate observed in the Population Census 2000.
People pay taxes and, thus, contribute to health insurance and LTC insurance. We assume
that social insurance premiums and taxes for social insurance benefits are paid from thesame income base, which is the compensation of employees and the mixed income interms of national accounts. For simplicity, we further assume that these incomes willgrow at the same rate as GDP.
When health care and LTC services costs are financed with a current scheme,
essentially, the pay-as-you-go system, a large increase in the future financial burden will
be inevitable; this will create an imbalance in the financial burden faced by the different
generations. One way in which the equity can be restored is that the social insurance- 10 -

program prefunds the rising future costs. We then consider two policies to finance thesecosts through social contributions and taxes.
Policy A: A balanced budget operation in which the benefits during each year are
financed by the taxes and insurance premiums of the corresponding year
Policy B: An attempt to reduce the inequity in the financial burden faced by thedifferent generations by prefunding future social insurance payments for the elderly. This
policy will ultimately create a fully funded system in FY2105, because the population
projection carried out by the National Institute of Population and Social Security
Research is available until then. This policy sets smooth premiums till FY2105.

For Policy A, we calculate the annual burden rate, which is defined as insurance
benefits including government subsidies divided by 90% of the compensation for
employees plus the mixed income. In FY2007, the annual burden rate was 8.65% forhealth insurance and 1.16% for LTC insurance.
Figure 3 shows the annual rate of social insurance premiums. The government’s
projection ends in FY2025; on the other hand, our projected costs are expected to

Figure 3 Social Insurance Contributions under the Pay-as-you-go Scheme(Percent of Lifetime Earnings)
20%

15%

Total

10%
Health Insurance

5%

LTC insurance

0%
2005

2025

2045

2065
Year

- 11 -

2085

2105

increase further after FY2025. The peak is projected at 32.29% (or 15.92% of the GDP)in FY2064. The growth rate of LTC insurance premium is much higher than that of healthinsurance.
Figure 4 shows the tax burden that subsidizes social insurance. Like the social
insurance premiums, these depict steady growth. Around FY2070, the subsidy for LTC
insurance will be almost equal to that for health insurance, because the growth rate of
subsidies for LTC insurance is higher than that of subsidies for health insurance.

Figure 4 Tax Burdens under the Pay-as-you-go Scheme (Percent ofLifetime Earnings)

10%
Total
Health insurance
5%
LTC insurance
0%
2005

2025

2045

2065

2085

2105

Year

We calculate the lifetime burden rate of generations, which is defined as thepresent discounted value of lifetime costs from FY2006 to FY2205 divided by the present
discounted value of the lifetime compensation of employees plus mixed income. “Costs”
implies contributions and taxes that are paid for the annual services, and not the services
that a person receives.
The age-wage profile was taken from the published cross-tables of the 2006
Basic Survey on Wage Structure (Ministry of Health, Labor and Welfare). For each age
group, labor income is calculated as a product of the total wage per worker and our
projected labor force.

- 12 -

Figure 5 shows the lifetime burden among the generations. The horizontal axis
represents the birth year of the cohort. The lifetime burden ratio is 14.2% for those who
were born in 1945 and 24.52% for those who were born in 2001. The pay-as-you-go
operation will create a huge difference in the financial burden faced by the different
generations.

Figure 5 Lifetime Burdens under the Pay-as-you-go Scheme (Percent ofLifetime Earnings)
35%

30%

25%

20%

15%

Pay-as-you-go

10%
1930

1950

1970

1990

2010
Birth Year

2030

2050

2070

2090

Policy B establishes a saving scheme in the health insurance and LTC insurance
sectors. Although this approach appears similar to the “Medical Saving Account,” ourscheme actually prepares for insurance premiums. On the other hand, the MSA pays theaccount holder’s health care expenditure. We then have to specify, in this simulation, theinterest rate and the growth rate. In our simulation, only the difference matters. Our
setting is that the interest rate minus the growth rate equals 1.6%. This number isobtained from the setting in the official financial projection of the public pension
program.
We formulate the three parts of the prefunding scheme.
The first part pertains to health care for the non-elderly. In this case, thepay-as-you-go scheme is assumed to be adopted. The contribution rate ranges between- 13 -

3.76% and 4.38%. Since the change in population structure does not have a major effecton this section of the social insurance sector, there is no serious need for prefunding.
The second part relates to the prefunding of health care, excluding government
subsidies, for those aged 65 years and above. Prefunds are provided to all individuals
between the ages of 15 and 105 years. For the cohort born in 2000, 3.27% of theinsurance premium during their lifetime provides adequate prefunding. When this rate isapplied to all new generations, the accumulated fund in FY2105 will be 94.76% of thethen GDP. A premium rate of 7.17% from FY2008 to FY2105 will successfully
accumulate this amount. The prefunding scheme sets the premium rate in the following
manner: In FY2007, the premium rate is 4.25%; it jumps up to 7.17% during the period
FY2008—FY2105. The rate will then decline to 3.27% after FY2106.
The third part involves LTC insurance excluding government subsidies for those
aged 40 years and above. All enrollees between 40 and 105 years old pay the premium.
The process of designing a prefunding scheme is the same as that for the health insurance
for the elderly. For the cohort born in 2000, the premium rate of 1.6% during their
lifetime provides adequate prefunding. When this rate is applied to all new generations,the accumulated fund in FY2105 will be 69.67% of the then GDP. The premium rate of
3.7% from FY2008 to FY2105 will successfully accumulate this amount of funding. The
premium rate is 1.16% at the starting period, 3.7% during the transition, and 1.6% after
the transition.
Figure 6 shows the financial burden faced by the different generations under theprefunding scheme. It presents some important observations. First, the older generations
will bear a higher burden. This is because social contributions substantially increase in
FY2008. Second, future generations will bear a lower burden, because the contribution
rate becomes low after the transition period. Third, the future generations who are bornaround 2030 will suffer from the “double burden.” These generations will not only pay
their health costs and LTC costs but also contribute to the accumulation of the fund that
finances the benefits of older generations. In our simulation, the cohort born in 2036
faces the highest lifetime burden.

- 14 -

Figure 6 Lifetime Burdens under the Prefunding Scheme (Percent ofLifetime Earnings)
28%
26%
24%
22%

Prefunding

20%
18%
16%
1930

1950

1970

1990

2010
Birth Year

2030

2050

2070

2090

Although this kind of double burden has been considered as a barrier toimplementing a prefunding scheme in which the benefits are to be given to the elderly,
Figure 7 leads to a very different implication. The figure compares the lifetime burden

Figure 7 Lifetime Burdens under the Pay-as-you-go Scheme and thePrefunding Scheme (Percent of Lifetime Burdens)
35%

30%

25%
Prefunding

20%

15%

10%
1930

Pay-as-you-go

1950

1970

1990

2010
Birth Year

- 15 -

2030

2050

2070

2090

between the two policy options. Some future generations will suffer from the double
burden. However, note that these are better off under the prefunding scheme, because
their burden under the pay-as-you-go system is much higher. Under the prefunding
scheme, social contributions are stabilized, and older generations bear a greater burden. A
lower burden is enjoyed by younger generations, including those who bear the double
burden.

- 16 -

4. Concluding Remarks

As the Japanese population structure changes, the current pay-as-you-go scheme
will create a large increase in future social contributions and taxes that subsidize social
security programs. We examined an alternative policy that prefunds the benefits meant
for the elderly.
Under our baseline scenario, the rate of increase in the total burden including
taxes devoted to subsidies is 43%. Implementing prefunding is a tough challenge because
the initial increase in the financial burden is politically unpopular. However, the cost of
not introducing this scheme is a heavier burden on future generations. Raising thecontribution rate aggressively will help to reduce the imbalance in the levels of financial
burden faced by the different generations. Furthermore, even those generations who
suffer from the double burden will be better off under the prefunding scheme. The double
burden cannot be the reason why the prefunding scheme is rejected as an alternative tothe current system.
We cannot determine which of the two options is better in the absence of acertain value judgment. Our framework for comparing policy options is essentially azero-sum game—allocating levels of burden to finance given social costs among thedifferent generations. Figure 7 indicates that all current voters are worse off under
prefunding. This means there is no conflict of interest among the current voters. A crucial
issue, then, is whether or not voters care about future generations.

- 17 -

References

Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff (1991), “Generational
Accounts: A Meaningful Alternative to Deficit Accounting,” in David Bradford ed.,Tax Policy and the Economy, Vol. 5, Cambridge, MA: MIT Press, pp. 55-110.
Fukui, Tadashi and Yasushi Iwamoto (2007), “Policy Options for Financing the Future
Health and Long-term Care Costs in Japan,” in Takatoshi Ito and Andrew Rose eds,
Fiscal Policy and Management in East Asia, Chicago: University of Chicago Press,
pp. 415-442.
Iwamoto, Yasushi (2008), “Taxation or Social Insurance? Financing Social Security(Shakai Hosho Zaigen to shiteno Zei to Hokenryo),” RIETI Discussion Paper
08-J-034 (in Japanese).
, and Tadashi Fukui (2007), “Prefunding Health and Long-term Care Insurance(Iryo Kaigo Hoken heno Tsumitate Hosiki no Donyu),” Financial Review, Issue 87,
September, pp. 43-73 (in Japanese).
, and(2008)，”Health and Long-term Care Insurance Model, April 2008

Version, (Iryo Kaigo Hoken Zaisei Moderu, (2008 Nen Shigatu Ban) ni tsuite)”mimeo (in Japanese).
Suzuki, Wataru (2000), “A Proposal for Removing Intergenerational Inequity from theJapanese Health Insurance System (Iryo Hoken ni okeru Sedaikan Fukohei toTsumitatekin wo Motsu Fea na Zaisei Hosiki heno Iko),” Nihon Keizai Kenkyu, No.
40, March, pp. 88-104 (in Japanese).

- 18 -