Discussion Paper No.

482

JAPAN’S PUBLIC PENSION SYSTEMIN THE TWENTY-FIRST CENTURYCharles Yuji Horioka

June 1999

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

JAPAN’S PUBLIC PENSION SYSTEM IN THE TWENTY-FIRST CENTURYCharles Yuji Horioka*
Institute of Social and Economic Research
Osaka University
6-1, Mihogaoka
Ibaraki, Osaka 567-0047, JAPAN
Telephone: 81-(0)6-6879-8586/8555
Facsimile: 81-(0)6-6878-2766
E-mail: horioka@iser.osaka-u.ac.jp
andNational Bureau of Economic Research, Inc.
Cambridge, Massachusetts, USA
May 1998
Revised November 1998
Second revision June 1999
Abstract
In this paper, I first briefly discuss the current structure of Japan's public pension system,
the history of that system, the raison d’etre of a public pension system, some of the defects in thecurrent system, the origins of those defects, possible ways of alleviating those defects, future
prospects for Japan’s public pension system in the face of rapid population aging, and proposals
for reforming Japan’s public pension system. I argue that Japan's current public pension system
has an adverse impact on the inter- and intragenerational allocation of resources, on the labor
supply of the aged and of women, and on national saving and that it implicitly condones thewidespread evasion of pension contributions to the National Pension System but that these
distortions can be corrected by reforming the system in the appropriate ways. In particular, I
recommend switching immediately to a system that is actuarially fair to all cohorts and to allgroups within each cohort, that does not contain perverse incentives for labor supply and saving
decisions, that eliminates the widespread evasion of pension contributions, and that ensures
retirees an uninterrupted flow of income.
Journal of Economic Literature Classification Code: H55 (Social Security and Public Pensions)
Key words: Social security, public pensions, Japan, intergenerational equity, intragenerational
equity, saving, labor supply*The author is grateful to Yoshibumi Asō, Yoshio Higuchi, Fumio Ohtake, Noriyuki Takayama, andMidori Wakabayashi, to participants of the Conferences on "Japan's Economy in the Twenty-first
Century: The Response to Crisis," held at the Stockholm School of Economics, Stockholm, Sweden,on June 14-16, 1998, and in Honolulu, Hawaii, on January 7-8, 1999, to the Editors of thisvolume, and especially to Tatsuo Hatta for their helpful comments and discussions. Any errors andomissions that remain are the sole responsibility of the author, and any views expressed hereinshould not be attributed to the National Bureau of Economic Research or to any other organization.
Forthcoming in Magnus Blomstrom, Sumner Lacroix, and Byron Gangnes, eds., Japan’s Economy
in the Twenty-first Century (tentative title).

I. Introduction
Japan's public pension system is essentially a pay-as-you-go system that is fraught withproblems. For example, it has an adverse impact on the inter- and intragenerational allocation of
resources, on the labor supply of the aged and of women, and on national saving, and it implicitly
condones the widespread evasion of pension contributions. Moreover, many of these problems canbe expected to become even more serious as the aging of the population proceeds at an accelerating
pace. The United States, Germany, and many other developed countries not only have pay-as-yougo public pension systems that are very similar to Japan's but also face very similar demographic
trends. Thus, the Japanese experience with, and the Japanese debate about, pension reform areof great potential value to policymakers in these countries, especially since the problems withJapan's public pension system are in many ways more serious and the aging of the population isproceeding much faster than in these countries.
In this paper, I briefly discuss the current structure of Japan's public pension system(section II), the history of that system (section III), the raison d’etre of a public pension system(section IV), some of the defects with the current system (section V), the origins of those defects(section VI), possible ways of alleviating those defects (section VII), future prospects for Japan’s
public pension system in the face of rapid population aging (section VIII), and two proposals forreforming Japan’s public pension system (section IX).

II. The Current Structure of Japan's Public Pension System
In this section, I briefly describe the current structure of Japan's public pension system(see Kōsei Tōkei Kyōkai (1996) and Takayama (1996) for more details).1 Japan's public pension
system is currently a two-tiered system consisting of a universal pension--the National Pension(Kokumin Nenkin) or basic pension (kiso nenkin)--and five second-tier pension programs forsalaried workers--the Employees' Pension (Kōsei Nenkin) and four types of Mutual Aid Pensions
1

(Kyōsai Nenkin). Those other than salaried workers (the self-employed, farmers, those not working,and students) belong only to the National Pension System.

They pay a flat-rate monthly

contribution (13,300 yen2 during the April 1, 1998-March 31, 1999 fiscal year and later) between
the ages of 20 and 59 and begin receiving a flat-rate monthly pension, the basic pension (about
67,000 yen during the April 1, 1998-March 31, 1999 fiscal year and later for those contributing forthe maximum period), starting at age 65.3 4 Note, however, that the spouses of salaried workers
are exempt from paying monthly contributions if their annual income is below a certain level(currently 1,300,000 yen), as are certain other groups such as the handicapped and the lowincome.
Salaried workers belong to both the National Pension System and to one of the five secondtier pension systems: most private-sector workers belong to the Employees' Pension System, while
national government employees, local government employees, employees of private schools, andemployees of agricultural, forestry and fishery organizations belong to one of the four Mutual Aid
Pension Systems. Those belonging to these systems pay pension contributions equal to a certain
percentage (17.35% since October 1996 in the case of the Employees' Pension) of their monthly
salary until age 59 (with the burden being shared equally by employer and employee) and receive a
two-tiered benefit--the basic pension plus an earnings-related component (30% of average monthly
real earnings for those contributing for the maximum period in the case of the Employees' Pension)-starting at age 60 (five years earlier than in the case of those other than salaried workers).5
According to Takayama (1996), the total benefits of a typical salaried worker with a non-working
spouse amount to about 68% (80%) of the average pre-tax (after-tax) monthly earnings of males
who are currently working in the case of the Employees' Pension. Note, however, that salaried
workers in Japan receive large lumpsum bonuses twice a year (three times a year in the case ofgovernment workers), that these bonuses amount to four to five times one's monthly salary in thecase of employees of large corporations, and that public pension benefits replace only about 51%2

(60%) of pre-tax (after-tax) annual earnings inclusive of bonuses in the case of the Employees'
Pension.
Japan's public pension system is essentially a pay-as-you-go system, with the benefits ofcurrent retirees being financed primarily by the contributions of current workers. Note, however,that one-third of basic pension benefits are financed by subsidies from the general accounts of thecentral government. The government also pays administrative expenses but does not provide any
subsidies for the earnings-related component of benefits. Finally, with respect to the tax treatmentof public pensions, employer and employee contributions are fully tax-deductible, and although
benefits are, in principle, taxable, there is a generous public pension benefit deduction, as a resultof which benefits are largely untaxed.

III. The History of Japan's Public Pension System
In this section, I briefly discuss the history of Japan's public pension system (for moredetails, see Niwata (1983) and Kōsei Tōkei Kyōkai (1996)). Japan's public pension system has a long
history, but universal coverage was not achieved until 1961 and benefits were relatively modest
until 1973. Noncontributory pension (onkyū) systems for retired army and navy servicemen andgovernment officials were established in 1875 and 1884, respectively, and laws institutionalizingthese pension systems were enacted in 1890. Moreover, noncontributory pension systems forschoolteachers and policemen were established during the middle to late Meiji period (1868-1912),
and a contributory pension system for blue-collar government workers not covered by existing
noncontributory pension systems was established in 1920. However, a comprehensive Mutual Aid
Pension (Kyōsai Nenkin) System for national government employees was not established until 1949,and similar Mutual Aid Pension Systems for employees of private schools, employees of public
enterprises, employees of agricultural, forestry, and fishery organizations, and local government
employees were not established until 1953, 1956, 1958, and 1962, respectively.6

3

The first public pension system for private sector workers (a pension system for seamen)
was not established until 1939, and a comprehensive pension system for private-sector workers-the Employees' Pension (Rōdōsha Nenkin) System--was not established until 1941. Moreover,Japan's existing public pension system for private-sector workers broke down due to the chaos andhyperinflation of the early postwar period and had to be overhauled, a process that was notcompleted until the establishment of the new Employees' Pension (Kōsei Nenkin) System in 1954,
and workers at companies with fewer than five employees, the self-employed, and farmers were notcovered until 1961, when the National Pension (Kokumin Nenkin) System was established.
Thus, universal coverage was finally achieved in 1961, and continuity of coverage for thoseswitching from one public pension system to another was achieved at the same time, but benefits
remained relatively modest despite upward adjustments in 1965-66, 1969, and 1971-72. It was
not until 1973 that benefit levels were increased enough to make the replacement rate comparable
to what it is in the major developed countries (roughly 60 percent), and it was not until the same
year that automatic cost of living adjustments were introduced for the first time. Since then,benefits have been adjusted not only for consumer price inflation but also for increases in real
wages.
Additional improvements in the benefit levels and other provisions of public pensions weremade during the remainder of the 1970s and in the early 1980s, but by 1980, it had become clearthat the imbalance between benefits and contributions and the rapid aging of the population would
necessitate a fundamental reform of the system, and a number of important changes were madeas part of the major pension reform package that passed the Diet in 1985 and took effect in April
1986. For example, this reform package provides for a gradual reduction in benefit levels over a
20-year period, an increase in the contribution rate, and a partial unification of the various public
pension systems into the current two-tiered system.
However, even this reform was insufficient, and in 1989 and 1994, additional reforms were4

implemented. Space limitations preclude me from discussing the provisions of these reforms indetail, but two important features of the 1994 reforms should be noted. First, it was decided thatthe age at which salaried workers can begin receiving the basic pension would be gradually raised
from the current 60 to 65 over the 2001-2013 period (note, however, that they will be able tocontinue receiving the earnings-related component of benefits starting at age 60). Second, whereas
the earnings-related component of the benefits of former salaried workers were formerly adjusted
by the rate of increase in the pre-tax wages of current workers, it was decided that, starting in
October 1994, the criterion would be the rate of increase in after-tax wages. Since the combined
rate of income taxes and pension contributions is projected to increase steadily over time, the new
adjustment method implies a slower rate of growth of benefits than under the old method.

IV. The Raison d'Etre of a Public Pension System
My goal in the remainder of this paper is to evaluate, and identify defects in, Japan's public
pension system and to propose ways of reforming that system, but before doing so, it is necessary
to be clear about the raison d'etre of a public pension system.

The public pension system has

been used for at least three policy objectives: (1) old age security, (2) income redistribution, and (3)macroeconomic stabilization. I consider each of these in turn.
(1) Old age security. One oft-stated goal of a pension system (be it public or private) is toprovide old age security, by which I mean the guarantee of an adequate income during retirement,
regardless of how long one lives, or to put it differently, to eliminate longevity risk (the risk of anuncertain lifetime). In my opinion, this should be the one and only goal of a public pension system.
It is difficult, if not impossible, to simultaneously achieve two or more policy goals using the same
policy instrument, and thus, each policy instrument should be assigned to the one policy target towhich it is best suited. And the policy target to which the public pension system is best suited isold age security.

5(2) Income redistribution. There are some who argue that the public pension system should
also be used to redistribute resources from the rich to the poor (from rich cohorts to poor cohorts
and/or from rich individuals to poor individuals within the same cohort), but I am against doing
so for at least two reasons: first, the public pension system is best suited to achieving the target ofold age security and should be assigned exclusively to that target. A progressive income tax, anegative income tax, and/or transfer programs such as welfare are, in my opinion, the policy
instruments best suited to achieving redistributional goals and should therefore be assigned to thattarget.
Second, as discussed in more detail later, Japan’s current public pension system
redistributes resources from younger cohorts to older cohorts on a massive scale, and one rationalethat is given for this is that younger cohorts have much higher lifetime incomes, on average, thanolder cohorts. However, not everyone in younger cohort groups is wealthy, and not everyone inolder cohort groups is poor. Thus, intercohort income redistributions will entail substantial
redistributions in the wrong direction (from poor individuals to wealthy individuals). To prevent
such perverse results, income redistribution should be done at the individual level rather than at
the cohort level and should be achieved via the tax and transfer systems rather than via the public
pension system.
(3) Macroeconomic stability. The Japanese government decided to temporarily suspendscheduled increases in the pension contribution rate as part of the 1999 pension reforms because
the Japanese economy was in the midst of the worst recession of the postwar period, but I am
against using the public pension system as an instrument of stabilization policy because fiscal andmonetary policies are far better suited to that purpose and because doing so will compromise thegovernment’s ability to meet the primary purpose of the public pension system (Hatta and Oguchi,
1999, pp. 26-28). Indeed, Hatta and Oguchi (1999, p. 163) show that suspending the scheduledincreases in the pension contribution rate will further exacerbate the already substantial

6intergenerational inequity of the public pension system.
Thus, I believe that the goal of the public pension system should be to provide old age
security to everyone and that redistributional and stabilization goals should be left to other policy
instruments. This implies that the public pension system must provide lifetime annuities that are
actuarially fair (i.e., for which expected lifetime benefits precisely equal expected lifetime
contributions) to all cohorts and to all individuals within each cohort and that it must not cause
any systematic redistributions of income among and/or within cohorts. Moreover, it is also
desirable that the public pension system be neutral and that it not distort people's behavior (saving
behavior, labor supply behavior, etc.).
I turn next to the question of whether the provision of old age security can be left to themarket (the private sector) or whether government intervention is warranted. What would happen
if the government abolished the public pension system and got out of the business of providing old
age security? Individuals who wanted to have old age security would purchase lifetime annuities
from private insurance companies and individuals who did not want old age security would do
nothing. This might seem fine, at first glance, but at least two problems would arise (see Hatta andOguchi, 1999, pp. 10-17).
The first problem is that of "moral hazard." Assuming there is a safety net such as welfare,many (low-income) individuals would choose not to purchase any lifetime annuities and would rely
instead on welfare to finance their living expenses after retirement. They would reason as follows:"Why should I purchase a lifetime annuity and pay monthly premiums throughout my working
years when I can pay nothing and get almost as much during my retirement years in the form of
welfare benefits?"

In effect, taxpayers would have to pay for the old age security of suchindividuals, and individuals who purchased lifetime annuities would have to bear a double burden:
they would have to pay not only for their own old age security but also for that of those who collectwelfare during their retirement years. This is clearly not equitable.

7

The second problem is that of "adverse selection" caused by the asymmetry of information.
Insurance companies would ideally like to charge healthy individuals with longer life expectancies
higher premiums for lifetime annuities because they can expect to have to pay such individuals
benefits for a longer period of time, but if insurance companies have less than full information
about the health status of insurees, they cannot base premiums on health status and would haveto charge all insurees the same premium. But if they did so, healthy individuals with longer life
expectancies would be more likely to enroll because they could expect to get back more in the formof benefits than they would have to pay in premiums. By contrast, frail individuals with shorter
life expectancies would be less likely to enroll because they would have to pay more in premiums
than they could expect to get back in the form of benefits. And if such adverse selection occurred,premiums would have to be jacked up above what they would be if participation were madecompulsory, and frail individuals would effectively be shut out of the market.
The best way to eliminate these two problems simultaneously is to make participation in
the pension program compulsory, and making the system government-run is one way of doing so.
Note, however, that it is not the only way--the government need only issue a decree making
participation in the pension system compulsory; there is no need for the pension system itself tobe government-run.
To summarize, the sole objective of a public pension system should be to provide old age
security to everyone by providing them with actuarially fair lifetime annuities. The public pension
system should not cause systematic redistributions of income among and/or within cohorts,should not be used for stabilization purposes, and should not distort people's behavior (e.g., saving
behavior, labor supply behavior, etc.).

V. Defects in Japan's Current Public Pension System
In this section, I compare Japan’s current public pension system to the ideal system8described in the previous section and identify some defects therein. I look first at the Employees’
Pension System and then at the National Pension System.7

A. The Employees’ Pension System
The Employees’ Pension System suffers from the following four defects: (1) the adverse
impact on intergenerational equity, (2) the adverse impact on intragenerational equity, (3) theadverse impact on the labor supply of the aged and of women and (4) the adverse impact onnational saving.
(1) The adverse impact on intergenerational equity. As Hatta and Oguchi (1997, 1999) haveshown using a generational accounting framework in the spirit of Kotlikoff (1992), lifetime benefits
greatly exceed lifetime contributions in the case of cohorts who were born before 1962, with thegap increasing with age, while lifetime benefits fall far short of lifetime contributions in the case ofcohorts who were born after 1962, with the gap being larger the younger the cohort (Takayama etal. (1990a), Asō (1995), and Tajika, Kaneko, and Hayashi (1996) do similar calculations and obtain
similar findings). Thus, the Employees’ Pension System is redistributing resources from younger
cohorts to older cohorts on a massive scale.
There are at least two reasons for this. First, benefits were made much too generous
relative to contributions at the time of the 1973 pension reform, especially for those close to
retirement in 1973, as a result of which the lifetime benefits of older cohorts far exceed their
lifetime contributions. For one thing, even those who were too old in 1973 to contribute for therequired number of years were made eligible to receive fairly generous benefits as a transitional
measure. Moreover, the overly generous benefits of older cohorts have necessitated cuts in thebenefits of younger cohorts as well as increases in their contribution rates, causing their lifetime
benefits to fall far short of their lifetime contributions. Second, Japan's population is aging at thefastest rate in human history and will become the most aged population in the world by the year92010 (see section VIII below for more details). Given the pay-as-you-go structure of the Employees’
Pension System, in which the benefits of current retirees are financed primarily by thecontributions of current workers, population aging (increases in the retiree-to-worker ratio) has
necessitated further increases in the contribution rates of younger cohorts, and this, in turn, hascaused the lifetime benefits of younger cohorts to fall even farther short of their lifetime
contributions.

Incidentally, the aging of the population in Japan is partly a permanent

phenomenon caused by increases in life expectancy and declines in the birth rate and partly atemporary phenomenon caused by the aging of the postwar baby boom generation born in 1947-49.
One reason why the lifetime benefits of younger cohorts will fall far short of their lifetime
contributions is that, given the pay-as-you-go structure of the Employees’ Pension System, they
will have to pay large contributions to finance the benefits of the unusually large baby boom
cohort.
(2) The adverse impact on intragenerational equity. The current Employees’ Pension
System has an adverse impact on intragenerational equity in at least three ways.

First, as

Takayama et al. (1990a) and Asō (1992) have shown, in any given cohort, the net transfer from thegovernment arising from the Employees’ Pension System is larger, the higher is the individual's
income (at least for cohorts born before 1945). Thus, the Employees’ Pension System has been a
regressive one until recently, redistributing income from the low-income to the high-income.
Second, exempting the spouses of salaried workers who are not working or whose incomesare below a certain level from paying pension contributions and paying them supplementary
spousal benefits between the time the primary beneficiary turns 60 and the time they themselves
turn 65, the basic pension after they turn 65, and survivors' benefits (equal to three-fourths of the
primary beneficiary's earnings-related benefits) after the primary beneficiary's death without
requiring any corresponding contributions causes a redistribution of resources from single salaried
workers and couples consisting of a salaried worker and a working spouse to couples consisting of

10

a salaried worker and a dependent spouse (see Takayama et al. (1990a), Asō (1992), Hatta andKimura (1993), Tajika, Kaneko, and Hayashi (1996), Hatta (1997), and Hatta and Oguchi (1999)).
Third, pension contributions were, until recently, levied only on one's monthly salary, eventhough a considerable portion (as much as one-quarter or more) of worker compensation is paid in
the form of semiannual or triannual lumpsum bonuses and even though there are enormous
variations across firms and industries and over time in the relative magnitude of bonuses.
Exempting bonus income from pension contributions has lead to a redistribution of resources fromworkers for whom bonuses are a relatively small proportion of their total compensation to workers
for whom bonuses are a relatively large proportion of their total compensation. Moreover, a similarargument can be made for lumpsum retirement payments, which are also not subject to pension
contributions even though the amounts thereof are quite large (as much as three times annual
income at retirement or more) and even though there is considerable variation among firms in theamounts thereof.
(3) The adverse impact on the labor supply of the aged and of women. Because the pension
benefits of former salaried workers are reduced or eliminated between the ages of 60 and 64 if they
continue working and earn more than a certain amount and because recent retirees can "double
dip" (i.e., collect pension benefits and unemployment compensation benefits concurrently), theEmployees’ Pension System discourages salaried workers from continuing to work after the
mandatory retirement age of 60. Company employees often have the option of continuing to workfor the same company, a subsidiary of the same company, or an unrelated company after
mandatory retirement, but they must accept a substantial pay cut, and as a result, they can often
earn more by retiring and collecting pension benefits and unemployment compensation benefits
than by continuing to work. Tachibanaki and Shimono (1985), Takayama et al. (1990b), Seike(1992, 1993), and others have found that the Employees’ Pension System has, in fact, substantiallyreduced the labor supply of the aged.

11

Similarly, because the spouses of salaried workers who are not working or whose incomesare below a certain level are exempt from paying pension contributions, the Employees’ Pension
System also discourages dependent spouses (usually wives) from working (i.e., it encourages themto reduce their working hours so as to keep their incomes below the critical level). Higuchi (1995)
finds some evidence of this effect: he finds that 11.5% of wives reduce their working hours for thisvery reason.
(4) The adverse impact on national saving. As pointed out by Feldstein (1974), the existenceof a public pension system will reduce private saving, assuming that the wealth replacement effectis larger than the induced retirement effect, and national saving will also be reduced if the pension
system is a pay-as-you-go system, meaning that government saving does not increase to offset the
decline in private saving. Empirical work on Japan has tended to find that public pensions have,in fact, reduced private saving and thence national saving (see, for example, Takayama et al.
(1990b)).

B. The National Pension System
The National Pension System suffers from the following defects: (1) the adverse impact onintergenerational equity, (2) the adverse impact on national saving, and (3) the widespread evasionof contributions.
(1) The adverse impact on intergenerational equity. Like the Employees’ Pension System,
the National Pension System has an adverse impact on intergenerational equity, with lifetime
benefits exceeding lifetime contributions in the case of cohorts born before 1970 and lifetime
benefits falling short of lifetime contributions in the case of cohorts born after 1970 (Hatta andOguchi, 1999, Chapter 5).
(2) The adverse impact on national saving. Like the Employees’ Pension System, theNational Pension System is essentially a pay-as-you-go system and hence has an adverse impact

12

on national saving.
(3) The widespread evasion of contributions to the National Pension System. It is estimatedthat about one-third of those who belong (or should belong) to the National Pension System do not
pay contributions. Sixteen percent are those who are legally exempt from paying contributions (forexample, due to their low incomes), but 7.5% are those who refuse to enroll in the National Pension
System and 8.2% are those who enroll but refuse to pay their contributions (Hatta and Oguchi,
1999, p. 81). These figures are not surprising because the government has done little about goingafter those who do not pay and because there is a widespread perception that the public pension
system is a losing proposition (that lifetime benefits will fall far short of lifetime contributions). It
is not that those who opt out of the National Pension System are not worried about theirretirement; in fact, many of them do prepare for their retirement but do so by putting their money
in banks, the postal savings system, individual pensions, etc., instead of in the National Pension
System because they believe that they can get a better return on their investment in the case of
the former. Many of those belonging to the pension systems for salaried workers would also
undoubtedly choose to opt out of the system if they could, but they cannot because their pension
contributions are deducted from their paychecks by their employers. Thus, the widespread evasionof contributions to the National Pension System causes not only a deterioration in the finances ofthe public pension system but also a further intragenerational equity (between salaried workers
and the self-employed).

VI. The Origins of the Defects in Japan’s Public Pension System
In this section, I consider why Japan adopted the public pension system it did even though
it suffers from the various defects enumerated above?
(1) The adverse impact on intergenerational equity. In my opinion, the most serious defectin both the Employees’ Pension System and the National Pension System is their adverse impact

13

on intergenerational equity, which in turn is due to the pay-as-you-go structure of these systems
as well as to the fact that benefits were made too generous (relative to contributions) in 1973.
Looking first at why benefits were improved so dramatically in 1973, Noguchi (1987) andTajika, Kaneko, and Hayashi (1996) identify the following two reasons: First, there was a growing
consensus that, now that Japan had recovered from the devastation of the war and more or lesscaught up with the other developed countries, she should shift her priorities from maximizing
economic growth at all costs to improving the quality of life, one important component of which is
better social welfare programs.

In response to this shift in priorities, the government madedramatic improvements not only in public pensions but also in health insurance, welfare programsfor the poor, etc., in 1973. Second, Japan had enjoyed double digit rates of economic growth since
the mid-1950s, the Japanese government's fiscal position in 1973 was very favorable, and there
was widespread optimism that these conditions would continue and that Japan could afford bettersocial welfare programs. Few suspected at the time that the first oil crisis of 1973-74 would bring
Japan's era of rapid economic growth to an abrupt end and require the government to run massive
deficits.
Looking next at why a pay-as-you-go structure was adopted, one likely reason is that
virtually all other countries had adopted a similar structure, but Tajika, Kaneko, and Hayashi(1996) identify two additional reasons: first, there was a widespread consensus that resources
should be redistributed from younger cohorts who were benefiting from Japan's current economic
prosperity to older cohorts who had endured many hardships during the war years and the early
postwar years and who had worked hard to make possible that prosperity.

Second, it waspolitically easier to postpone the burden of financing benefits to future generations because future
generations do not yet have a vote (Tajika, Kaneko, and Hayashi (1996) argue that the Japanese
Ministry of Health and Welfare was well aware of the excessive burden that future generations
would have to bear).

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(2) The adverse impact on the labor supply of the aged. Another major defect in the current
Employees’ Pension System is the earnings test on workers aged 60 to 64, but Japan cannot be
faulted for this provision either because the public pension systems of most countries contain asimilar provision and because this earnings test has been gradually relaxed over time.
(3) The adverse impact on intragenerational equity and on the labor supply of women. A
third major defect of Japan’s current Employees’ Pension System is the favorable treatment ofdependent spouses, which not only causes intragenerational inequities but also discourages womenfrom working. Until a provision exempting dependent spouses from paying pension contributions
was introduced as part of the 1986 reforms, dependent spouses had the choice of enrolling in the
National Pension System or foregoing public pension coverage altogether (except for survivors’
benefits), and about 30% of dependent spouses chose the latter option (Hatta and Oguchi, 1999, p.
253). The 1986 reform package contained several unpopular provisions such as cuts in future
benefit levels and increases in future contribution rates, and the government decided to include a
provision providing for the exemption of dependent spouses from paying pension contributions inorder to marshall support for the reform package.
(4) The adverse impact on national saving. Both the Employees’ Pension System and the
National Pension System have an adverse impact on national saving as a result of their pay-as-yougo structure. See (1) above for a discussion of why a pay-as-you-go structure was adopted.
Thus, the current structure of Japan’s public pension system with all its defects arose
partly because Japan followed the example of other countries, partly because of political
expediency, and partly because of undue optimism about Japan’s future growth prospects.

VII. Possible Ways of Alleviating the Defects in Japan's Public Pension System
In the previous section, I identified four defects inherent in the Employees’ Pension Systemand three defects inherent in the National Pension System. In this section, I discuss possible ways

15

of alleviating or eliminating these defects.

A. The Employees’ Pension System(1) The adverse impact of the public pension system on intergenerational equity could be
eliminated by switching to an actuarially fair system in which the expected lifetime benefits of eachcohort exactly equal its expected lifetime contributions, as recommended by Tajika, Kaneko, andHayashi (1996), Hatta (1997), and Hatta and Oguchi (1999). This would require raising thecontributions and/or lowering the benefits of older cohorts and lowering the contributions and/or
raising the benefits of younger cohorts. The government has already taken some steps to containthe increase in the benefits of older cohorts and to increase their contributions (e.g., it decided togradually reduce benefit levels over a 20-year period as part of the 1985 reforms, it has begun
indexing the earnings-related component of the benefits of salaried workers to after-tax wages
rather than to pre-tax wages as a way of holding down increases therein, it is gradually increasing
the age at which salaried workers can begin receiving the basic pension from 60 to 65, and it has
been gradually increasing the contribution rate). However, all of the aforementioned measures are
piecemeal measures. Personally, I would favor more comprehensive measures and would also favor
performing explicit calculations to ensure that the system is actuarially fair to all cohorts. In my
opinion, the best way to achieve intergenerational equity would be to switch over immediately toan actuarially fair system and to service the government’s net pension debt (the net transfers topast, current, and future beneficiaries which the government has already paid or to which thegovernment has already committed itself) via a progressive income tax and/or the issuance of longterm government bonds; in either case, the burden of servicing the government’s net pension debt
should be spread out as evenly as possible over future generations in order to preserve
intergenerational equity (see Tajika, Kaneko, and Hayashi (1996), Hatta (1997), and Hatta andOguchi (1997, 1999) for more details).

16

(2) The adverse impact of the public pension system on intragenerational equity could be
alleviated or eliminated in the following ways. First, the adverse impact on equity among income
classes could be alleviated by taxing pension benefits more heavily in the case of the high-income.
This could be done by limiting or eliminating the pension benefit deduction in the case of the highincome.8
Second, the adverse impact on equity among household types could be eliminated byrequiring the dependent spouses of salaried workers to pay their fair share of pension
contributions, as proposed by Hatta (1997) and Hatta and Oguchi (1999).9
Third, the adverse impact on equity among workers receiving varying amounts of bonuses
and lumpsum retirement payments could be eliminated by ending the exemption of bonus income
and lumpsum retirement payments from pension contributions, as proposed by Hatta (1997).10
Beginning in April 1995, salaried workers are required to pay an additional pension contribution
equal to one percent of their bonus income (with the burden being shared equally by employer andemployee), but this contribution rate is far lower than the contribution rate applied to monthly
salary (17.35% since October 1996).

Moreover, another problem with this reform is that

contributions from bonus income are not taken into account when calculating benefits. The
contribution rates on monthly salary, bonuses, and lumpsum retirement payments should beequalized immediately, and they should all be taken into account when calculating benefits.
(3) The adverse impact of the public pension system on the labor supply of the aged and of
women could be alleviated or eliminated in the following ways. First, the adverse impact on thelabor supply of the aged could be alleviated by relaxing the earnings test on the pensions of former
salaried workers and/or prohibiting double dipping (the simultaneous receipt of pension benefits
and unemployment compensation benefits). The earnings test on the pensions of former salaried
workers aged 60 to 64 has been relaxed several times (most substantially in April 1995), but there
is room for further relaxation. As for double dipping, it was abolished in April 1998, and moreover,17

a further step has been taken to encourage those aged 60 and older to continue working. Since
April 1995, salaried workers who experience a sharp decline in their salary after mandatory
retirement are regarded as being quasi-unemployed and are eligible for unemployment
compensation benefits that amount to as much as 25% of their new salary. The pension benefitsof such workers are reduced by an amount equal to 10% of their new salary, but even so, they aremuch better off than before, and more importantly, it is now less likely that they can earn more by
retiring than by continuing to work.
Second, the adverse impact of the public pension system on the labor supply of women
could be eliminated by requiring the dependent spouses of salaried workers to pay their fair shareof pension contributions, a measure that would also alleviate the intragenerational inequities of
the current system (see (2) above).
If adopted, these measures would not only eliminate distortions caused by the public
pension system but would also alleviate the serious labor shortages that are forecast to emerge as
the population ages by inducing the aged and women to increase their labor supply.
(4) The adverse impact of the public pension system on saving could be alleviated byconverting Japan's public pension system from what is essentially a pay-as-you-go system to a fully
funded system so that increases in government saving would fully offset any pension-induced
reductions in private saving. It would be difficult to make this transition any time soon given themassive unfunded liabilities of the current pension system, but Hatta (1998) and Hatta and Oguchi(1999) show that there are a number of ways to complete the transition to a fully funded system by
the year 2150.

B. The National Pension System(1) The adverse impact on intergenerational equity (see (1) above)(2) The adverse impact on national saving (see (4) above)18

(3) The widespread evasion of contributions to the National Pension System could be
eliminated by funding the basic pension out of general tax revenues or by means of an earmarked
tax that would be used exclusively for the purpose of financing the basic pension.

C. Two Additional Recommendations
One additional recommendation I have is to raise the mandatory retirement age from 60 to
65 and to take other steps to enable and/or encourage those aged 60 and older to continue
working. It is hard to believe, but Japan has traditionally had a mandatory retirement age of 55
despite having virtually the longest life expectancy in the world (83.82 years for females and 77.19
years for males as of 1997) and despite the fact that the pensionable age for salaried workers is 60.
A mandatory retirement age of 60 was introduced in steps after 1986 but was not fully
implemented until 1998. First, a law requiring firms to “strive” for a mandatory retirement age of
60 passed the Diet in 1986, but the adoption of a mandatory retirement age of 60 was a very
gradual process: of companies imposing a uniform mandatory retirement age, the proportion that
had adopted, or planned to adopt, a retirement age of 60 was only 71.4% in 1992 and 90% in 1996
(Maeda (1997)). A law fully implementing a mandatory retirement age of 60 (i.e., prohibiting firms
from adopting a mandatory retirement age earlier than 60) finally passed the Diet in 1994 and tookeffect on April 1, 1998.
Now that it has been decided that the age at which salaried workers can begin receiving thebasic pension will soon be raised to 65, it is imperative that the mandatory retirement age be raisedfurther to 65 as soon as possible (at the latest by the time the pensionable age is increased to 65)
to ensure that salaried workers have an uninterrupted flow of income. Note, moreover, that raising
the mandatory retirement age to 65 and taking other steps to enable and/or encourage those aged
60 and older to continue working would also alleviate the severe labor shortages that are projected
to emerge early in the next century and thus that two birds could be killed with one stone.

19

My last recommendation is that all social insurance programs affecting the elderly should
be examined in their totality with a view toward insuring old-age security without wasteful overlap
among programs and without excessive intergenerational inequities. In addition to the public
pension system, Japan has a medical insurance system for the aged, and a public long-term careinsurance system will be introduced in April 2000. Better coordination between the these threeprograms is badly needed.

D. Overall Recommendation
In short, what I recommend (not only for Japan but for all countries) is a public pension
system that is actuarially fair to all cohorts and to all groups within each cohort, that does notcontain perverse incentives regarding labor supply and saving decisions, that eliminates theevasion of pension contributions, that ensures retirees an uninterrupted flow of income, and thatis well-coordinated with other social insurance programs affecting the aged.11 Note, moreover, thatsome of my recommendations would simultaneously ease future labor shortages, thus enabling two
birds to be killed with one stone.

VIII. Future Prospects for Japan's Public Pension System
Japan's population is aging at the fastest rate in human history and will become the mostaged population in the world by the year 2010, surpassing even the long-time leader Sweden.
According to the projections of the National Institute of Population and Social Security Researchof the Japanese Ministry of Health and Welfare, the aged ratio (the ratio of the population aged 65
or older to the total population) will increase from 16.2% in 1998 to 22.0% in 2010 and will risefurther to 26.9% in 2020, 28.0% in 2030, 31.0% in 2040, and 32.3% in 2050. In this section, I
discuss future prospects for Japan’s public pension system in the face of such rapid population
aging.

20

The rapid aging of Japan’s population will cause the ratio of retirees to workers in Japan toskyrocket, and given the pay-as-you-go structure of Japan's public pension system, this in turnwill necessitate drastic reforms of the system (e.g., sizable benefit reductions and/or sizable
increases in contribution rates) if the solvency of the system is to be maintained.

For example,

according to calculations by the Japanese Ministry of Health and Welfare, the contribution rate for
the Employees' Pension would have to be doubled from the present level of 17.35% to 34.3% by theyear 2025 in order to maintain current benefit levels. Such a high contribution rate would impose
too heavy a burden on salaried workers, especially when one considers that they would also haveto pay national, prefectural, and municipal income taxes and separate contributions for healthinsurance and long-term care insurance. Thus, some sort of reform of the public pension system
is badly needed. The next section describes and evaluates two reform proposals.

IX. Two Proposals for Reforming Japan’s Public Pension System
A major reform of Japan's public pension system is implemented every five years, after thelatest population projections have been released, and 1999 is one of those years. The Japanese
Ministry of Health and Welfare finalized its 1999 reform proposal on February 26, 1999, and theruling Liberal Democratic Party approved it with some modifications on March 5, 1999. Moreover,various individuals and groups have announced their own proposals. Both the Ministry of Healthand Welfare/Liberal Democratic Party proposal (hereafter the MHW/LDP proposal) and the otherproposals purport to maintain the solvency of the system while at the same time keeping the peak
contribution rate more manageable than under the current system. In this section, I describe the
MHW/LDP proposal (which will almost definitely have been approved by the Diet by the time thisbook is published) as well as the most promising alternative--the various proposals of Hatta andOguchi (1999)--and evaluate each on the basis of the extent to which it solves the defects
enumerated in section V.

21

A. Reform of the Employees’ Pension System(1) The Ministry of Health and Welfare/Liberal Democratic Party Proposal
A major goal of the MHW/LDP proposal is to reduce future benefit expenditures by about
20 percent so that future increases in contribution rates can be held down. The MHW/LDP
proposal seeks to reduce benefit expenditures in the following ways:(1) It proposes a five-percent reduction in the earnings-related component of the benefitsof former salaried workers who begin receiving benefits after April 1, 2000 (the benefits of thosealready receiving benefits as of April 1, 2000, would not be affected).
(2) It proposes a temporary suspension of the wage indexation of benefits effective April
2000 (benefits would be indexed to consumer prices instead of wages, which implies a lower rateof increase as long as there is productivity (real wage) growth). (The suspension would be lifted
after benefit levels fall below 80% of the level that would have been attained if wage indexation had
been maintained.)(3) It proposes gradually raising the age at which the earnings-related component of thebenefits of former salaried workers are paid from 60 to 65 (by one year every three years between
fiscal 2013 and 2025 in the case of males and by one year every three years between fiscal 2018and 2025 in the case of females). Recall that the age at which the basic pension of former salaried
workers is paid will be gradually raised from 60 to 65 between 2001 and 2013, pursuant to the1994 reforms, and thus this provision implies that the pensionable age of salaried workers will becompletely raised from 60 to 65.12(4) It proposes applying the earnings test to those aged 65-69 and collecting pension
contributions from all workers aged 65 to 69 beginning in April 2002 (these provisions currently
apply only to those aged 60-64).
Four other provisions included in the MHW/LDP proposal are as follows:22

(1) It proposes suspending scheduled increases in the contribution rate until thegovernment subsidy to the basic pension is raised from one-third to one-half (see (2) below).
(2) It proposes raising the government subsidy to the basic pension from one-third to onehalf as soon as a stable revenue source can be found and by the next pension reform (2004) at thelatest.
(3) It proposes taxing bonus income at the same rate as regular wages beginning in April
2003.
(4) It proposes exempting employers from the employer share of pension contributions while
employees are on child care leave beginning in April 2000.
In my opinion, the MHW/LDP proposal is totally unsatisfactory because it is a piecemealreform whose primary aim is to maintain the solvency of the public pension system in the face of
rapid population aging. It pays little heed to intergenerational or intragenerational equity, theadverse impact of the public pension system on the labor supply of the aged and of women and on
national saving, or to the other issues I enumerated earlier.

According to Hatta and Oguchi's(1999) calculations, the MHW/LDP proposal would further exacerbate the already substantial
intergenerational equity of the public pension system. With respect to older cohorts, although theirbenefits will be reduced by the five percent cut in the earnings-related component of benefits andby the temporary suspension of wage indexation, they will escape the reduction in lifetime benefits
caused by the increase in the age at which the earnings-related component of benefits is paid
because it will not be implemented until 2013 and only gradually after that and their contributions
will also be reduced as a result of the temporary suspension of scheduled increases in thecontribution rate, meaning that their lifetime benefits will exceed their lifetime contributions byeven more than under the current system. With respect to younger cohorts, although increases intheir contribution rates would be held down, their benefits would also be reduced as a result of thefive percent cut in the earnings-related component of benefits, the temporary suspension of wage

23

indexation, and the increase in the age at which the earnings-related component of benefits is paid,
meaning that their lifetime benefits would fall short of their lifetime contributions by even morethan under the current system.
Moreover, the MHW/LDP proposal exacerbates the adverse impact of the public pension
system on the labor supply of the aged by extending the earnings test to the 65-69 age group, andit does nothing to alleviate the intragenerational inequities and the adverse impact on the labor
supply of women that arise from exempting the spouses of salaried workers who are not working
or whose incomes are below a certain level from paying pension contributions or the
intragenerational inequities caused by the exemption of lumpsum retirement payments frompension contributions. Furthermore, the adverse impact on national saving would not be alleviatedas the system would continue to be operated as a pay-as-you-go system. Finally, since there are
no plans to raise the mandatory retirement age from 60 to 65 anytime soon, the MHW/LDP
proposal would create a five-year gap between the mandatory retirement age (60) and thepensionable age (65).
About the only good things about the MHW/LDP proposal are that it alleviates
intragenerational inequities by taxing bonus income at the same rate as regular wages and that italleviates intergenerational inequities somewhat by indexing benefits to consumer prices rather
than to after-tax wages, at least for the time being, which will hold down the benefits received byolder cohorts and reduce the amount by which their lifetime benefits exceed their lifetime
contributions.

(2) The Hatta-Oguchi 23% Reform Proposal
The most serious defect of both the current system and the MHW/LDP proposal is theirenormous intergenerational inequity. Both systems propose to maintain the solvency of the public24pension system in the face of rapid population aging by gradually raising contributions andgradually lowering benefits. Examples of the latter are the current provision to gradually raise theage at which former salaried workers can begin receiving the basic pension from 60 to 65 and the
proposed provision to gradually raise the age at which former salaried workers can being receiving
the earnings-related component of benefits from 60 to 65. But gradually raising contributions andgradually lowering benefits means that older cohorts will be able to escape the higher contributions
and lower benefits, and thus will make out like bandits. By contrast, younger cohorts will have tobear the full brunt of both higher contributions and lower benefits and hence will receive a double
whammy. The only way to minimize the intergenerational inequities of the public pension system
is to raise contributions and lower benefits (e.g., by raising the age at which benefits are paid)
immediately, and the Hatta and Oguchi’s (1999) “23% Proposal” does just that. The main featuresof this proposal are as follows:(1) It proposes immediately raising the contribution rate from 17.35% to 23.1% and keep it
constant thereafter.
(2) It proposes suspending the wage indexation of the earnings-related component of thebenefits of former salaried workers until 2030.
(3) It proposes continuing the wage indexation of the basic pension.
(4) It proposes immediately raising the age at which the earnings-related component of thebenefits of former salaried workers can be received from 60 to 65 but offering salaried workers theoption of retiring early (between the ages of 60 and 64) and collecting actuarially reduced benefits.
Provision (1) will lead to an immediate increase in contributions and provisions (2) and (4)will lead to an immediate reduction in benefits, and thus the 23% proposal goes a long way towardrectifying the intergenerational inequity of the current system while at the same time maintaining
its solvency. (The authors do not propose suspending the wage indexation of the basic pension
because they feel that its purpose should be to guarantee a minimal standard of living during old
25

age.)
Moreover, the 23% Proposal would eliminate the adverse impact of the Employees’ Pension
System on the labor supply of the aged because the benefits of early retirees would be reduced only
actuarially, and it would also eliminate the adverse impact of the Employees’ Pension System onnational saving because it would achieve the transition to a fully funded system by 2150.

B. Reform of the National Pension System(1) The MHW/LDP Reform Proposal
The MHW/LDP Reform Proposal contains at least two provisions relating to the National
Pension System:(1) It proposes the introduction of a partial exemption option for moderately low-income
individuals enrolled in the National Pension System beginning in April 2002. Under this option,
moderately low-income individuals (whose incomes are not low enough to qualify them for the fullexemption) would have the option of paying half of the full contribution and receiving two-thirds ofthe full benefit.
(2) It proposes the introduction of an option for deferring the payment of contributions to
the National Pension System for the period that one is enrolled as a student for up to ten years
beginning in April 2000.
These provisions are designed to reduce the evasion of pension contributions by providing
incentives for the moderately low income and for students to pay up, but in my opinion, they are
not nearly enough to solve the problem entirely.

Moreover, they do nothing about theintergenerational inequity of the current system or about its adverse impact on national saving.

(2) The Hatta-Oguchi Uniform Unification Proposal
The Hatta-Oguchi 23% Reform Proposal that I described earlier looks at the Employees’

26

Pension System in isolation, but Hatta and Oguchi (1999) also propose a plan (their so-called
Funded Unification Proposal (Tōgō Tsumitate An)) to unify the various public pension schemes andto effect the transition of the public pension system as a whole to an actuarially fair fully fundedsystem by 2150. Its main features are as follows:(1) It proposes reducing future per capita benefit expenditures by 20%.
(2) It proposes abolishing contributions to the National Pension System and financing thebasic pension via an earmarked 5% consumption tax.
(3) It proposes reducing the contribution rate of the Employees’ Pension System to 5.7%.
(4) It proposes replacing the one-third government subsidy of the basic pension with asubsidy equivalent to a 13.4% tax on labor income.
Since responsibility for collecting the earmarked consumption tax would fall on the Ministryof Finance, which has more expertise at collecting taxes than the Ministry of Health and Welfare,this proposal would hopefully largely solve the evasion problem. Moreover, the proposal to keep
the various tax rates constant over time instead of hiking them gradually would greatly ameliorate
the intergenerational equity of the public pension system (see the discussion in section A above),
and the use of a consumption tax rather than a lump-sum tax as at present would enhance theprogressivity and hence the equity of the overall tax system. Furthermore, this proposal would
eliminate the adverse impact on intergenerational equity and on the labor supply of women causedby exempting the dependent spouses of salaried workers from paying pension contributions.
Finally, the proposal would also eliminate the adverse impact of the public pension system onnational saving because it would achieve the transition to a fully funded system by 2150. The only
drawback of the proposal is that breaking the link between benefits and contributions would
discourage people from working, but since the current public pension system strongly discourages
the dependent spouses of salaried workers from working and since this distortion would be
eliminated by the Hatta-Oguchi proposal, it would, on balance, alleviate the disincentive effects on

27

labor supply.
Thus, in almost every respect, the Hatta-Oguchi proposals are far preferable to the
MHW/LDP proposal and should be adopted instead of the MHW/LDP proposal. The likelihood ofthat happening is small, in large part because the older cohorts who have the most to lose fromthe Hatta-Oguchi proposals are already of voting age whereas the younger cohorts who have themost to gain from the Hatta-Oguchi proposals are not yet born or are still not of voting age. Buttime is rapidly running out, so I earnestly hope that the government and the people of Japan will
have the wisdom and the courage to adopt a public pension system that not only maintains its
solvency in the face of rapid population aging but also meets the requirements of an ideal public
pension system.

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Footnotes

1I focus primarily on old-age pensions even though disability, survivors', and welfare pensions arealso available.
2The yen-dollar exchange rate was about 120 yen/dollar as of June 1999.
3Those aged 60 to 69 and Japanese nationals living abroad are also eligible to enroll in the National30

Pension System on a voluntary basis.
4Those other than salaried workers ordinarily do not receive any earnings-related benefits, butsince 1991, they can pay additional contributions and receive additional benefits under the
National Pension Fund (Kokumin Nenkin Kikin) System.
5Since 1966, large corporations can partially contract out of the earnings-related component ofbenefits by setting up a private fund called an Employees' Pension Fund (Kōsei Nenkin Kikin), but
to do so, they must pay benefits that are at least 30% higher than in the case of the Employees'
Pension.
6The Mutual Aid Pension Systems for employees of formerly public enterprises (Japan Railways,
Japan Tobacco, and Nippon Telephone and Telegraph) were absorbed by the Employees' Pension
System in April 1997.
7Space limitations preclude me from discussing the Mutual Aid Pension Systems, but they are very

similar in structure to the Employees’ Pension System.
8Takayama (1992) advocates eliminating the favorable tax treatment of pension benefits altogether,and there is considerable merit to his argument.
9The inequity between salaried workers with a dependent spouse and salaried workers with aworking spouse was alleviated as part of the 1994 reforms. Until then, dependent spouses were
eligible to receive a survivors' benefit equal to three-fourths of the primary beneficiary's earningsrelated benefit after the primary beneficiary's death, while working spouses had to choose between
receiving the same survivors’ benefit as dependent spouses and receiving an earnings-related
benefit based on their own earnings; they could not receive both. Since April 1995, however,working spouses have an additional choice--namely, to receive half the combined earnings-related
benefits of husband and wife. This reduces the inequity between salaried workers with adependent spouse and salaried workers with a working spouse but does not eliminate it, andmoreover, it introduces an additional inequity: not only salaried workers with dependent spouses
but also salaried workers with working spouses are now favored vis-à-vis single salaried workers.
Thus, my proposed solution appears to be the more equitable one.
10Takayama(1992) also advocates ending the exemption of bonus income from pension
contributions.
11Tajika, Kaneko, and Hayashi (1996) also strongly advocate a public pension system that is

actuarially fair to all cohorts and to all groups within each cohort.
12Note, however, that the MHW/LDP proposal includes a provision for salaried workers to retire at

60 and collect benefits equal to 70 percent of what they would have received if they had waiteduntil age 65.

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