Silviase/jgov_v1.4_full_ann huggingface dataset:
Pension Reform" or "the 2004 Reform") that the government should examine the current situation and future prospects of the financial conditions of public pension schemes and verify their financial viability at least every five years. The government carried out a first such verification in 2009. It was revealed in this 2009 Financial Viability Verification Report (hereafter referred to as "the 2009 Verification") that the financial conditions of public pension schemes were much worse than expected in 2004 due to significant changes in economic and demographic conditions. As regards economic conditions, both CPI and wage inflation were lower than expected; furthermore, CPI inflation was higher than wage inflation, which was opposite to the assumption made in the 2004 Reform. According to a recent population forecast by the National Institute of Population and Social Security Research, a less-favorable picture of population aging for public pension finance was projected than its previous population forecast published five years ago.

## (4) Organization of the paper

As mentioned earlier, deflation raises the real pension benefit level while keeping the real pension contribution schedule constant; it therefore has an adverse effect on public pension finance. On the benefit side, there are three problems. First of all, the current pension benefit level is higher than the permanent benefit level on a provisional basis, and this overpayment will not be corrected under deflationary circumstances. Second, the automatic adjustment mechanism, which was introduced in the 2004 Pension Reform to automatically reduce the pension benefit level as the population ages, will not be activated until deflation is brought to an end. Finally, even after the automatic adjustment mechanism is activated, no adjustment will be actually made if deflation resurfaces. These problems are examined in Sections 2, 3, and 4, respectively. The total impact of deflation on public pension finance up till FY 2015 is quantitatively examined in Section 5. Section 6 analyzes the sustainability of public pension schemes under various economic conditions. Finally, Section 7 concludes the paper.

### 2. Provisional Treatment and Its Impact on Real Pension Benefits

## (1) Origin of the problem

The actual pension benefit level has been higher than the permanent level on a provisional basis since FY 2000. Prior to the 2004 Reform, the pension benefit level
was indexed to the CPI $ ^{1} $ , but this rule was not observed in the early 2000s. Although the CPI declined by 0.3% in 1999, 0.7% in 2000, and 0.7% in 2001, the pension benefit level was maintained in FY 2000, FY 2001, and FY 2002 on a provisional basis. As a result, the actual benefit level in FY 2002 was 1.7% higher than the permanent level, which was fully indexed to the CPI.

## [Figure 1]

Since FY 2003, the gap between the provisional level and the permanent level has actually widened to 2.2% by FY 2010, essentially because of negative or low inflation. The CPI fell by 0.9% in 2002, and the provisional and permanent pension benefit levels were both reduced by 0.9% in FY 2003, but the 1.7% gap was maintained. Again in FY 2004 the provisional and permanent levels were both reduced by 0.3% as the CPI fell by 0.3% in 2003, and the gap remained intact. Neither the provisional nor permanent levels changed, and thus neither did the gap again in FY 2005 because of a 0.0% CPI inflation in 2004.

## (2) The gap not eliminated by FY 2009

In the 2004 Pension Reform, the 1.7% gap was expected to be eliminated by inflation in a couple of years by holding the provisional level constant and by raising the permanent level by the inflation rate. However, the gap did not narrow from FY 2006 to FY 2007 despite 0.3% CPI inflation in 2006. It also narrowed only by 0.9% from FY 2008 to FY 2009, despite 1.4% CPI inflation in 2008. To understand why this was the case, we have to gain a proper understanding of the indexation of the permanent benefit level.

## [Table 1]

To be precise, the permanent pension benefit level is indexed to per-capita disposable income of active workers for newly awarded beneficiaries and to the Consumer Price Index (CPI) for already-awarded beneficiaries. This is the principal indexation rule set by the 2004 Pension Reform. The 2004 Pension Reform also assumed that wage inflation in terms of per capita disposable income was higher than CPI inflation. However, when wage inflation is actually lower than CPI inflation, a slightly different
indexation rule will be applied. If both wage and CPI inflation are positive, the wage inflation rate -- the lower rate -- will be used for both newly and already-awarded beneficiaries. If wage inflation is negative and CPI inflation is positive, there will be no revision for either beneficiary. If both wage and CPI inflation are negative, the CPI inflation rate -- the higher rate -- will be used for both beneficiaries.

## [Figure 2]

Between 2005 and 2009, because wage inflation was consistently lower than or equal to CPI inflation, the same rate of change was applied to both newly and already-awarded beneficiaries between FY 2006 and FY 2010. In FY 2007 and FY 2009, the rate of wage inflation -- the lower positive rate -- was applied to both beneficiaries, whereas in FY 2008 and FY 2010, the rate of CPI inflation -- the higher negative rate -- was applied to them. In FY 2006, the rate of wage inflation was equal to that of CPI inflation.

The gap between the provisional level and the permanent level would have narrowed from 1.7% in FY 2006 to 1.4% in FY 2007 and would have been eliminated in FY 2009, if the permanent level had increased by the rate of CPI inflation rather than by that of wage inflation in FY 2007 and FY 2009. In reality the gap was still 0.8 (= 1.7–0.9)% in FY 2009, since the rate of wage inflation was applied in FY 2007 and FY 2009.

(3) The widened gap in FY 2010 and the indexation of the provisional benefit level

Curiously enough, the gap widened from 0.8% in FY 2009 to 2.2% in FY 2010, because the provisional level did not decline in FY2010, despite 1.4% CPI deflation (and 2.6% wage deflation) in 2009. To see the reason why the gap widened, a proper understanding about the indexation of the provisional benefit level is required.

To be precise, the provisional level is indexed to the lowest yearly Consumer Price Index (CPI) since 2003. That is,

1) if $ p_{t} \geq p_{0} $ , $ b_{t} = b_{0} $

2) if $ p_{t} < p_{0} $ , $ \mathbf{b}\mathbf{t} = \mathbf{b}_{0} \times (\mathbf{p}_{t}/\mathbf{p}_{0}) $

where $ p_{t} $ : the CPI for year t

po: the lowest yearly CPI since 2003

$ b_{t} $ : the provisional benefit level in fiscal year $ t+1 $

bo: the provisional benefit level corresponding to po.
Until 2009, the lowest yearly CPI since 2003 was 100.0, which was recorded in 2005, and so the provisional benefit level has been fixed since FY 2006. In 2009, the CPI fell by 1.4% and yet the provisional level did not decline in FY 2010, since the CPI in 2009 was 100.3 and still higher than the level reached in 2005. The provisional level will not decline until the CPI falls below 100.0.

## (4) The gap will widen further

It is very likely that the CPI will fall again in 2010 and 2011. According to a Bank of Japan (BOJ) projection, released in April 2010, the rate of CPI inflation is -0.5% for FY 2010 and 0.0% for FY 2011, excluding the impact of the newly introduced subsidies for high school tuition. The BOJ excluded this impact as a special factor, which was not related to a basic trend in consumer price inflation. However, the actual CPI statistics will inevitably capture this impact, and, with its inclusion, the CPI is projected to fall by 1.0% in 2010 and 0.2% in 2011.

This implies that the gap between the provisional benefit level and the permanent benefit level is most likely to expand in FY 2011. To simplify our discussion, let's assume that the rate of change in after-tax nominal wage is equal to that in the CPI in 2010 and 2011 for now. Then the CPI inflation rate is applied to revise the permanent benefit level of both newly and already-awarded beneficiaries. The CPI is projected to decrease from 100.3 in 2009 to 99.3 in 2010. Based on our assumptions, the provisional level will decline by 0.7% (= 1-99.3/100), while the permanent level will fall by 1.0% in FY 2011, so the gap will widen from 2.2% in FY 2010 to 2.5% in FY 2011.

## (5) When will the gap be eliminated?

When will the gap between the provisional level and the permanent level be eliminated? To answer this question, a longer-term CPI projection is required. As was mentioned earlier, the CPI is projected to fall by 1.0% in 2010 and by 0.2% in 2011 in this paper. For 2012 and beyond, this paper assumes 1.0% CPI inflation every year, which is equal to the BOJ's understanding of price stability in the medium-term. Based on this CPI projection, the gap is expected to be eliminated in FY 2015. Here we also assume that the after-tax wage inflation rate is equal to the CPI inflation rate for simplicity.
So the actual pension benefit level is expected to be higher than the permanent level on a provisional basis for 15 years, between FY 2000 and FY 2014. However, this overpayment is not the only financial problem caused by deflation for public pension finance. Let us now turn to the next one caused by deflation, which is related to a new mechanism introduced in the 2004 Pension Reform.

### 3. Automatic Adjustment Mechanism Not Activated

## (1) The 2004 Reform and the automatic adjustment mechanism

In the 2004 Reform, a very important new mechanism was introduced to ensure the financial viability of public pension schemes in the face of population aging. As we have seen already, the pension benefit level is basically indexed to after-tax wage or CPI inflation, but it is automatically reduced by the sum of the following two rates as well: 1) the rate of decrease in the number of covered persons by public pension schemes 2) the projected average annual rate of increase in life expectancy (0.3%).

This automatic adjustment mechanism, once activated, will not be terminated until financial viability of public pension schemes is ensured.

## (2) Deflation and an activation of the automatic adjustment mechanism

Although the most important device introduced in the 2004 Reform to ensure financial viability of public pension schemes is the automatic adjustment mechanism, this mechanism has not been activated. This automatic adjustment mechanism will not be activated until the gap between the provisional benefit level and the permanent benefit level is eliminated. In the 2004 Pension Reform, the gap was expected to be eliminated around FY 2008, but it was not eliminated or even reduced by that time. In the 2009 Financial Viability Verification Report, the gap was expected to be eliminated around FY 2012, assuming that there will be a 1% VAT (value added tax) hike every year and the rate of inflation will be higher accordingly between FY 2011 and FY 2015. However, the gap is now expected to be eliminated in FY 2015, assuming that there will be no VAT hikes in several years and that CPI inflation is -1.0% in 2010, -0.2% in 2011 and 1.0% in 2012 and beyond. Even if a 1% VAT hike and a resultant higher inflation are assumed every year from FY 2011, the gap is now expected to be eliminated in FY 2013.
It is very likely that the automatic adjustment mechanism will not be activated for 10 years or even more after its introduction. This has the following two major impacts.

## 1 ) Impact on fiscal balance

Public pension finance will worsen and the general government fiscal deficit will be larger in the near future until the automatic adjustment mechanism is activated, although fiscal discipline is seriously called for in Japan.

2) Intergenerational distributional impact

Older generations will benefit from the delayed adjustment period at the expense of younger and future generations.

## (3) A VAT hike

It is noted that an increase in the VAT rate will have an indirect impact on fiscal balance of Japan's general government by pushing up inflation and thus activating the automatic adjustment mechanism earlier, unless special treatment is given to this policy-induced inflation in setting the public pension benefit level.

### 4. Automatic Adjustment Mechanism After Activation

Even after the automatic adjustment mechanism is activated, only a partial adjustment will be made if the rate of inflation is moderate, and no adjustment will be made if the rate of inflation is negative. A full adjustment will be made only when the rate of inflation is higher than the automatic adjustment rate, which is the sum of the rate of decrease in the number of covered persons by the public pension schemes and the projected average annual rate of increase in life expectancy (0.3%). The automatic adjustment rate set out in the 2009 Verification is slightly more than 1.0% on average during the 2010s and slightly less than 1.0% on average during the 2020s. If inflation is positive but lower than the adjustment rate, the actual rate of adjustment is equal to the inflation rate and consequently the nominal benefit level is not altered. If inflation is negative, no adjustment will be made and thus the nominal benefit level is reduced by the negative inflation rate. This mechanism aims at reducing the real pension benefit level without decreasing the nominal benefit level when the rate of inflation is positive. When it is negative, the real pension benefit level is not reduced at all, with the nominal benefit level being cut by the rate of deflation. When it is positive but moderate, i.e., lower than the adjustment rate, the real pension benefit level is not fully but only partially reduced, with no change in the nominal benefit level. Even after the
automatic adjustment mechanism is activated, it is evident that financial viability of public pension schemes is heavily dependent on the rate of inflation because of this asymmetric treatment of the automatic adjustment.

## [Figure 3]

When a full adjustment is not made due to deflation or moderate inflation, this needs to be compensated by automatic adjustment at a later stage, which implies an inter-generational transfer of financial burden of public pension from the older or current generation to younger/future ones as well as deterioration in current financial conditions.

The rates of automatic adjustment expected in the 2004 Reform and the 2009 Verification are summarized in Table 2. When the 2004 Reform was published, the automatic adjustment was expected to reduce the pension benefit level by 15.0% between FY 2008 and FY 2023, if fully implemented, i.e., if the rate of inflation was consistently higher or equal to the adjustment rates. In the 2009 Verification, the automatic adjustment was expected to reduce the level by 33.3% between FY 2012 and FY 2038 $ ^{2} $ , again if fully implemented. The total effect of the adjustment is now much larger than it was five years ago, and the duration of the adjustment process is much longer as well. This reflects both the overpayment of public pension benefits in recent years and a higher rate of decrease in the projected number of the insured.

[Table 2]

### 5. Quantitative Assessment

## (1) Three channels summarized

Let us summarize the impact of deflation on financial sustainability of public pension schemes. First of all, the actual benefit level has been higher than the permanent level on a provisional basis for more than ten years, primarily because of deflation. This anomalous situation will not be corrected until deflation is brought to an end. Second, the automatic adjustment mechanism, which was introduced in the 2004 Reform to ensure the financial viability of Japan's public pension schemes, has not been activated.
so far and is not expected to be activated until FY 2015 or so. Again, this is primarily due to deflation. Third, even after the automatic adjustment mechanism is activated at some point in time, following a period of positive inflation, no adjustment will be actually made, if deflation strikes again. Again, this will have a serious detrimental impact on financial sustainability of public pension schemes.

## (2) Assumptions

Let us now quantitatively analyze the impact of deflation on public pension finance. We will try to capture the magnitude of the impact through the first and second channels in the previous paragraph. To do so, the following assumptions are made.

1) The rate of CPI inflation is -1.0% in 2010, -0.2% in 2011, and 1.0% in 2012 and beyond.

2) The rate of wage inflation (after tax and social security contribution) is assumed to be equal to the rate of CPI inflation for simplicity.

3) Nominal GDP grows by 2% every year from FY 2010 onward.

4) The total amount of public pension benefits expands by 2% every year from FY 2008 onward.

5) The nominal public pension benefit amounts for a fiscal year are deflated by the previous calendar year's CPI, rather than the current fiscal year's CPI, to calculate the real public pension benefit amounts.

As mentioned earlier, assumption 1) on CPI inflation is based on a) the actual CPI during the first quarter of 2010, b) the BOJ forecast for FY 2010 and FY 2011, published in April 2010, and c) its understanding of price stability in the medium-term, i.e., 1%. Regarding assumption 2), it is noted that the rate of (before-tax) wage inflation was 0.3% lower than the rate of CPI inflation on average in the last five years, although the former was expected to be higher than the latter in the 2009 Verification as well as in the 2004 Reform. On assumption 4), the last five-year average until FY 2007 was 2.7%, the last ten-year average was 3.4%, and the last 20-year average was 5.1%. The rationale for assumption 5) is that the nominal pension benefit level in a fiscal year is institutionally indexed to the nominal wage level or the CPI in the preceding calendar year. On assumptions 3) and 4), a sensitivity analysis will be conducted at a later stage.
## (3) Nominal benefit level and overpayment

The gap between the provisional level and the permanent level is 1.7% in FY 2008, 0.8% in FY 2009 and 2.2% in FY 2010. Based on the assumptions above, the gap is projected to become 2.5% in FY 2011 and FY 2012, before gradually falling back to -0.4% in FY 2015.

The amount of overpayment is estimated by multiplying actual total public pension benefits for a fiscal year by $ (1-\text{permanent level} / \text{provisional level}) $ . When the permanent level is higher than or equal to the provisional level, there is no overpayment. The total overpayment between FY 2000 and FY 2010, the last year for which the benefit level is already fixed, is estimated at ¥7.2 trillion, which is equal to 1.4% of GDP. Based on our current assumptions, the total estimated overpayment between FY 2000 and FY 2014 amounts to ¥10.6 trillion, which is 2.1% of GDP $ ^{3} $ . On a yearly basis, the overpayment peaks at ¥1.2 trillion in FY 2012. In FY 2015, there is no overpayment, since the permanent level is projected to exceed the provisional level. Here the amount of overpayment refers to all public pension schemes, which include not only the National Pension and the Employees' Pension but also Mutual Aid Associations. Apparently, the overpayment is due to the simple fact that the actual provisional benefit level exceeds the permanent level.

## (4) Real benefit level and overpayment

The provisional benefit level exceeds the permanent level not only in nominal terms but also in real terms. The total overpayment in real terms between FY 2000 and FY 2010 is estimated at ¥7.3 trillion in FY1999 prices, which is roughly 1.5% of GDP in that fiscal year. Based on our assumptions, the total estimated overpayment between FY 2000 and FY 2015 is ¥11.0 trillion in FY1999 prices, which is equal to 2.2% of FY1999 GDP.

The overpayment in real terms is not confined to the difference between the provisional benefit level and the permanent level. The 2004 Reform assumed that the gap between the provisional and permanent levels would be eliminated in FY 2008 and thus the automatic adjustment mechanism would be activated in that fiscal year. Once
activated, the automatic adjustment mechanism would reduce the permanent benefit level in real terms as well as in nominal terms. Since the gap has actually not been eliminated and the mechanism has not been activated, however, the actual permanent benefit level in real terms has been higher than the level envisaged in the 2004 Reform since FY 2008.

## [Figure 4]

Now let us look at the magnitude of real overpayment in terms of the difference between the actual provisional benefit level and the benefit level envisaged in the 2004 Reform. In FY 2010, the actual benefit level is 3.7% higher than what the 2004 Reform envisaged in real terms, and it is projected to be 4.9% higher in FY 2011, and 5.8% higher between FY 2012 and FY 2015.

The 2004 line in Figure 4 (in blue), however, refers to benefit level of already-awarded beneficiaries in FY 2004. As was mentioned earlier, in the 2004 Reform, the benefit level of already-awarded beneficiaries was indexed to the CPI, and that of newly awarded ones to the after-tax wage level. In the 2004 Reform, the CPI inflation rate was projected to be 0.8% lower than the after-tax wage inflation rate until 2008 and 1.1% lower than that in 2009 and beyond. Therefore the rate of increase in the benefit level for newly awarded beneficiaries was expected to be higher than that for already-awarded beneficiaries.

So the amount of real overpayment for a fiscal year calculated by

total real pension benefit amount in that fiscal year

× (1−the benefit level envisaged in the 2004 Reform for already-awarded beneficiaries / the actual benefit level),

inevitably overestimates the magnitude of the overpayment, and the degree of overestimation is larger in a more distant future. The degree of overestimation is minimal, however, until FY 2010 or so, and it is not so large until FY 2015 or so, essentially because of a small proportion of newly awarded beneficiaries to total ones in the near future $ ^{4} $ .
The estimated real overpayment is ¥1.8 trillion, 0.4% of FY1999 GDP for FY 2010, ¥2.5 trillion, 0.5% of FY1999 GDP for FY 2011, ¥3.0 trillion, 0.6% of FY1999 GDP for FY 2012 and so on. The total real overpayment between FY 2000 and FY 2015 is estimated at ¥22.9 trillion in FY1999 prices, which is 4.6% of FY1999 GDP. This overpayment is due to the following two factors: 1) the fact per se that the actual provisional benefit level exceeds the permanent level, and, as a consequence, 2) non-activation of the automatic adjustment mechanism.

The overpayment in real terms is not confined until FY 2015. Based on our assumptions, the permanent benefit level will exceed the provisional level in FY 2015 and afterward, and so the actual benefit level is not the provisional level but the permanent level from FY 2015 onward. The difference in real terms between the actual permanent level and the level envisaged in the 2004 Reform is 5.8% in FY 2015. The difference will not narrow much until FY 2023, when the automatic adjustment was to be terminated in the 2004 Reform.

## (5) Sensitivity analysis

To check how sensitive these results are to our assumptions, we conducted a sensitivity analysis. Regarding the total amount of public pension benefits, we assume 2% annual growth from FY 2008 onward as a standard case. In addition to this case, a 3% growth case and a 4% growth case are also examined. On the nominal GDP growth rate from FY 2010 onward, a 1% growth case and a 3% growth case are also studied on top of the standard 2% growth case. The results of this sensitivity analysis are summarized in Table 3. The nominal overpayment between FY 2000 and FY 2015 as a percentage of nominal GDP does not change very much, with the lowest number being 2.09% and the highest being 2.23%. It is 2.12% in our standard case, with the 2% total pension benefit growth and the 2% nominal GDP growth.

[Table 3]

## (6) If inflation is lower than 1%

In the analysis above, we assumed 1% inflation from 2012 and onward. Based on our recent experience, however, the actual inflation rate may well turn out to be lower than