Appendix B: Simulation Analysis in an Aging Japan

Table of Contents:

B1 Introduction

Japan is an aging society, so it is important to control the increasing level of social- welfare expenditures in order to attain and sustain long-term fiscal balance in the government’s budget.

This advanced study examines the macroeconomic effects of fiscal and social security reforms on economic growth and intergenerational welfare in Japan, based on Ihori et al. (2005, 2011). The existing public health insurance and public pension schemes receive particular attention in the analysis. This is because payments from these programs, especially medical expenditures and the public pension, will increase rapidly in an aging Japan.

B2 The Model

The model employs multi-period overlapping-generations growth, developed by Auerbach and Kotlikoff (1983). The economy consists of household, firm, and government sectors. For simplicity, we assume that there is only one good.

Each household has a limited life expectancy, but its length is assumed to be uncertain. Namely, a household has a certain percentage chance of death in each period. A household earns a wage, obtains its utility from consumption, and is assumed to optimize its intertemporal consumption through its lifetime, taking the wage rate, the interest rate of savings, and its own survival rate as given. The tax system, the public pension scheme, and the public health insurance scheme are also assumed to be taken as given for the household sector. A household obtains its wage by supplying its labor inelastically until it retires; and once it retires, it never returns to the labor market. There are no altruistic bequest motives and Ricardian equivalence does not hold.

The firm is assumed to maximize profits, taking the wage rate and the interest rate as given. The wage rate and the interest rate are determined in each factor market with their equilibrium conditions.

Taxes, a public pension scheme, and a public health insurance scheme that reflect existing Japanese arrangements are incorporated in the model. The government sector collects taxes from the household. It also issues government bonds to finance its consumption and its transfers to a social security system. The government sector runs a pay-as-you-go public pension scheme and a public health insurance scheme. The government also accumulates a public pension fund from the contributions collected from working generations.

There is no private life insurance; thus, there is no mechanism for a household to hedge its risk of dying in any period. This risk means that a household has too few savings to consume goods sufficiently if it lives longer unexpectedly. Because a household does not have any bequest motives, a household leaves an accidental bequest in each period when it dies. There is certainty in the whole economy in terms of the population of each generation; thus, there is certainty about the total (aggregate) amount of bequests inherited in each period.

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