A numerical analysis of Japan’s fiscal sustainability in a simple OLG model

Abstract

We investigate the size of primary balance that can be sustained and the change in public debt and physical capital under transition dynamics in the Japanese economy. For our investigation, we construct a simple overlapping generations model. We find that a large primary surplus, 13.8–18.7% of GDP, is needed to prevent the public debt-to-GDP ratio from diverging infinitely. We also show that even if the large primary surplus can be maintained, the Japanese economy faces a sharp reduction in physical capital from 191 to 70.0% of GDP on the transition path.

Keywords:

• fiscal sustainability
• public debt
• crowd out
• fiscal policy

JEL Classification:

• E62
• H62
• H63

Acknowledgements

We thank the participants of the CAPS seminar at Kyoto University for their comments. We are grateful for the joint research project programme of KIER.

Notes

¹ The data source is OECD Outlook 93 database.

² There are a few exceptions. İmrohoroğlu and Sudo (2011) show that unprecedentedly high growth rates are necessary to reduce the public debt-to-GDP ratio. However, they take fiscal variables and payments of interest as exogenous variables and do not take into account general equilibrium effects, unlike in this study. Arai and Ueda (2013) investigate the maximum size of the primary deficit-to-GDP ratio that prevents the debt-to-GDP ratio from diverging, with consideration for general equilibrium effects. However, they derive only a necessary condition for fiscal sustainability because their analysis focuses on the steady state. This study complements the literature on quantitative investigation of sustainable fiscal policies.

³ The values of preference parameters used here are very similar to those adopted in simulations of Japanese economy (e.g. Chen et al., 2007; Braun et al., 2009).

⁴ We use the average values of capital income share, fixed capital depreciation and physical capital in 2000–2009 to calculate and . These values are obtained from the Japan’s SNA statistic account. The stock of physical capital is defined as the sum of corporate capital, noncorporate capital and (corporate and noncorporate) inventories. It also should be noted that δ = 1−(1−0.0888)⁴⁰ = 0.9758.

⁵ We target the yearly growth rate as 1.0%. Using n = 0, we obtain

(4)

⁶ The labour income tax and contribution rates are calculated by using the Japan’s SNA statistic account (the household’s secondary distribution of income account and the social security contributions). The capital income tax rate is set as in Arai and Ueda (2013). The Japan’s consumption tax rate is scheduled to rise to 10% in 2015.

⁷ After Japan’s government reduces the public debt sufficiently in the distant future, the government seems to increase public spending and/or cut tax rates. This fiscal relaxation leads to a higher public debt-to-GDP ratio and a lower capital-to-GDP ratio than those obtained in our calculation.