Section 2 Prospects for Economic Growth under Aging and Declining Population

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As we have seen in the previous section, due to the rapid advance in the declining birthrate and aging population, Japan's productive population has already begun decreasing after hitting a peak in 1995 and its total population is expected to begin decreasing after hitting a peak in 2006. Such a drastic change in population dynamics is expected to have the following major impacts on the Japanese economy and society.

First, it will affect economic growth. Due to a decrease in productive population caused by the declining birth rate, the contribution of labour input to economic growth is expected to decrease. Moreover, if the savings rate of the country as a whole decreases amid an increasing percentage of elderly people in the total population, the contribution of capital input to economic growth would also decrease. In this way, the aging and declining population may slow economic growth through slower growth of labour and capital, the major production factors that determine long-term economic growth.

Second, it will affect the public sector. A population decrease and an accompanying slowdown of economic growth may decrease tax revenues. In addition, the advance in the declining birthrate and aging population is expected to increase the percentage of social benefit-receiving generations to the generations still working, or the supporters of the social security system, and this would make the conditions of the social security system increasingly severe. The deterioration of the environment surrounding the fiscal and social security systems may dramatically decrease the sustainability of the public sector.

Third, the excessive rise in the ratio of national burden may further slow down economic growth, as it reduces the disposable income of households and corporations and discourages work and business investment.

In this section, we will examine the first impact-the impact on economic growth. The second and third impacts will be examined in Section 3.

1. Past Record of Japan's Economic Growth

Population growth rate and economic growth

A look at the long-term trend of Japan's real economic growth rate reveals that it has been on a downward trend, with the average growth rate posting 10.0% in the 1960s, 4.4% in the 1970s, 4.3% in the 1980s, and 1.3% in the 1990s (See Figure 3-2-1). Per-capita economic growth, as measured by the aggregative economic growth rate minus the population growth rate, has also been on a downward trend.

Generally speaking, when population increases, per-capita economic growth rate is lower than the aggregative economic growth rate. However, the gap between the two has narrowed recently due to the slowdown in population growth rate. If the population takes a downward turn, per-capita economic growth rate will be higher than the aggregative economic growth rate.

Figure 3-2-1 Changes in Economic Growth Rate and Per-Capita Economic Growth Rate

Decline in potential growth rate

Behind the downtrend of the economic growth rate has been a decline in the potential growth rate (economic growth rate that can be achieved without inflation by fully exploiting such factors as capital stock and labour force). A look at the changes in Japan's potential growth rate shows that the rate stood at above 4% during what was known as the bubble years of the late 1980s, but fell to slightly above 2% in the first half of the 1990s and to slightly above 1% in the second half. Japan's potential growth rate on average for 2001 and 2002 remained low at about 1% (See Figure 3-2-2).

The major factors that determine economic growth are generally believed to be (1) labour, (2) capital, and (3) total factor productivity (technological progress and human capital development, etc.). We will break down Japan's potential growth rate into contributions made by the three factors by using the growth accounting(30) method (See Figure 3-2-2). It shows that labour input made an average contribution of 0.5% in the 1980s but began to make a negative contribution in the 1990s. Most recently, its negative contribution stood at 0.5%. This is partly due to drops in working hours and a decrease in the number of potential workers caused by a rise in structural unemployment. It is also due to the fact that the slower growth and decrease in the number of productive population caused by the declining birthrate has already begun to have its effect.

Capital input has made a positive contribution, but this contribution has been falling year by year, from a contribution of 2% on average in the 1980s to 1.5% in the 1990s and mostly recently to 1%. The downtrend can be attributed to the fact that the growth of capital stock has slowed down, as corporations have refrained from business investment due to a decline in their expected growth rate.

As to the total factor productivity, although it made a 1.2% contribution in the 1980s and helped to sharply push up the potential growth rate, its contribution dropped to 0.7% in the 1990s and mostly recently to 0.6%.

As we have seen, Japan's potential growth rate has declined considerably in recent years. This can be partly attributed to the fact that the growth of capital stock and total factor productivity has slowed down due to a delay in shifting to an economic system responding to a new environment. If the Japanese economy is put on a sustainable growth path as a result of economic revitalization through structural reform, it will be possible to raise the potential growth rate.

Figure 3-2-2 Changes in Potential Growth Rate and Its Factor Decomposition

2. Economic Growth under Aging and Declining Population

Pessimism and optimism

Although it is possible to increase the contributions of capital stock and total factor productivity by economic revitalization through structural reforms, the aging and declining population may become restraining factors for economic growth in the middle and long run.

There are several points of contention with regard to the impacts of demographic changes on economic growth and there is both pessimism and optimism concerning the impact. The main points of contention and both the pessimism and optimism regarding them are briefly put in order below.

The first point of contention is concerning the size of population and economic growth. Other things being equal, the larger the size of the population of a country, the bigger the scale of the economy of the country as a whole, and the country's productivity is expected to increase due to the expansion of the scale of production of same products.(31) However, if the country's total population begins to decrease, the scale of its economy will also begin to shrink and the scale of the economy may lose its economic effect.

Against such concerns, one could contend that even if the population of well over 100 million decreased to a certain extent, the scale of the economy would not lose its economic effect. One could also argue that even if the economic scale shrinks due to the declining population, it would not become an issue if per-capita GDP, which is the basic indicator for judging the level of economic welfare, increases (See Column 3-2).

The second point of contention is concerning labour input and economic growth. If the population of the generations still working decreases by the falling birthrate, the labour force will decrease if the labour force participation rate is equal and the contribution of labour input to economic growth will be negative. Furthermore, if the average labour force participation rate declines due to a higher percentage of elderly people in the total population, it will further reduce labour input.

Against such concerns, one could argue that the decrease in labour force can be cancelled out to a certain extent, if, as we have examined in the previous section, we promote employment of women and elderly people whose skills are not fully exploited in spite of their desire to work, and utilize foreigners/immigrant workers.(32) Moreover, a decrease in labour force works to raise(33) the capital labour ratio (per-worker capital stock) and the total factor productivity can be increased through promotion of efficient production methods and technology advancement, etc. One could also argue that the labour shortage can be eased and the total factor productivity can be increased by shifting labour-intensive production to developing countries and promoting the transfer of domestic labour to knowledge- and technology-intensive fields.

The third point of contention is concerning capital input and economic growth. According to the life cycle hypothesis, since the aging population increases the percentage of people who dip into their savings as compared with the percentage of people who save their money, the average household savings rate will decline and this, in turn, will hamper capital stock accumulation through investment restraint caused by higher interest rates, resulting in economic growth being held down. If the investment-savings balance of the general government deteriorates due to an increase in social security-related expenditure caused by the aging of the population, the country's overall savings rate will decline and this may become a factor hampering economic growth.

Against such concerns, one could argue that elderly people do not necessarily dip into their savings as they have inheritance and other motives and that, therefore, it cannot be said outright that the progress in the aging of population will reduce the savings rate. Moreover, if the employment rates of elderly people and women rise, it would halt the downward trend of the savings rate. Furthermore, even if capital stock accumulation using domestic savings as the source backs up due to a decline in the national savings rate, the accumulation of capital stock would not be hampered if a smooth inflow of capital from abroad is secured.

The fourth point of contention is concerning technological advancement/human capital and economic growth. Generally speaking, young people are believed to be good at accepting and creating new technologies. However, with young labour force decreasing due to the declining birthrate and aging population, there is a worry that young people may find it increasingly difficult to display their creativity and positive attitude in the overall economy. Moreover, if the role of labour-intensive industries, such as medical and care services, increases in the economy, it would become necessary to increase the input of the scarce labour force and the growth of productivity of the entire economy may decline.

Against such concerns, one could argue that since human capital, such as knowledge, skill, and know-how, that individuals acquire and cultivate increases as they build up experience, the quality of labour force would increase in proportion to a rise in age up to a certain age. Therefore, we cannot categorically say that the economy's productivity will decrease due to the aging of the population. Moreover, as we described earlier, a decrease in labour force may promote labour-saving production methods and technical progress, and the progress in the declining birthrate may enhance the quality of human capital through an increase in per-capita education investment.

Implications obtained from cross-country data

As we have seen, since the aging and declining population affects economic growth through multiple routes that have mutually dependent relationships, it is important to examine which argument-pessimism or optimism-is more likely to become a reality and study the extent of both the positive and negative impacts caused by these factors. By comparing data from several countries that have different population growth rates and different degrees of progress in aging population, we will now examine the following three points of contention: (1) impact of a declining population on economic growth, (2) impact of a decline in productive population caused by declining birthrate on labour productivity, and (3) impact of the aging population on savings rate and capital accumulation.

Declining population and economic growth

In order to find clues as to the extent of the impact of the declining population on the economic growth rate, we will first take a look at the relationship between population growth rate and economic growth rate during the period from 1971 to 2001 in OECD countries (See Figure 3-2-3). It shows a loose positive correlation between population growth and economic growth. This is the logical result of a population increase that expands an economy's supply capability through increased labour input. The result suggests that, other things being equal, if population growth slows down, or if population decreases, the growth rate of the overall economy is also likely to slow down, or the economy is likely to post negative growth.

At the same time, however, individual countries' deviations from the overall trend line are relatively large, suggesting that population growth is a key determinant of economic growth in any country but that other fundamental economic conditions, including capital stock, technological levels and human capital, are also important.

A study of the relationship between population growth and per-capita economic growth in the same sample shows that there is no positive correlation between them as a whole (See Figure 3-2-3). This indicates that per-capita GDP growth has no correlation with population growth and that per-capita GDP growth is determined by other fundamental economic conditions.

Figure 3-2-3 Relations between Population Growth Rate and Economic Growth Rate

Declining birthrate and labour productivity

In order to maintain economic growth amid declining population, it is important to increase per-capita productivity by enhancing fundamental economic conditions other than population. Since the productive population is decreasing faster than total population amid declining birthrate and aging population, it is particularly important to enhance labour productivity (productivity per employed person).

In that case, what relationship is there between employment growth and labour productivity growth? A study of the relationship between employment growth and labour productivity growth in OECD countries shows that there is a loose negative correlation between them. This means that as employment growth decelerates, or as employment declines, labour productivity growth accelerates (See Figure 3-2-4 (1)). As a general rule, labour productivity growth can be divided into the portion stemming from increasing capital stock per worker and from technology advancement and human capital development, etc.(34) Accordingly, we will divide labour productivity growth into a capital labour ratio rise and total factor productivity growth and see the relationship between the growth of the two and employment growth.(35)

There is a relatively clear negative correlation between capital labour ratio rise and employment growth (See Figure 3-2-4 (2)). This is due to the fact that capital stock per worker increases while employment growth slows down or decreases. This is believed to help increase labour productivity.

There is also a loose negative correlation between total factor productivity growth and employment growth, indicating that the lower the growth rate of employment, the higher the growth of total factor productivity (See Figure 3-2-4 (3)). This suggests that declining birthrate and slowdown/decrease of employment may increase total factor productivity through efficient production methods and technology advancement or through human capital development stemming from a rise in per-capita education investment.

Figure 3-2-4 (1) Relation between Employment Growth Rate and Labour Productivity Growth Rate

Figure 3-2-4 (2) Relation between Employment Growth Rate and Capital Labour Ratio Growth Rate

Figure 3-2-4 (3) Relation between Employment Growth Rate and Total Factor Productivity Growth Rate

Aging population and savings rate, capital inflow

In order to sustain economic growth, it is important to accumulate high quality capital stock and enhance total factor productivity. Savings of a country as a whole (national savings) and capital inflow from abroad are the sources for the accumulation of capital stock. What relationship is there between aging population and national savings rate? We will now look at time-series relations between declining birthrate/aging population and national savings rate in major advanced countries by using the share of the population made up by the elderly as an indicator of the progress of aging. Although there are some irregular movements caused by business fluctuations, etc., it shows that there is a loose downward-sloping correlation between the two. We can see from this that a declining birthrate and aging population reduce the national savings rate (See Figure 3-2-5).

A study of Japan's savings-investment balance shows that Japan posted a savings excess, as the household sector's savings rate, which is extremely high by international standards, more than offset the investment excess of the corporate and government sectors, allowing Japan to continue to post a huge current account surplus. In recent years, however, the margin of saving excess of the household sector, which had contributed greatly to Japan's saving excess, has been on a decreasing trend(36) (See Figure 3-2-6). In the circumstances, if the savings rate of the household sector decreases further due to the progress of population aging, and if the margin of government sector investment excess expands further due to an increase in expenditure for social security benefits, etc., the accumulation of capital stock would be hampered and the nation's economic growth would decline, as long as the country's savings alone remain the main financial source for business investment.

Figure 3-2-5 Relation between Elderly Population Ratio and National Saving Rate

Figure 3-2-6 Changes in Savings-Investment Balance Classified by Institutional Sectors

Hence, is it possible to make up for a domestic savings shortage by capital inflow from abroad? If the movement of international capital is completely free, there should be no correlation between domestic savings and investment. This is because countries' savings respond to investment opportunities around the world and because countries' investment can be financed by savings around the world. However, Feldstein-Horioka (1980) demonstrated in their analysis of savings rates and investment rates in OECD countries that there is a clear positive correlation between the two, asserting that, even after international capital movement is liberalized, the increments of a country's savings tend to be used for domestic investment due to lack of information on overseas investment, uncertainties, and other reasons(37) (See Appended Table 3-2 (1)).

Feldstein-Horioka's analysis was made shortly after the liberalization of international capital movement began in earnest in the 1970s. Does Feldstein-Horioka's hypothesis still hold good? In order to study this, we conducted the same analysis as Feldstein-Horioka did by using data obtained thereafter. We found that the value of savings rate's coefficient to fluctuations of the investment rate stands far below 1 and is moving downward (See Appended Table 3-2 (2)). This trend becomes more evident if the estimation is made with a panel analysis which is believed to be a better statistical method than the estimation method used by Feldstein and Horioka (See Appended Table 3-2 (3)).

The estimate results suggest that the kind of constraints on international capital mobility that Feldstein and Horioka claimed to exist have been eased in recent years and that an environment to induce the inflow of foreign capital in case of a shortage of domestic savings has been established.(38)

The above results show an overall trend in the OECD countries as a whole. The question is if Japan's situation allows investment by using foreign capital inflow, independently of its domestic savings. In order to study it, we estimated the relation between time-series fluctuations between the investment rate and the savings rate in five countries-Japan, the U.S., the U.K., France, and Germany. We found that the impact of the savings rate on the fluctuations of the investment rate is small and less convincing in the U.S., the U.K. and France but it is large and more convincing in Japan and Germany (See Appended Table 3-3).

In fact, the long-term relation between the savings rate and investment rate in Japan has been moving almost parallel to each other, except for in the 1980s, when direct foreign investment, mainly in the United States, increased against the background of the huge current account surplus. In particular, the investment rate has been declining since the 1990s in line with the decline in the savings rate caused by the sluggish national income and aging population, etc (See Figure 3-2-7).

In sum, the investment trend in Japan shows a marked tendency to be determined by the trend of domestic savings. If this structure is maintained, it would become difficult to maintain the high level of investment rate amid the mid- and long-term decline in national savings rate caused by the aging of the population. Japan must become a more attractive investment target for foreign countries in order to promote capital inflow into Japan by enhancing the return on investment through economic revitalization and by removing various barriers to capital inflow (See Column 3-3).

Figure 3-2-7 Changes in Japan's Savings Rate and Investment Rate

Strategy for sustainable economic growth under aging and declining population

Since population growth is related to overall economic growth, other things being equal, overall economic growth will inevitably decline if population growth decelerates or if population decreases. As to what specific degree of growth we can expect, growth depends on many factors, including demographic change, labour force participation rate of women and elderly people, domestic savings rate and availability of foreign savings, and trend of total factor productivity. Moreover, the impact of aging and declining population on economic growth is by no means final. Its negative impacts can be cancelled out by making proactive efforts toward economic revitalization.

As for the measures that should be taken to revitalize the economy, they are discussed in detail in the Annual Report on the Japanese Economy and Public Finance 2001-2002. To recap on the main points, first of all, Japan must drastically dispose of non-performing loans, or the "negative legacy" of the past, in order to break free of the prolonged recession and put the economy back on a sustainable recovery path, and increase productivity through structural reform in order to bring about a vibrant economy. Specifically, the labour force, management resources, and capital that have been fixed to low-productivity sectors should be reallocated to higher productivity sectors by expanding private sector's business areas through regulatory reform, etc. and by accelerating the disposal of non-performing loans.

Since labour force is expected to become scarce in the medium and long terms due to growth restraining factors, such as a decrease in production age population and a decline in savings rate, the basic strategy should be boosting labour productivity as well as the labour force participation rates of women and elderly people.

Labour productivity can be enhanced to some extent by a rise in capital labour ratio stemming from the decreasing population and by growth of total factor productivity. However, it is important for Japan to boost labour productivity with such policy measures as the accumulation of capital stock, technological innovation through revitalization of research and development investment, and human capital development through education investment. A rise in the percentage of elderly people stemming from the declining birthrate and aging population may reduce the macro savings rate, thus hampering capital accumulation. Since Japan holds abundant financial assets and net external assets that it accumulated in the past, it is inconceivable that Japan would become unable to raise the financial resources necessary for business investment. Still, it is necessary for Japan to establish an environment that would facilitate smooth flow of capital from abroad in the long run.

As a result of taking the measures mentioned above, if labour productivity growth can be maintained when the overall economic growth rate declines, it is possible to maintain positive per-capita economic growth, and if a rise in labour productivity brought about by the growth of total factor productivity is faster than a decrease in the number of workers, it is possible to maintain positive growth of the overall economy even under declining population. As has just been outlined, the extent of the economic growth that can be achieved under an aging and declining population depends largely on future policy efforts.

3. Economic Growth Simulation Using Macroeconomic Models

Outline of simulation

Since economic growth under the aging and declining population is determined by many factors, we can discuss anticipated economic growth only in general terms. However, we believe it to be instructive to discuss, in quantitative terms as much as possible, to what extent the aging and declining population will lower the economic growth rate and to what extent policy efforts can offset a growth rate decline.

We will now simulate long-term economic growth by using macroeconomic models based on the assumption of certain conditions of population and economic movements.(40) Specifically, we first study to what extent factors, such as a decline in labour force stemming from the aging and declining population, will lower economic growth. Then, we assume, as measures to offset the negative effects that aging and declining population would bring about, (1) enhancing the labour force participation rate, especially for women and elderly people, (2) increasing the future labour force by raising the birthrate, and (3) enhancing total factor productivity through progress in structural reform and technological advancement, etc., and study the extent of their effectiveness on economic growth when we changed them based on certain premises.(41)(42) However, we must keep in mind that simulation results should be interpreted broadly, as they vary depending on how we assume various premises used in the simulation, such as formulation of the macroeconomic model, population dynamics, economic conditions and policy measures.

The "Baseline Scenario," which serves as the starting point of the simulations, is the results of the simulation under the following premises. For population, we use the "median variant projection" in the "population projections for Japan." As for labour force participation rate by age group and gender, for aged men and women, we use the values determined endogenously by the model under certain premises, and for men in other age groups, we assume that the level of labour force participation rate in fiscal 2001 will remain constant.(43) As for total factor productivity, we assume that productivity will rise 0.8% every year, the rate estimated by the model based on the latest actual achievement data.(44) The "Baseline Scenario" can be said to be the status quo scenario in that the growth of the labour force participation rate and the total factor productivity are based on the economic environment and the policy premises extended from the status quo.

As an alternative scenario, we consider the "Economic Vitalization Scenario." Under this scenario, we assume that the labour force participation rate (potential labour force participation rate) in the case of people wishing to work, mainly women and elderly people, entering the labour force will be achieved in fiscal 2050 and that the total factor productivity will rise to 1.4% (0.6 percentage point higher than in the Baseline Scenario), the average growth rate in the 1980s, thanks to the progress in structural reform and technological advancement, etc.

We also study the impacts on future economic growth of the demographic change stemming from the birthrate, although they are different in nature from the above economic invigoration effects. To this end, we consider a case in which the birthrate rises (high variant projection) under the Economic Vitalization Scenario and a case in which the birthrate declines (low variant projection) under the Baseline Scenario.

Simulation results

(1) Baseline Scenario

The (real) economic growth rate in the Baseline Scenario is low, with the average growth rate for each 10-year period after fiscal 2011 ranging from 0.2% to 0.4% (See Figure 3-2-8). Reflecting a decrease in productive age population, the negative contribution of labour input lowers the economic growth rate by 0.7 to 0.9 percentage point. The declining population will affect labour input and substantially lower economic growth over the next several decades.

On the other hand, the exogenously given total factor productivity makes a positive contribution. In addition, private capital stock makes a positive contribution of about 0.4-0.5 percentage point to economic growth for each period. However, the contribution decreases slightly in the second half of the forecast period in line with a decline in the savings rate.

Incidentally, in the median variant projection, since total population decreases 0.2-0.8% during the period, per-capita economic growth rises 0.5-1.1% (See Figure 3-2-8).

Figure 3-2-8 Changes in Real Economic Growth Rate (Baseline Scenario)

(2) Economic Vitalization Scenario

The (real) economic growth rate in the Economic Vitalization Scenario averages 1.4-1.6% for each 10-year period after fiscal 2011, more than 1 percentage point higher than in the Baseline Scenario (See Figure 3-2-9). As a result, per-capita economic growth rate is higher at around 1.7-2.2%.

A higher labour force participation rate raises economic growth by 0.2 to 0.5 percentage point, mainly due to higher contribution by labour input (See Appended Table 3-4). In contrast, progress in structural reform and a total factor productivity rise of 0.6% will boost economic growth by 0.8 to 0.9 point. This is due to the effect of a rise in total factor productivity and due to the fact that economic vitalization promotes labour supply and accumulation of private capital stock.

(3) Impact of Birthrate Change

The case of a rise in birthrate under the Economic Vitalization Scenario shows the ceiling of the economic growth rate that can be achieved under the premises of this simulation. The average economic growth rate in such a case comes to 1.5-1.7% for each 10-year period after fiscal 2011. A rise in the birthrate raises economic growth in the latter half of the forecast period by 0.2-0.3 points over the Economic Vitalization Scenario (See Figure 3-2-9).

On the other hand, the case of a decrease in birthrate under the Economic Vitalization Scenario shows the bottom of the economic growth under the premises of this simulation. Although the average economic growth rate in such a case will remain in the positive territory in the first half of the forecast period, it will fall to 0.0-0.1% negative growth in the latter half. A decline in the birthrate will lower economic growth by 0.3 to 0.4 point in the latter half of the forecast period.

Figure 3-2-9 Real Economic Growth Rate by Scenarios

Summary

As the above simulation results show, other things being equal, a decline in the birthrate lowers the potential economic growth rate, as labour input makes a large negative contribution to economic growth under the aging and declining population. If total factor productivity remains at a low level due to lack of progress in structural reform, or if the birthrate drops faster than expected, the economy is likely to post negative growth.

The results also show that there is a gap of about 1-2 percentage-points in the economic growth rate between the higher growth case and the lower growth case throughout the forecast period, indicating that economic growth is determined by many factors, including birthrate, the labour force participation rate of women and elderly people, and total factor productivity. Economic invigoration through increasing the labour force participation rate, especially for women and elderly people, and through the enhancement of total factor productivity stemming from progress in structural reform and technological advancement will have the effect of boosting the future economic growth path. Furthermore, a rise in the birthrate, which influences growth in the latter half of the forecast period, has the effect of boosting economic growth for a long time.

Establishing an environment where people who wish to work can work and where women who wish to have children can bear and raise children at peace is in itself an important policy objective. Establishing such an environment is also effective from the standpoint of boosting economic growth. Even if the labour force decreases in line with the progress of the aging and declining population, its negative effects can be largely cancelled out if total factor productivity recovers to the growth level posted in the 1980s through progress in structural reform and technological advancement and through human capital development through education investment. In order to maintain economic growth even under the aging and declining population, Japan should adopt a comprehensive policy to enable these factors make positive contributions to growth.

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