Section 1 Demographic Change and its Economic Significance

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The arrival of FY2007 in two years will mark a turning point for Japan. It will represent the first fiscal year after the end of the "Concentrated Consolidation Period," which aims at building a new economic base. At the same time, according to the population projection, Japan's overall population will begin to decline for the first time since the end of World War II. Also, the first baby boomer generation (known in Japan as the "Dankai generation"(1)) born after the end of the war will reach the mandatory retirement age of 60. Since the end of the war, the "Dankai generation" has shaped trends in the Japanese economy not only owing to the size of the population, but also with regard to consumption and savings activity, housing acquisition, and employment, etc. The retirement of this baby boomer generation will bring major changes concerning both the state of the economy from the perspective of households and the behavior of corporate sector relating to appropriate schemes for employment and retirement benefits. These demographic changes will also once again bring to the surface the issue of maintaining economic vitality through the improvement of productivity. This chapter adopts the year "2007" as its keyword and discusses demographic change over the next few years and well into the future in Section 1. From Section 2 onwards, issues concerning policy administration will be illuminated through in-depth analysis of the following questions:

Will there be a further shift in consumption structure to services due to the aging of the Dankai generation? Will change of residence after their retirement and housing acquisition by second-generation baby boomers (referred to here as the "Dankai Jr. generation") induce a change to the pattern of housing demand? (Section 2)

Will aging of the population lead to a further decline in the macro savings rate, sending it down, for instance, below 0% in the near future? How will the financial asset portfolio of households change? How will this affect financial markets? (Section 2)

Since the Dankai generation has heretofore been a factor placing upward pressure on labor costs, has it dampened the youth employment of young people? As the retirement of this generation approaches, are signs of increased employment of new graduates coming into view? (Section 3)

While it is expected that the retirement of the Dankai generation will cause a decline in total labor costs, it could also lead to an increase in retirement benefits, putting a negative impact on corporate profits. Therefore, what issues need to be addressed concerning retirement benefit plans, particularly corporate pension plans? (Section 3)

From the perspective of maintaining, amid a declining population, competitiveness on a macro economic and individual company base, what issues need to be addressed, such as spurring innovation and securing talented technical and research personnel, for the aim of improving productivity, including the service sector? (Section 4)

Section 1 Demographic Change and its Economic Significance

Total population to decline after 2007

This section will begin with an overview of trends in Japan's population. First of all, Japan's total population has been marked by a declining birthrate which began with the drop in the replacement level of the total fertility rate to below 2.11 in 1974 following the birth of the children of the first generation of post-war baby boomers (those born between 1947 and 1949, the so-called "Dankai generation") to form the second-generation baby boomers (those born between 1971 and 1974, referred to here as the "Dankai Jr. generation"). According to future population estimates, as the birthrate declines, deaths will exceed births in 2006 (the beginning of natural decrease in population) and total population, which in the post-war era has never experienced a single decline, is expected to peak in 2006 and begin to decline. Although a decline in population or a downturn in the population growth rate is also expected in other industrialized countries as well, Japan's population will turn downward the earliest and decline at the sharpest rate (Figure 3-1-1)

Figure 3-1-1 Trends in Japan's total population, births and deaths, and the rate of change in population in industrialized countries

Expansion of interregional disparities in population

Second, looking at demographic change by region in Japan, it can be observed that population continues on a trend toward an inflow into central urban areas, partially due to the decline in land prices. Although population continues to increase in Tokyo and other metropolitan areas, as well as in Okinawa where the birthrate is high, population has already reached a peak in other regions (Hokkaido, Tohoku, Hokuriku, Chugoku, Shikoku, and Kyushu). As the population continues to decline, interregional disparities in population are expected to expand (Figure 3-1-2). Within the Tokyo metropolitan area, where the influx of population is relatively high, the population growth rate in the 23 wards of Tokyo exceeds the overall average (Appended Figure 3-1) and, as seen in the increase in apartment construction starts in downtown areas, the trend toward a return of population to city center areas is continuing. However, the population decline in the regional areas could moderate to a lesser extent than currently predicted primarily due to the following recent trends: (1) the "U-turn ratio," which represents the percentage of people who have returned to their prefecture of birth to reside after having relocated elsewhere, is increasing, and (2) the number of people considering a move from large metropolitan areas to smaller municipalities is also increasing to a greater extent than the reverse population flow, and the group of elderly males, including the Dankai generation, is considering relocating upon mandatory retirement.(2)

Figure 3-1-2 Trends in Population by Regional Block

Households shrinking in size and increasing in number for the time being

Third, looking at the number of households, it is seen that while the number of members of private households is, like the total population, expected to reach a peak in around 2005, the average number of persons per household will continue to decline moderately due to the increase in single households and households consisting of husband and wife only, which reflects declining birth rates and aging of the population. It is expected that the number of private households will increase moderately from 46.78 million in 2000 to the forecasted peak of 50.48 million in 2015 (Figure 3-1-3). A comparison of household trends in Japan with trends in other countries shows that as of 2000, the average number of persons per household in Japan was relatively large, as it currently is in the United States and Canada, etc., and the percentage of households with a single member was relatively low. However, like many European countries at present, the average number of persons per household is expected to decline in the future (i.e. single households will increase).

Figure 3-1-3 Trends in the number of households and the average number of persons per household

Aging of population pushing Dankai generation toward 60s

In 2007, the total population will begin to decline and the first Dankai generation will reach the current standard mandatory retirement age of 60, marking another important juncture in Japan's demography. Looking at the size of the Dankai generation, as of 2004, the population of the generation, i.e. people between 55 and 57, was 6.8 million (5.3% of the total population), and the number of employed persons (including self-employed) within this population was 5 million (or 8% of the total number of people employed). Thus, this generation constitutes a particularly large "bulge" in Japan's population (Figure 3-1-4).

Figure 3-1-4 Population distribution of Japan (2004)

After 2012, when the Dankai generation enters the 65 and older age group, Japan will become a truly aged society. The population of people in their productive years between 15 and 64 already started to decline in 1995 due to declining birth rates and aging of the population until today, but from 2012, it is expected that the Dankai generation will reach old age and the decline in the population of people in their productive years will quicken. (Appended Figure 3-2).

Sharp increase in the burden shouldered by the current working generation seen from the viewpoint of consumption needs

The discussion will now turn to the trend in the dependent population ratio seen from population trends by age group. The dependent population ratio is the percentage of the total population accounted for by the population of people under 14 and over 65, and is one of the indicators that show the burden of the current working population. This ratio turned upward in the middle of the 1990s and is expected to continue rising from now.

The dependent population ratio as given here simply represents a percentage calculated from the population composition ratio. However, to use this ratio as an index to gauge the sense of economic burden felt by the current working population, it is also necessary to take into account the dependent population ratio weighted in terms of the consumption needs of the population of each age group (referred to as the "dependent population ratio of the consumption base").(3) To compute the dependent population ratio of the consumption base, consumption needs relating to the educational costs and medical costs transferred in kind from the government sector are included. The higher this ratio becomes, the heavier the economic burden the current working generation, seen as the population in the productive years, must shoulder to support the elderly and children. Although the dependent population ratio of the consumption base is low compared with the dependent population ratio of the population base, it is projected to increase more rapidly reflecting declining birth rates and increase in population of elderly whose consumption needs are high. (Figure 3-1-5). Particularly if the dependent population ratio is calculated in terms of medical benefits costs, the ratio will increase rapidly over about the next 15 years with the advancing age of the Dankai generation and most likely will push up the consumption base.

Figure 3-1-5 Dependent population ratio of the consumption base

Decline in labor force due to aging of the population

After 2007, the segment of the population occupied by the Dankai generation will enter the age group whose labor force participation ratio is relatively low, which will contribute to the contraction of the labor force population of the economy as a whole. To take a simple case, if the change in the labor force population from now is calculated assuming that the labor force ratio by age group in 2004 is maintained (standard case), the labor force ratio and the labor force population will decline, respectively, from 60.4% and 66.42 million in 2004 to 58.5% and about 64.60 million in 2010 (a decline of about 1.8 million in five years) and to 56.8% and about 62.60 million in 2015 (a decline of about 3.8 million in ten years) (Figure 3-1-6). To take an extreme case of a decline in the labor force ratio of the elderly group, assuming that by 2030 the labor force ratio of Japan's elderly group contracts to the same level as the current average of industrialized countries, the labor force population will decline to nearly 60 million by 2015 (case of contraction). However, if the labor market is improved to allow diverse modes of work through measures by companies to cope with the labor force shortage, the labor force ratio of the elderly group could increase to some extent.(4)

Figure 3-1-6 The labor force population and labor force ratio of Japan

The decline in the labor force population means that one of the sources of economic growth will shrink. It would be instructive at this point to compare Japan's situation with that of other industrialized countries concerning the trend toward declining birth rates and aging of the population. Although the baby boom phenomenon occurred in other industrialized countries as well following World War II, the characteristics of the baby boom in Japan differed somewhat, particularly in comparison with the United States, in that the period of the baby boom was comparatively short and the population, once the baby boom was over, experienced a relatively sharp decline (in other words, the peakedness of the boom was strong) (Figure 3-1-7). For this reason, the decline in the proportion of the population of those in their productive years and the increase in the proportion of the population of those 65 and older will come earlier and more suddenly along with the declining birth rates compared with other countries. Therefore, even though the labor force ratio of the elderly group in Japan is high compared with other industrialized countries, it is expected that the labor force population will decline relatively quickly and by a greater extent because of the magnitude of the population factor represented by the aging of the Dankai generation.

Figure 3-1-7 Population distribution and labor force population in other countries

Dankai Jr. generation will constitute the core generation

A major trend that can be identified in the developments described above is that the post-war baby boomer generation (Dankai generation) will shift from an era in which it constituted the core of the current labor force to an era of diverse post-retirement modes of living while the generation of children of the baby boomer generation (Dankai Jr. generation) will form the core of the current working generation. From a population viewpoint, the Dankai Jr. generation accounts for 6.2% of the total population (as of 2004) and constitutes a second demographic "bulge" on par with the Dankai generation.

In comparing this Dankai Jr. generation with the second baby boom generation of other industrialized countries, it is difficult to identify distinct points in common because, as mentioned above, the length and scale of the post-war baby boom differed between industrialized countries. The second baby boom generation in the US (the generation born between the later half of the 1970s and the mid-1990s) is called Generation Y and constitutes a population segment that is regarded as particularly important to marketing strategies. Comparing Japan's population distribution with that of the US, the second baby boom, like the first, also commenced slightly earlier in Japan and the period was relatively short (i.e. peakedness was strong). (Appended Figure 3-3). Hence, in Japan, the young age group's proportion of the population will rapidly fall due to the effect of declining birth rates and, accordingly, the "bulge" represented by the Dankai Jr. generation seems to be large in relative terms. Nevertheless, at least from the point of view of its size, the economic impact of this generation will not be insignificant.

First, because women of the Dankai Jr. generation. are positioned in the hollow of the M-shaped labor force ratio curve represented by people from 30-34 because of the recent trend toward later marriage, the negative contribution of this generation to the decline in the labor force ratio and the labor force population has been growing since the beginning of the 2000s (Figure 3-1-8). However, because those women will enter the age group whose labor force ratio is relatively high, the labor force of this generation will probably have a certain supporting effect, despite the decline in the total labor population.

Figure 3-1-8 Changes in the labor force ratio and population composition by gender and age

Second, an analysis of the composition of households by age of head of household reveals that the demographic impact of the Dankai generation and the Dankai Jr. generation has been strong, and as of 2005, the composition of households by age of head of household had two peaks, one at 55-59 and another at 30-34, which includes the Dankai Jr. generation (Appended figure 3-4). This bi-modal composition of households will be maintained over the long term. Nevertheless, the weight of Dankai households relative to total households will shrink due to the increase in dependents among this generation. However, as members of the Dankai Jr. generation grow older, they will become the heads of households and their weight relative to total households will increase. As will be described in a later section, the role of the Dankai Jr. generation in economic activity will expand in the future not only due to the increase in households headed by this group, but also because the 30-40 age group has relatively higher incomes and supports consumption and savings activity, and further, will soon reach the age of housing acquisition.

Relationship between the population decline and aging of the population and per-capita added value

From 2007, the labor force population will decrease because of the decline of the total population and the large number of retirees to appear from the aging of the Dankai generation. Assuming that there is no major change in the trend of working hours, the decline in the labor force will have a negative impact on economic growth through the reduction of potential labor input. On the other hand, the per-capita capital stock (capital equipment ratio) will increase under the condition that capital stock per se will not be affected, and if so, consequently, the decline in the labor force population will work in the direction of an increase in per-capita added value (labor productivity). If the decline in the labor force has the effect of spurring innovation in labor-saving technology, it will lead to an even further increase in per-capita added value.

A time series analysis of the relationship between Japan's labor productivity growth rate and the rate of change in the labor force population yields interesting results. For one, the analysis cannot confirm that there is a negative relationship between rises in productivity and population declines. Particularly since 1988, as the labor force population shifted from low growth to a decline, labor productivity growth has slowed moderately (Figure 3-1-9). However, taking an example from the US, a negative relationship is found to exist, and it was confirmed that, since 1975, downturns in labor population growth rate are associated with rises in the labor productivity growth rate. Looking at this relationship since the 1990s in the OECD countries (although it should be noted that variation in each of these countries is not small) in countries like Sweden, where there has been a decline in the labor force population, and in countries whose labor force population growth rate is low, the labor productivity growth rate has been relatively high (Appended Figure 3-5). Amid these trends, Japan has been positioned in the lower range of the trend line, and compared with the average of other countries, Japan has not achieved productivity growth commensurate with the population fluctuation rate. These facts suggest that the long-term slump in the economy in the 1990s, as described in Chapter 1, has generated factors apart from demographic trends that have worked to keep labor productivity low, such as slow progress in technological innovation and inefficient allocation of production factors; consequently, alarms are sounding that as Japan's population continues to decline, a corresponding increase in labor productivity will not necessary arise unconditionally.

Figure 3-1-9 Relationship between the labor productivity growth rate and the rate of increase in the labor force population in Japan and the United States

The labor force taking quality of labor into account to increase with popularity of higher education

With the expected decline in the labor force population, sustaining this higher productivity as a source of economic growth will require not only improvements in productivity through innovation, as will be described in Section 4, but also efforts to maintain the quality of the labor force.(5) In order to ascertain these changes in quality of labor (accumulation of human capital) quantitatively, it is useful to look at trends in the Divisia Labor Index trend (Figure 3-1-10). The Divisia Labor Index is an index which examines the degree to which the labor force, taking quality of labor into account, varies due to changes in the composition of workers. It is based on the assumption that wages actually paid reflect differences in the quality of workers by attribute (i.e. productivity), which itself is predicated on other assumptions: (1) that the quality of workers differs by gender, age, educational history and number of continuous years of service and (2) that the labor market is perfect.(6) Calculated values of the Divisia Labor Index show that although growth in the number of people employed is stagnant, the Divisia Labor Index is increasing. In other words, increases in the Divisia Labor Index underpin corresponding improvements in labor quality. These improvements in quality are affected by factors including the age effect and the continuous years of service effect, whose contributions have been maintained at a high level since the latter half of the 1990s due to the increase in the labor force of the comparatively high-age group whose wages are high, and the education effect whose contribution has been gradually increasing because of the trend toward the popularization of higher education in the labor force.

Figure 3-1-10 Divisia Labor Index and trends in the number of people employed

These changes in the quality of labor can be explained in closer detail by the perspective that they are attributable to the "demographic wave." A characteristic of the Dankai generation is that while its population of employed people is large compared with the generations preceding and following it, the proportion of college graduates in this population is relatively low, reflecting the high degree of competition for university admission. It has been pointed out that this fact may possibly have raised the relative value, or, in other words, the wages, of the workers who are college graduates in this generation.(7) If this effect is large, then, presumably, this generation has contributed to the high growth of the Divisia Labor Index from the 1980s to the 1990s, reflecting the increase in the labor force participation rate as this generation passed from youth into the prime years, the accumulation of continuous years of service under the long-term employment system and relatively high wages. On the other hand, the Dankai generation has been off the peak of wage profile since 2000, and this trend could be working to depress growth of the Divisia Labor Index. Moreover, the Dankai Jr. generation began to participate in the labor market mainly in the first half of the 1990s and this "return to youth" in the labor force composition has resulted in a decline in the age effect and the continuous years of service effect, contributing to slow growth in "quality." However, the Dankai Jr. generation has passed into a more mature age level in recent years and should contribute to an increase in the index.

Possibility of a decline in labor quality

The discussion will now turn to an examination, from a number of perspectives, of how the Divisia Labor Index can be expected to change from now.(8) First, wages by labor attribute are strongly affected by the nature of employment practices, such as the structure of the wage curve and changes in the number of years of continuous service. Generally speaking, however, the labor force composition will grow older because of the passing of the Dankai Jr. generation into the prime years amid declining birth rates, and this will probably continue to push up the index. Second, if the flattening-out of wages continues along with the expansion of the labor market for job-changers and the decline in long-term employment, it is possible, on the other hand, that the increase in the quality of labor will taper off or decline. Third, growth in education and training costs as a percentage of companies' welfare expenses not stipulated by law are relatively leveling off with the increase in retirement benefits costs due to the aging of employees and the increase in welfare expenses stipulated by law through the hike in social insurance premiums, and thus it is difficult to expect that in-house company training will lead to an increase in labor quality as in the past. Fourth, as will be discussed later, the rise in university advancement rate is producing more highly educated workers, but unless the quality of education is maintained, this higher educational level will not necessarily contribute positively to labor quality.

In the future, it is expected that the labor force population will decline due to the retirement of workers in the Dankai generation and declining birth rates. In this circumstance, to realize an increase in labor productivity, the following elements are essential: (1) labor quality must be maintained by improving the quality of higher education and adult education and by securing technical and research personnel, (2) innovative development, including innovation in the service sector, must be promoted and the results achieved through these innovations must be used effectively.

Relative growth of per-capita social stock in the population decline and the aging

The discussion will now turn to an often-mentioned subject, the effect of the decline in population on per-capita stock. This effect can be analyzed from various angles, not only from per-capita value added and national land area, but also from social capital stock such as housing area, housing stock, and easing of traffic congestion, as well as from other capital stock such as universities and other school education facilities and financial assets. The population decline will generally result in a rise in the per-capita scale of both flow and stock side. And there will be some excessive stock relative to population size and composition. This point is discussed below from various points of view.(9)

First, with regard to housing stock, a look at the long-term trend in housing starts reveals that up to the first half of the 1970s, when the Dankai generation reached their late-20s and began to start independent households of their own, housing starts climbed steeply. Afterward, housing starts leveled off, despite a temporary phase of lively growth due to trends such as the rental housing boom in the bubble era. (Figure 3-1-11). Housing stock is now continuing on a moderate uptrend reflecting the trend in the number of housing starts and number of households. Although for the time being it is expected that the number of households will continue to increase, the current level of housing stock has already exceeded by 10% the number of households to be reached in 2015, the projected peak year. Therefore, as the rate of increase in the number of households gradually declines, the quantitative increase in housing stock through an increase in new housing starts as seen up to the present is unlikely. Rather, the challenges to be met from now are improving the quality of housing stock and using the stock effectively. On the other hand, it can be thought that housing demand will probably grow to some extent over the medium term as Dankai Jr. generation enters the age of housing acquisition, although demand could also be affected by the trend in the inheritance of housing assets from the parent generation.

Figure 3-1-11 Long-term trend in housing starts and rate of increase in the number of households

Second, with regard to the financial assets held by households, the long-term slump in stock prices and the narrowing of the flow of financial transactions that followed the collapse of the bubble economy sent the financial asset balance downward. However, in FY2003, the balance rebounded with the rally in stock prices, and in FY2004 reached 1,416 trillion yen (Figure 3-1-12). A close examination of net financial assets by age group reveals that, unlike in the United States, for example, the amount of holdings tends to rise with age, and that the older people become, the larger is the weight of risk assets such as stocks and stock investment trusts. Assuming that this age-related trend in financial assets continues, population factors alone, such as the entry of the Dankai generation into the elderly group, can be expected to spur an increase in stocks and other financial assets of about 0.3% annually up to around 2015, when the number of households peaks.(10) On the other hand, with the downtrend in savings rates due to aging of the population, a crucial challenge to be met will be to make use of financial stock effectively by promoting a shift "from savings to investment."

Figure 3-1-12 Trends in private financial assets

Improving the quality of education as required by the "era in which everybody goes to college"

Third, with regard to school education facilities, the decline in birthrates will lead to a large reduction in the number of incoming students per school unless the current number of schools including elementary schools, junior high schools, high schools, universities and two-year colleges is largely changed. In particular, the decline in students entering universities and two-year colleges with the drop of in population of 18 year olds will give these schools an admissions capacity (number of new students/number of applicants) of 100% by FY2007, which has raised concerns that there will be an increase in unmet quotas (Figure 3-1-13). Taking into account that admissions capacity and acceptance rate have a nearly reciprocal relationship, and assuming that tuition of universities and other schools will be lowered due to the increase in acceptance rates in order to attract students, the quality of education as measured by the number of instructors per student could decline.(Appended Table 3-7). Such a decline in the quality of education could lead to a drop in the quality of labor, which makes it more imperative to maintain and improve the quality of higher education in the future. As will be discussed in a later section, while securing sufficient number of talented scientific and technical personnel to fuel innovation will become an important challenge from the quality and quantitative perspective, providing high-quality educational programs, etc. by tapping into the creativity of universities through the reorganization of academic departments, trimming quotas and reviewing curricula, will also become a challenge.

Figure 3-1-13 Trends and forecasts for the number of university applicants and the number of new students

The issue of social capital stock management

Fourth, the decline in population will lead to a relative increase in per-capita social capital stock. Such an increase has been made possible by the improvements, in both quality and quantity, of social capital that were achieved in the process of pursuing economic restoration efforts in the post-war period and in high economic growth. This abundance of social capital stock contributes to the richness of people's lives by, for example, easing commuting and traffic congestion, etc. On the other hand, the stock accumulated during Japan's high economic growth era will approach the period of replacement in a few decades, and investment for maintaining and replacing infrastructure will expand dramatically. According to estimates by the Ministry of Land, Infrastructure and Transport, maintenance and replacement costs as a percentage of total investment will expand from about 20% in FY2001 to 50% in around FY2020, assuming that the total amount of investment in social capital remains constant (Figure 3-1-14).(11) This expansion of investment is expected to be accompanied by a sharp increase in maintenance and replacement costs per capita of population. According to the trend of decrease in National Accounts, the consumption of fixed capital of general government (a concept that supposes a depreciation of social capital, etc.) and the fixed capital formation of general government excluding this decrease, the former has been steadily increasing against the backdrop of the accumulation of social capital stock up to now, while the latter has been declining, and as a result, the former exceeded the latter in FY2001. These trends allow inferences of the potential impact that this existence of huge social capital stock will have on the economy as a whole.

Figure 3-1-14 Maintenance and replacement cost projections and per capita cost trends of investment in social capital

In addition, it is likely that the allocation of stock could not respond to the demographic change depending on the type of social capital. For example, in the broad definition of the term "social capital," an analysis by prefecture of the relationship between (1) welfare facilities for the elderly and the proportion of persons 65 and older in the population, and between (2) elementary and junior high school facilities and the proportion of persons 14 years and younger in the population reveals that there is almost no correlation found for (2) while there is a positive but slight correlation for (1) despite with variation to some extent, which means that stock distribution is probably not appropriate (Appended Figure 3-8). Since the cost of disposing of excessive social capital stock is high, disposal is not an easy task. For example, there have been some cases where elementary schools that have been closed permanently due to declining birthrates have been left standing. This means that in order to deal with the problem of infrastructure distribution that cannot cope with huge maintenance and replacement costs and changes in social conditions, public investment must be limited to those fields where it is truly necessary. At the same time, improvements in technology for maintaining and managing individual stock are needed, such as extensions of the life of social capital and conversions to welfare facilities through technological development. Also required is strategic social capital stock management in which stock in a given area can be managed and operated in an integrated manner by setting appropriate management units.

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