Japan faces the intertwined challenges of rapid population ageing and high government debt. Ageing is partly driven by long life expectancy. Half of the children born in Japan in 2007 are expected to live to the age of 107, which has major implications for the labour market. The number of elderly is projected to rise from 50% of the working-age population in 2015 to 79% by 2050, remaining the highest in the OECD (Figure B).

The increasing elderly population has driven a sharp rise in social spending since 1992. Twenty-seven consecutive years of budget deficits have driven gross government debt to 226% of GDP in 2018, the highest ever recorded in the OECD area. The government projects that population ageing will boost spending on health and long-term care by 4.7% of GDP by 2060. Measures to ensure the sustainability of Japan’s social insurance programmes, as spending rises and the number of working-age persons falls from 2.0 per elderly to 1.3 by 2050, is a priority.

Output growth has slowed since 2017, reflecting weaker exports as world trade decelerated (Figure C). Still, output growth is expected to remain close to ¾ per cent through 2020, as shortages of labour and capacity, combined with record-high profits, continue to support business investment and wages. The temporary effect of the planned hike in the consumption tax rate from 8% to 10% in October 2019 will be less than after the 2014 tax hike thanks to offsetting fiscal measures.

Global uncertainties weigh on the outlook. Trade tensions have clouded the outlook for businesses and risk disrupting investment and global value chains. Japan is also vulnerable to a slowdown in China’s domestic demand. On the domestic side, wage growth is a major uncertainty. Larger increases in basic wages are important to sustain private consumption.

The Bank of Japan should maintain monetary easing until achieving its inflation target while taking account of risks and problems. Headline consumer price inflation has edged up from negative territory in 2016, but remains well below the 2% target. Under qualitative and quantitative easing, the central bank’s holdings of government bonds have reached 85% of GDP (Figure D).

The government now aims to achieve a primary surplus by FY 2025. Due to lower-than-expected growth, repeated supplementary budgets and delays in raising the consumption tax from 8% to 10%, the FY 2018 benchmark for the primary defict was missed. Moreover, it was decided to use some of the additional revenue from the 2019 tax hike for new social spending. In this context, the FY 2020 target, set in 2010, is no longer realistic. Japan needs a comprehensive fiscal consolidation plan including specific spending cuts and tax increases, as well as an improved fiscal framework to ensure implementation of the plan. To reduce the government debt ratio to 150% of GDP by 2060, OECD estimates suggest a sustained primary surplus of 5% to 8% of GDP would be required.

Containing spending growth requires focusing on health and long-term care by making more efficient use of healthcare resources while providing high-quality care. Priorities for reform include taking long-term care out of hospitals and shifting its focus to home-based care, promoting greater use of generic drugs and improving preventive care. With Japan’s population projected to fall by one-fifth to around 100 million by 2050, many parts of the country are facing depopulation. Efficiency would be increased by expanding the joint provision of local public services, including health and long-term care and infrastructure, across jurisdictions and developing compact cities.

Japan should rely primarily on the consumption tax to boost revenue as it is a relatively stable revenue source, is less harmful for growth and improves intergenerational equity. The current 8% rate is one of the lowest in the OECD. Achieving a sufficient primary surplus through the consumption tax alone would require raising the rate to between 20% and 26%, above the 19% OECD average. A hike in environmentally-related taxes from their relatively low level would also be beneficial. In addition, broadening the personal income tax base would raise revenue while reducing inequality and disincentives to work. Policies that encourage employment and output growth are crucial for fiscal sustainability.

The labour force will decline by one-fourth by 2050, assuming constant labour force entry and exit rates. Japan’s traditional labour model – lifetime employment, a seniority-based wage system and mandatory retirement – is poorly suited to the era of 100-year lives, as it discourages the employment of older persons and women, and labour mobility. Abolishing the right of firms to set mandatory retirement at 60 would increase employment and productivity as workers who are re-hired at age 60 are usually shifted to non-regular jobs with lower responsibilities and pay. It would also weaken the role of seniority in setting wages, which would benefit women in particular.

Women face obstacles to employment and are under-represented in leadership roles. For example, they account for only 10% of the members of the lower house of the Diet. Removing barriers to women requires policies to: i) improve work-life balance by strictly enforcing the new 360-hour annual limit on overtime; ii) further reduce waiting lists for childcare; and iii) attack discrimination, which tends to exclude women from fast-track career paths. Breaking down labour market dualism is also essential, as women account for two-thirds of non-regular workers, who are paid substantially less. This would also eliminate a key source of income inequality and poverty.

It is essential to increase the role of foreign workers. The new residency status that allows lower-skilled foreigners to work in sectors facing labour shortages is a major step in this direction.

Output per hour worked in Japan is more than a quarter below the top half of OECD countries (Figure E). The government set a goal to double productivity growth to 2% by 2020. One key area for reform is corporate governance, which has the potential to encourage firms to use their large cash holdings for fixed investment and wages. In 2015, Japan introduced a Corporate Governance Code, but the changes thus far have been primarily form rather than substance. The government should closely monitor and promote the Code’s implementation, notably the measures to reduce cross-shareholding and increase diversity on corporate boards.

Another priority for reform relates to small and medium-sized enterprises (SMEs). Despite a high level of public support for SMEs, productivity in large firms was 2.5 times higher than in SMEs in FY 2017 in manufacturing, a large gap by international standards (Figure F). Narrowing the gap is essential to achieve inclusive growth. The government has scaled back credit guarantees to SMEs and the proportion of loans that is guaranteed. Further reducing support would strengthen incentives for banks to provide appropriate monitoring and for SMEs to increase productivity. Successfully implementing programmes to promote entrepreneurship and reduce the use of personal guarantees would boost the creation of innovative firms. The large share of older SME owners creates succession issues but also opportunities to achieve economies of scale.

Japan faces the challenge of reducing CO₂ emissions and air pollution. Japan plans to build new and more efficeint coal-fired power plants. These nonetheless produce more CO₂ emissions than other types of power plants. Increasing the use of renewables, which are becoming more competitive, could reduce emissions and improve air quality. This requires facilitating their entry in electricity markets. Gradually increasing effective carbon prices, while taking into account the already high price of electricity, as well as the social and economic impacts in Japan, would be an option to achieve emission reductions cost-effectively and further increase Japan’s high level of energy efficiency.