Most fiscal analysts realize that official government debts do not include implicit liabilities. But most analysts do not realize that the division of government liabilities between implicit and explicit (official) is arbitrary. The same holds for assessing the share of any particular program that is financed by general revenue. Two observers of the same fiscal reality can use different, but equally valid, fiscal labels, report entirely different levels of implicit and explicit debts, and reach entirely different conclusions about the fiscal condition of particular programs. This is one of several lessons to be learned from examining fiscal policy by means of generational accounting, a relatively new method of long-term fiscal analysis that has found increasing application around the world.
Definition of Generational Accounts
Generational accounts represent the sum of the present values of the future net taxes (taxes paid minus transfer payments received) that members of a birth cohort can expect to pay over their remaining lifetimes if current policy is continued. The sum of the generational accounts of all members of all living generations indicates how much people who are now alive will pay toward the government's bills. The government's bills are the sum expressed as a present value of all the government's future purchases of goods and services plus its official net debt (its official financial liabilities minus its official financial assets, including the value of its public-sector enterprises). Bills not paid by current generations must be paid by future generations. This is the zero-sum nature of the government's intertemporal budget constraint: the basic building block of modern dynamic analyses of fiscal policy.
This budget constraint can be written as A + B = C + D, where is the government's official net debt, C is the sum of future government purchases valued to the present, B is the sum of the generational accounts of those now alive, and A is the sum of the generational accounts of future generations valued to the present. Given C + D, the smaller B (the net payments of those now alive) is, the larger A (the net payments of those yet to be born) must be.
The Fiscal Burden of Future Generations
A critical feature of generational accounting is that the size of the fiscal burden confronting future generations (A) is invariant to the government's fiscal labeling, that is, how the government describes its receipts and payments. Unfortunately, this is not true of the government's reported size of its official debt. In terms of the equation A + B = CD, different choices of fiscal labels alter B and D by equal absolute amounts, leaving C and A unchanged; that is, the values of B and D depend on language and are not economically well defined. However, the value of A and the difference D -B are independent of language and are economically well defined. Since the terms A, B, and C are all present values, they all depend on assumed discount rates, productivity growth rates, and population growth rates. Higher population and productivity growth rates can be expected to raise all three terms. Higher discount rates lower all three terms.
The difference between the lifetime net tax rate of current newborns (the generational account of current newborns divided by their lifetime earnings) and the projected net tax rate on future newborns (the collective net tax burden on future newborns, the term A, divided by the projected present value of their future earnings) measures the imbalance in generational policy. The lifetime net tax rates of current and future newborns are directly comparable because both involve net taxes over entire lifetimes. If the lifetime net tax rate facing future generations is higher than the lifetime net tax rate facing current newborns, current policy not only is generationally imbalanced, it also is unsustainable. In other words, the government cannot continue over time to collect the same net taxes measured as a share of lifetime income from future generations that it would collect under current policy from current newborns without violating the intertemporal budget constraint.
Achieving Generational Balance
The calculation of generational imbalance is an informative counterfactual, not an indication of a likely policy scenario, because it imposes the entire fiscal adjustment needed to satisfy the government's intertemporal budget constraint on those born in the future. Although unrealistic, this counterfactual delivers a clear message about the need for policy adjustments. Once that need is established, interest turns to alternative means of achieving generational balance that do not involve foisting the entire adjustment on future generations.
As an example, one can determine the percentage reduction in C that would lower the size of A (i.e., the size of C + D -B) enough to achieve generational balance. Regardless of the size of that percentage reduction in the present value of government purchases, the policy could be implemented by means of an immediate and permanent cut in the annual flow of those purchases by that percentage. Another example is an immediate and permanent percentage increase in annual income tax revenues. This would raise B–the collective generational accounts of those now alive–and thus reduce A. The precise size of the percentage income tax hike needed to achieve generational balance is found when the growth-adjusted generational accounts of future generations equal those of newborns.
Applications of Generational Accounting
Although it was developed only recently, generational accounting has been applied to more than thirty countries around the world. The generational accounts for the United States that were prepared in June 2001 can be taken as an example. For newborns, who are assumed to pay taxes and receive benefits over their lifetimes in accordance with current (2001) U.S. policy, the lifetime net tax rate was 17.7 percent. For future generations the tax rate required to meet the intertemporal budget constraint was over twice as large: 35.8 percent. Stated differently, future generations, according to the policies in place in 2001, would have to be asked to pay 18.1 cents more per dollar earned than current newborns will pay.
To understand the gravity of the long-term U.S. generational imbalance, suppose the government tried to eliminate the generational imbalance by immediately and permanently raising the federal corporate and personal income tax by a given percentage. How large would the tax hike have to be? The answer as of 2001 was 68.2 percent. An alternative to raising federal income taxes alone is to raise all federal, state, and local taxes. In that case an across-the-board tax hike of 25.7 percent could achieve generational balance. Of course, cutting transfer payments and decreasing government purchases are alternatives to raising taxes. Cutting all Social Security, Medicare, Medicaid, food stamps, unemployment insurance benefits, welfare benefits, housing support, and other transfer payments by 43.5 percent would be another way to eliminate the generational imbalance. Two final options one can consider are immediately and permanently cutting all government purchases by 38.9 percent or totally cutting all federal purchases (the latter course would still not achieve a generational balance: to do so the cut that would be needed is calculated to be 116.9 percent). The U.S. generational imbalance is, as these numbers indicate, of grave national concern. Remarkably, this imbalance is smaller than those of many European countries and of Japan.
While economic growth would mitigate the generational imbalances in the United States and other countries, it represents no panacea. The reason is that in the U.S. and many other countries, government spending is fairly closely tied to the general level of a country's per capita income. Indeed, in the U.S. programs like Social Security are explicitly indexed to the level of real wages earned by workers. Hence, as the economy grows, so do the government's bills.
Immigration is also generally viewed as a cure for generational imbalances. In the United States, simply increasing the number of immigrants, while maintaining their composition, would do little to reduce the size of the intergenerational imbalance. In contrast, allowing only highly skilled and highly educated individuals to immigrate would provide some fiscal relief because these immigrants would pay more in taxes than they receive in benefits. Unfortunately, the source of such immigrants would be Japan and the European Union, which will seek, for the same reasons, to reduce out-migration of skilled workers to the extent possible.
Auerbach, Alan J., Laurence J. Kotlikoff, and Willi Leibfritz, eds. 1999. Generational Accounting around the World. Chicago: University of Chicago Press.
Kotlikoff, Lawrence J. 2002. "Generational Policy." In Handbook of Public Economics, 2nd edition, ed. Alan J. Auerbach and Martin S. Feldstein. Amsterdam: North Holland.
Laurence J. Kotlikoff