Is War Between Generations Inevitable?

Policy Reports | Social Security

No. 246
Friday, November 30, 2001
by Jagadeesh Gokhale and Laurence J. Kotlikoff

Taking a Closer Look at Generational Accounts

Exhibit I - Intertemporal Budget Constraint

Generational accounting is a fundamentally new way of looking at government finance. It not only provides precise measurements of the size of fiscal problems, it also helps resolve important policy questions.

The Intertemporal Budget Constraint. As Exhibit I shows, generational accounting over time is constrained by the following equation:

(1) NTC + NTF = G + D

"If people today enjoy transfer program benefits they do not pay for, they shift the cost to taxpayers not yet born."

where NTC is the sum of net taxes paid by current taxpayers (people alive today), NTF is the sum of net taxes paid by future taxpayers (people not yet born), G is government purchases of goods and services, D is government debt, and all terms are expressed as present values. Equation (1) simply imposes the requirement that all government spending must be paid for by someone.

Now suppose we hold fixed the government's expected future purchases of goods and services as well as the current debt. Then the budget constraint tells us that any change in the net tax burden on current taxpayers requires an offsetting change in the expected burden for future taxpayers:

(2) ΔNTC = - ΔNTF

So if people today enjoy transfer program benefits they do not pay for, they shift the cost of those benefits to taxpayers not yet born. The primary goal of generational accounting is to measure the magnitude of these changes.

Deficit Delusion and the Need for Generational Accounting.8 Most fiscal analysts realize that official government debts do not include implicit liabilities. They also realize that Social Security and Medicare are financed partly through general revenues. As mentioned, in the case of Social Security, the government collects income taxes on Social Security benefits, and in the case of Medicare, the government pays most of Part B with general revenues. What most fiscal analysts fail to realize is that the division of government liabilities between implicit and explicit (official) is entirely in the eyes or mouth of the beholder. 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 quite different conclusions about the fiscal condition of particular programs. Generational accounting solves this problem.

Generational Accounting versus Deficit Accounting. A critical feature of generational accounting is that the size of the fiscal burden confronting future generations (the term NTF above) is invariant to the government's fiscal labeling - how it describes its receipts and payments. The values of NTF as well as government spending on goods and services (G) are independent of language and are economically well defined. By contrast, values for the reported size of official government debt (D) and the tax burden for the current generation of taxpayers (NTC) are not well-defined.

Table III - Alternative Policies to Achieve Generational Equity

"The size of the deficit depends on the set of words used to measure it."

Suppose, for example, that the U.S. government chose to label this year's roughly $500 billion in contributions to the Social Security system as "loans" instead of "taxes." Also suppose that instead of calling the future benefits it promises to pay current workers in exchange for these contributions "transfer payments," it instead calls them "return of principal plus interest" on these loans less an "old age tax" (levied at the time contributors receive their benefits). This alternative set of words would leave the U.S. government reporting a $500 billion larger deficit this year, putting the overall budget in deficit to the tune of about $300 billion. A year from now, the government's debt (D) would be larger but so would the generational accounts of currently living generations (NTC) since their future "old age tax" would now be included in their accounts. Since D and NTC will both be larger by the same amount, the burden on future generations (NTF), is unchanged. The economic position of each generation would also be unaffected by the alternative set of labels. Each worker would hand the government the same amount of money this year and receive from the government the same amount of money in the future. The only difference would be in the words the government uses to describe these flows.9

That the government uses one set of words to describe what it's doing does not make those words sacrosanct. Each of us is free to use our own set of words to describe the government's actions. Since each set of words results in a different measure of the deficit, which is correct? The answer is, there is no correct measure. Nothing in economic theory leads one to choose one measure over another. Stated differently, economic theory does not pin down the absolute size of D and NTC, just their difference. Since G is economically well defined, so is NTF, which equals G minus the difference between D and NTC.10

A corollary of the fact that NTC by itself is not well defined is that components of NTC are not well defined. This means that breaking up the government's transfers and taxes and calling some "Social Security" and others "Medicare" has no economic basis. While the government may call a payment it receives from a worker a "payroll tax contribution to pay for Social Security benefits," the worker herself might call it a "payroll tax contribution to pay for building antiballistic missiles." Since money is fungible, economics offers no way to say who is right. But using the government's language makes the Social Security system's finances appear to be in better shape than using the worker's language.

"Generational accounting looks at all government programs simultaneously and assesses overall balance."

The ongoing confusion in our national discussion of Social Security's finances and the reality of its trust fund is simply this point writ large. The government may have the Treasury hand the Social Security Trust Fund an IOU and claim that it has helped to "fund" the system and improve its long-term finances. The man on the street may observe that the Social Security trust fund is simply internal bookkeeping - that this asset is offset by an offsetting liability of the Treasury, and that there is no real asset or improvement in the system's finances. We live in a free country, where everyone can choose her or his own language. If the government wants to say that Social Security is in fine shape and the rest of the government's finances are in bad shape, and someone else wants to say that Social Security is in bad shape but the rest of the government's finances are in good shape, who's to stop them? The argument is intrinsically meaningless. The only meaningful fiscal analysis entails looking at all the government's programs simultaneously and assessing overall intertemporal and generational fiscal balance, which is precisely what generational accounting does.

Digging a Deeper Hole - The Impact of the 2001 Tax Cut. The Bush tax cut helped make a terrible situation significantly worse. Had the 2001 tax cut not been enacted, future generations would have faced net tax rates that were 80 percent rather than 96 percent larger than those facing current generations. Tables A-I and A-II repeat Tables I and II but assume that the 2001 tax cut had not been enacted. Table A-III repeats Table III under the same assumption. With the Bush tax cut, the lifetime net tax rates are 18.65 percent and 34.69 percent for newborn and future generations, respectively. Hence, the Bush tax cut worsened the generational imbalance (the percentage difference between the 34.69 percent and 18.65 percent rates) by about one-fifth at a time when it already was huge.

"Generational equity would require large tax increases, large spending cuts or both."

What was the alternative to the tax cut? President Bush's defenders will argue that but for the tax cut, Congress would have spent the funds on other programs - including expanding elderly entitlements and thus (implicitly) creating even greater burdens for future taxpayers. The ideal, of course, would have been to sequester the funds and invest them.

Can We Be Rescued by Higher Economic Growth? It's worth noting that higher productivity growth would not necessarily reduce the imbalance in generational policy. Indeed, assuming a 3 percent productivity growth rate, the imbalance is 139.0 percent; i.e., future generations face lifetime net tax rates that are 2.4 times those facing today's newborns. While the percentage difference in these lifetime net tax rates grows, the absolute size of each declines with higher productivity growth.

A more basic problem is that higher growth isn't likely to happen. The reason is that the higher tax burden associated with the demographic transition will siphon off lots of saving and culminate in less, not more, capital per worker. Rather than mitigate our fiscal dilemma, the economy's performance will likely exacerbate it.

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