The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
April 15, 1998
Federal Reserve Bank of Cleveland
Generational Equity and Sustainability
in U.S. Fiscal Policy
by Jagadeesh Gokhale
P
olicymakers’ budget perspectives
show a puzzling dichotomy. Their projections and plans for the general budget
seem to extend only five years out, but
President Clinton’s recent proposal for
Social Security—that future budget surpluses be “reserved” until the program’s
solvency is restored—suggests a much
longer perspective. After all, the official
figures of the Social Security Administration (SSA) indicate that the program
will not go bankrupt under current law
until the year 2032.1
The President’s emphasis on Social
Security reform may have been motivated by concern about generational
equity. Preserving the program’s current
structure involves a choice between two
politically unpopular alternatives:
increasing taxes or cutting benefits. The
former will impose larger burdens on
working-age and future generations,
while the latter will hurt retired generations. Achieving an equitable solution is
likely to be an important goal of future
reforms. Moreover, the required policy
adjustments will probably be smaller if
reforms are implemented sooner.
Social Security, however, is but one element in the government’s fiscal policy
and provides but one kind of benefit—
income for retirees and the disabled and,
on their death, for their survivors. The
government, however, provides myriad
other public goods and services that benefit citizens and are paid for by levying
taxes. I argue here that financing these
benefits merits the same long-term perspective and deserves the same concern
about generational equity as does Social
ISSN 0428-1276
Security. This means that long-term projections and actuarial calculations similar to those reported by the SSA should
be extended to the entire budget. Such
calculations would reveal the stance of
fiscal policy regarding the tax treatment
of different generations—and would
inform us about its fairness.
Some may judge that equity across age
groups is important on its own merits,
but it also has significant implications
for fiscal sustainability and economic
efficiency. I briefly discuss the importance of generational accounting—a
method of long-term fiscal analysis—
and present results from calculations for
the United States.2 These show that the
stance of U.S. fiscal policy is prospectively generationally inequitable; in
other words, the implied fiscal burden on
future generations is disproportionately
large relative to that on living generations. It turns out that such a policy is
also unsustainable over the long term.
However, maintaining it for a few years
will necessitate larger future policy
adjustments and permanently higher fiscal burdens for future generations, on
average. I also report calculations, similar to those the SSA made for the Social
Security program, showing the magnitudes of alternative policy changes that
are needed to establish prospective generational equity and long-term sustainability in U.S. fiscal policy. The results
make a clear case for implementing corrective measures as early as possible.
U.S. policy is not evenhanded in its
tax treatment of older, younger, and
future generations. If living generations are taxed according to current
policy until they die, they will give
up 28.6 percent of their lifetime
labor income. But if government
spending goes as projected, future
generations will give up almost half
their lifetime labor income to balance the government’s books. This
indicates that current policy cannot
be sustained indefinitely. The size
and timing of the required changes
are reported here. Postponing them
is likely to prove costly.
■ The Importance of
Generational Accounting
The U.S. government purchases goods
and services for its citizens, financed by
levying taxes on them.3 Part of annual
revenue is handed back to the public
immediately through Social Security,
Medicare, Medicaid, welfare, and other
transfer programs. Thus, government
purchases are financed with net taxes
(taxes net of transfers).4
Long-term budget balance requires that
all future net taxes be equal, in present
value, to the existing debt plus the present value of all future purchases. However, in any given year, net tax receipts
need not equal purchases plus debt service in that year. The time profile of net
tax receipts can be altered — for example, by lowering taxes in one year and
increasing them in a future year in a
way that preserves their present value
—without disturbing the present-value
balance between net taxes and debt plus
purchases.
A change in the time pattern of net taxes
will usually redistribute burdens among
generations. For example, reducing income taxes today and increasing them
several years hence so that the present
value of income taxes (and, hence, of
net taxes) remains unchanged, will
reduce the net taxes of those who retire
or die in the intervening period. Doing
so, however, will impose larger net
taxes on younger (and possibly future)
generations.
This may suggest that comparing different streams of net taxes with purchases—in effect, comparing alternative
time paths of budget deficits and debt—
is sufficient to reveal the generational
stance of fiscal policy. However, the net
tax burdens on different generations can
also be altered without changing the time
profile of aggregate net taxes or purchases, or, by implication, that of budget
deficits and debt. For example, increasing both payroll taxes and Social Security benefits by the same amount in each
future year would leave the time path of
total net taxes unchanged. However,
already-retired generations would gain
through larger Social Security benefits,
while young and future generations
would lose because, in present value,
their larger payroll taxes would exceed
their larger Social Security benefits.5
Evaluating a given fiscal policy for generational equity, therefore, involves
looking beyond budget deficits. Indeed,
one must trace in detail which generations pay taxes and which receive transfers under that policy, and keep track of
the timing of these transactions. This is
precisely what generational accounting
accomplishes.6
Understanding how today’s policy distributes net tax burdens across living
generations and how changing it might
alter those burdens is important for economic efficiency. Such changes are likely to affect these generations’ resources
and, consequently, their decisions about
how much to work and consume.7 Evaluating the implications of fiscal policy
for future generations is important for
the same reason: Maintaining, for even a
few years, a policy stance that is highly
unfavorable to future generations is
likely to harm their incentives to work,
save, and invest, thereby weakening
future economic performance.
■ The Fiscal Burden
Generational accounting calculations
show that under “reference” projections,
the present value of the government’s
bills amounts to $31.5 trillion ($29.4 trillion in purchases plus $2.1 trillion in
outstanding debt).8 If we assume that
living (including newborn) generations
are treated throughout their lives as they
are under reference policy, these generations will collectively pay net taxes of
$22.1 trillion in present value. Therefore, under the same assumption, the
requirement of long-term budget balance
implies that future generations (those
born after 1995) would collectively have
to pay $9.4 trillion in present value.9
This latter figure—rather than outstanding government debt—more meaningfully reflects the fiscal burden that reference policy places on future generations.
■ Lifetime Net Tax Rates
A given generation’s lifetime net tax
rate is the fraction of its lifetime labor
earnings that it pays in net taxes to the
government, where both numerator and
denominator are present values at
birth.10 First, consider only living generations (including the one just born).
Their fiscal treatment under reference
policy is reflected by the lifetime net
tax rates they would pay if that policy
were maintained. Figure 1 shows that
the generation born in 1900 pays at the
rate of 23.9 percent. Lifetime net tax
rates increase steadily for later-born
generations, peaking at 33.4 percent for
those born in 1950 then gradually
declining to 28.6 percent for those born
in 1995.11 Thus, reference policy projections, combined with past payments
by living generations, imply a differential lifetime fiscal treatment of the generations alive today.12
Looking forward, one may ask whether
reference policy’s generational stance is
equitable toward future generations. To
answer this question, we need to compare that policy’s implicit treatment of
future generations with its treatment of
some living generation. The newborn
generation is the natural candidate
because its entire lifetime lies in the
future. Calculations show that the present value gap of $9.4 trillion—future
generations’ implicit burden under the
assumption that all living generations
will pay net taxes under reference policy
—implies an average lifetime net tax
rate of 49.2 percent!13, 14 The difference
between this and the 28.6 percent rate on
1995 newborns (assuming lifetime fiscal
treatment under reference policy) can be
viewed as a measure of the prospective
generational inequity contained in reference policy.
Prospective generational equity (the relative fiscal treatment of newborn and
future generations) is a serious concern
because it implies long-term unsustainability. If reference policy were maintained, each new generation would pay
the same lifetime net tax rate as 1995
newborns (28.6 percent). However, obtaining the revenue needed for all projected purchases would require future
generations to pay an average rate of 49.2
percent. So, at some future date, either net
taxes must be increased (by hiking taxes
or reducing transfers) or government
must cut purchases to balance its books.15
The change must be large enough to
achieve prospective generational equity
and sustainability; that is, the lifetime net
tax rate on newborns under the new policy must equal the implied average rate
on future generations.16
FIGURE 1 LIFETIME NET TAX RATES: REFERENCE POLICY
SOURCE: Jagadeesh Gokhale, Benjamin Page, and John Sturrock, “Generational Accounts for the United
States: An Update,” in Alan Auerbach, Laurence J. Kotlikoff, and Willie Leibfritz, eds., Generational Accounting
around the World. Cambridge, Mass.: National Bureau of Economic Research (forthcoming).
FIGURE 2 POLICIES FOR ACHIEVING PROSPECTIVE
GENERATIONAL EQUITY AND FISCAL
SUSTAINABILITY
NOTE: Indirect taxes include excise and property taxes.
SOURCE: Jagadeesh Gokhale, Benjamin Page, and John Sturrock, “Generational Accounts for the United
States: An Update,” in Alan Auerbach, Laurence J. Kotlikoff, and Willie Leibfritz, eds., Generational Accounting
around the World. Cambridge, Mass.: National Bureau of Economic Research (forthcoming).
■ Policies for Achieving
Prospective Generational Equity
and Sustainability
The SSA’s report shows that under intermediate demographic and economic assumptions, restoring long-term solvency
would require increasing payroll tax rates
2.19 percentage points,17 which would
mean raising the rate from the current
12.4 percent to almost 14.6 percent.
In the same spirit, I now address the
question of what fiscal measures are
required to achieve prospective generational equity and long-term sustainability in the entire government budget.18
Figure 2 provides some answers. It
shows alternative policy changes, beginning either in 1998 or 2003, that impose
higher lifetime net tax rates on living
(including newborn) generations, thus
reducing the implied average net tax rate
on future generations.19 Each of these
policies would make the lifetime net tax
rate on 1995 newborns equal to the
implied rate on future generations.
Figure 2 shows that beginning in 1998,
income tax revenues would have to
increase 20.4 percent forever relative to
reference projections. For social insurance contributions, the revenue increase
would have to be higher (31.0 percent),
because the contributions base is smaller
for social insurance than for income tax.
Hiking other taxes (excise, sales, and
property) would involve a 39.7 percent
revenue gain. Alternatively, all tax revenues together would have to be 8.9 percent higher forever, beginning in 1998.
As an example, figure 3 shows the lifetime net tax rates facing various living
and future generations after the 8.9 percent tax hike is implemented in 1998.
The resulting fiscal policy hits workingage generations hard but changes older
generations’ rates comparatively little.20
The figure shows that the lifetime net tax
rate on newborns and the implied rate on
future generations are equalized at 32.3
percent. As a result, this policy is sustainable—as are all the others described
in this section. If the new policy is kept
in place, each succeeding generation will
pay the same 32.3 percent rate as 1995
newborns. Now, however, the rate on
future generations that is just sufficient
to pay for all projected government purchases is also 32.3 percent, not higher
than the rate on newborns (as would
occur under reference policy).21
Prospective generational equity and sustainability could also be achieved by
permanently cutting either health care
(Medicare and Medicaid) benefits by
36.8 percent or Social Security benefits
by 47.5 percent in 1998.22 Health care
spending requires a lower percentage cut
than Social Security benefits because
rapid growth in the per capita cost of
care causes future medical expenditures
to grow faster. As a result, living generations receive more, in present value,
from health care transfers than from
Social Security benefits, and a given percentage reduction in health care benefits
increases older generations’ net taxes
much more than the same percentage
reduction in Social Security benefits.
The equivalent result could be achieved
by lowering government purchases 15.4
percent every year relative to reference
projections, beginning in 1998.23
Using these numbers, one can compare
the imbalance of the unified government
budget with that of Social Security
alone. As mentioned earlier, one way to
make the entire government’s budget
sustainable is to hike social insurance
contributions 31 percent. Because the
payroll tax base is much smaller than the
base for social insurance contributions,
it would require a much bigger hike—
FIGURE 3 LIFETIME NET TAX RATES: REFERENCE POLICY
VS. RAISING ALL TAXES 8.9 PERCENT
NOTE: The 8.9 percent tax hike begins in 1998.
SOURCES: Jagadeesh Gokhale, Benjamin Page, and John Sturrock, “Generational Accounts for the United
States: An Update,” in Alan Auerbach, Laurence J. Kotlikoff, and Willie Leibfritz, eds., Generational Accounting
around the World. Cambridge, Mass.: National Bureau of Economic Research (forthcoming); author’s calculations.
FIGURE 4 FUTURE GENERATIONS’ LIFETIME NET TAX RATES:
POLICY CHANGES IMPLEMENTED IN 1998 AND 2003
■ Conclusion
For all the attention they receive, fiscal
deficits are largely irrelevant when it
comes to evaluating fiscal policy’s generational equity and sustainability or
estimating the financial burdens being
heaped on young and future generations.
In contrast to deficit accounting, generational accounting is a direct method for
assessing the sustainability of fiscal policy and for determining which generations will pay the biggest share of the
government’s bills. Applying this
method to the United States suggests
that national fiscal policy is generationally inequitable and unsustainable:
Additional initiatives are needed to
avoid imposing enormous burdens on
today’s and tomorrow’s children. For
example, beginning in 1998, revenue
from all taxes would have to be increased almost 9 percent forever. Alternatively, all transfers would have to be
reduced 19 percent, or all government
purchases cut about 15 percent. Moreover, postponing initiatives to achieve
prospective generational equity and
sustainability will only make the future
economic environment more taxing.
■ Footnotes
1. See the 1997 Report of the Trustees of the
Old Age and Survivors’ Insurance and Disability Trust Funds. Washington, D.C.: U.S.
Government Printing Office, 1998. Note that
trust fund income excluding interest will
begin to fall short of outgo in the year 2013.
SOURCES: Jagadeesh Gokhale, Benjamin Page, and John Sturrock, “Generational Accounts for the United
States: An Update,” in Alan Auerbach, Laurence J. Kotlikoff, and Willie Leibfritz, eds., Generational Accounting
around the World. Cambridge, Mass.: National Bureau of Economic Research (forthcoming).
56.4 percent. 24 This means raising the
payroll tax rate from 12.4 percent to
19.3 percent to achieve generational
equity and fiscal sustainability, a far
larger increase than the one needed to
restore Social Security solvency.
■ The Costs of Postponing
Corrective Policy Changes
Figure 2 also shows that waiting a few
years to implement policies establishing
prospective generational equity and
long term sustainability will be costly.
Such a delay will enable some living
generations to escape the tax hike or
transfer cut, so the change, when it
comes, will have to be larger. For purchase reductions, waiting implies bigger
outlays for a few years, necessitating a
deeper future percentage cut to generate
the present value reduction needed as of
1995, the base year. Moreover, figure 4
indicates that average lifetime net tax
rates on future generations after the policy change would be higher (except for
purchase reductions) if the changes
were deferred for five years.25
2. This Economic Commentary borrows
heavily from Jagadeesh Gokhale and Laurence J. Kotlikoff, “Generational Equity and
Generational Accounting,” in John B.
Williamson, Diane Watts–Roy, and Eric R.
Kingson, eds., The Generational Equity
Debate, Columbia University Press (forthcoming), and from Jagadeesh Gokhale,
Benjamin Page, and John Sturrock, “Generational Accounts for the United States: An
Update,” in Alan Auerbach, Laurence J.
Kotlikoff, and Willie Leibfritz, eds., Generational Accounting around the World.
Cambridge, Mass.: National Bureau of
Economic Research (forthcoming).
3. As used here, the word “government”
encompasses federal, state, and local agencies. “Purchases” refers to spending on
national defense, legislative, judicial, and
administrative services, infrastructure for
transportation and trade, public parks, education, and so on. Public provision of these
goods is justified on the grounds that private
firms would fail to provide them in sufficient
quantity, a situation that is likely to occur
when the goods entail significant “externalities” that prevent firms from charging a price
to all who benefit from them. For example,
the existence of public parks improves the
environment, benefiting even those who
never visit them.
8. The “reference” budget projections used
here do not incorporate the policy changes
enacted in the Balanced Budget and Taxpayer Relief Acts of 1997 because long-term
projections under the new policies were not
available when the calculations were made.
However, the reference projections are
generic in the sense that they cut base spending, health care, and other (non-Social Security) programs in about the same proportions
as under the 1997 Acts. Hence, the results
reported here should roughly correspond to
those under the Acts. The long-range projections were provided by the Congressional
Budget Office. For more details, see
Gokhale, Page, and Sturrock (footnote 2).
14. The equal distribution of the aggregate
residual burden (except for a growth adjustment) implies that lifetime net tax burdens
grow at the same rate as the present values of
lifetime labor incomes.
4. Government purchases also confer benefits on current and future generations. However, it is difficult if not impossible to allocate these benefits by age and sex because of
their public nature. Here, I assume that these
benefits are equally distributed across living
and future generations.
9. When the calculations were made, 1995
was the latest year for which a full set of
actual budgetary and other necessary data
was available. Hence, 1995 is used as the
base year, and living generations are defined
as those born in 1995 or earlier. Note that
$9.4 trillion in present value is not a small
number because it refers to net tax payments
that will begin several years in the future. For
example, someone born in 1996 will not pay
income and other taxes for another 15 years
or more, someone born 20 years hence will
not pay taxes for another 35 years or more,
and so on.
17. The current Old Age, Survivors’ and Disability Insurance (OASDI) tax rate is 12.4
percent. The “long-term” calculations in the
SSA’s report pertain to a 75-year horizon.
Here, payroll taxes refer to the part of Federal
Social Insurance Contributions taxes used to
fund the OASDI program. Apart from the
results based on its intermediate assumptions
cited here, the SSA also reports the payroll
tax hikes required under alternative (highand low-cost) assumptions on several economic and demographic variables.
5. The same is true of revenue-neutral
changes in the tax structure. For example,
substituting income for sales taxes shifts burdens from older to younger generations
because the ratio of older generations’ consumption spending to that of younger generations is greater than the ratio of their income
to that of younger generations. Similarly, cutting welfare benefits and increasing health
care benefits augments the fiscal burdens of
younger generations, who receive relatively
more welfare and less health care benefits
than do older ones.
6. For a more detailed, technical description,
see Alan J. Auerbach, Jagadeesh Gokhale,
and Laurence J. Kotlikoff, “Generational Accounts: A Meaningful Alternative to Deficit
Accounting” in David Bradford, ed., Tax Policy and the Economy, vol. 5. Cambridge,
Mass.: National Bureau of Economic Research, 1991; and Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays,
and When, for What We Spend. New York:
The Free Press, 1992. Generational accounts
have been constructed for 24 countries,
including Germany, Italy, Norway, Sweden,
Canada, New Zealand, Australia, Japan, Portugal, Argentina, and Thailand.
7. See, for example, Jagadeesh Gokhale,
Laurence J. Kotlikoff, and John Sabelhaus,
“Understanding the Postwar Decline in
United States Saving: A Cohort Analysis,”
Brookings Papers on Economic Activity,
vol. 1 (1996).
10. “Generation” refers to all people born in
a given year. “Future generations” include
those born in 1996 and later. All dollar figures are reported as constant 1995 dollars.
11. The decline in the rate for those born
after 1950 occurs because of the steep projected growth in future health care outlays.
12. The newborn generation’s lifetime net
tax rate is based entirely on projected taxes
and transfers under reference policy.
13. To find the required rate on future generations, we distribute the residual aggregate
burden ($9.4 trillion) equally among all
future generations (except for an adjustment
for labor productivity growth), and divide the
resulting net tax burdens by the present values (at birth) of their per capita projected
labor earnings. This yields the uniform lifetime net tax rate that future generations must
bear to achieve long-term budget balance.
15. The length of time that can elapse before
a policy adjustment becomes imperative is
demonstrably finite.
16. Of course, a policy that equalizes net tax
rates on newborn and future generations will
not necessarily establish equity across all living and future generations, although that may
be possible with a complicated set of tax
hikes, transfer reductions, and purchase cuts.
18. There is, however, a conceptual difference between achieving prospective generational equity and sustainability in the entire
budget as described here and restoring longterm solvency to the Social Security program
as indicated by the SSA’s report. The latter
requires only that there be enough funds in
present value to pay legislated benefits annually for the next 75 years with terminal-year
assets sufficient to meet expenditures for one
year. On the other hand, prospective generational equity requires that the implied average lifetime net tax rate on all future generations be the same as the lifetime net tax rate
on current newborns under a given policy.
19. “Achieving prospective generational
equity” refers to equalizing the lifetime net
tax rates of 1995 newborn and future generations only. The policy changes considered do
not equalize these rates for all living and
future generations, although they do bring
them closer together.
20. This is not true for all the policies. For
example, cutting health care benefits would
increase older generations’ lifetime net tax
rates by more than the rates of younger and
future generations.
21. These experiments are based on reference
projections and a 6 percent real discount rate.
All of them equalize the lifetime net tax rates
of newborn and future generations, but the
equalized rate is different for different policies. For example, raising income taxes yields
an equalized lifetime net tax rate of 31.9 percent; raising payroll taxes yields a rate of
32.4 percent; hiking other taxes produces
33.3 percent, and increasing all taxes equalizes the rates at 32.3 percent. Cutting Social
Security benefits yields an equalized rate of
30.1 percent, whereas reducing health care
benefits produces an equalized rate of 31.3
percent. Cutting purchases by 15.4 percent
does not affect the rate on newborns; it reduces future generations’ rate to 29.6 percent,
equal to that on newborns (see figure 4).
22. Note that, because the policy changes
considered are immediate and permanent,
living generations’ net payments will
increase. In particular, 1995 newborns’ lifetime net tax rate will rise. Larger net tax payments by living generations will ease the burden on future generations and reduce the
average lifetime net tax rates they must bear.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
23. In the case of purchase cuts, living generations’ lifetime net tax burdens do not
change because they continue to pay the
same taxes and receive the same benefits as
under reference policy. Nevertheless, the required average lifetime net tax rate on future
generations is reduced because the present
value of the government’s bill is lower.
24. This result follows from the fact that
OASDI taxes constitute 55 percent of all
federal, state, and local social insurance contributions. Since the latter must be increased
by 31 percent to achieve sustainability for
the entire government budget, the former
must be increased by {[(.55 + .31)/.55]–1}
3 100 = 56.4 percent.
Jagadeesh Gokhale is an economist at the
Federal Reserve Bank of Cleveland. He
thanks Terry Fitzgerald and an anonymous
referee for helpful comments.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or the Board
of Governors of the Federal Reserve System.
Economic Commentary is available electronically through the Cleveland Fed’s site on
the World Wide Web: http://www.clev.frb.org.
We also offer a free online subscription service to notify readers of additions to our Web
site. To subscribe, please send an e-mail message to econpubs-on@clev.frb.org.
25. For example, figures 2 and 4 show that a
hike of 20.4 percent in income tax revenues,
if implemented in 1998, equalizes the lifetime net tax rate on newborns and future generations at 31.9 percent. Waiting until 2003
to implement this policy, however, increases
the required revenue hike to 25.3 percent and
raises the equalized rate to 32.6 percent.
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385
@FedFRASER