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Taxes and the Budget: What is Generational Accounting?

Almost all public policy decisions have some impact on generations yet unborn. We leave them official debt when we run budget deficits, and we expect them to pay for some of the government benefits that we and our predecessors have promised to the elderly and others. On the other side of the ledger, current taxpayers leave future generations with both tangible assets and a body of government-financed technological knowledge with which to generate additional wealth. And we bequeath a benefit structure that will provide them with social insurance and a public safety net, but they will have to figure out a way to either pay for it, reform it, or pass the bill along to still later generations. Generational accounting-a concept originally developed by Laurence J. Kotlikoff, Alan J. Auerbach, and Jagadeesh Gokhale-attempts to quantify the value of these net assets or liabilities transferred from generation to generation.

  • The net tax rate faced by future generations is then calculated by dividing the present value of the net tax burden (taxes minus transfer payments) by the present value of expected future earnings from labor. The calculation can be made either for particular birth cohorts or for all those to be born in the future. A basic assumption is that there is no default and no free lunch-all net liabilities transferred forward must be paid for eventually.
  • The present value of the burden passed forward consists of official government debt, net of assets, plus the present value of all future government purchases, plus the present value of all government payments to individuals (such as Social Security benefits) promised to those now alive, minus the present value of all the taxes that will be paid by those now alive. The calculations usually include all levels of government: federal, state, and local.
  • The implied tax burden passed to the future is huge, mainly because current generations will not come close to paying for the present value of government purchases plus the benefits that they are promised, most of which go to the elderly. Medicare and Medicaid, the main public health insurance programs, pose a special problem because health care costs are growing so much faster than tax revenue.
  • When the present value of the burden being passed to future generations is compared with the present value of their future labor income to arrive at a net tax rate, the calculation suggests that unborn generations will face twice the lifetime tax burden faced by those alive today.
  • Generational accounting is often criticized because its calculations are based on numerous assumptions regarding a highly uncertain future. For example, health care costs must be projected to infinity. Historically, these costs have been rising 2 percentage points a year faster than incomes. That cannot continue indefinitely, or else they will eventually exceed total income. But when will their growth slow down? Medicare trustees assume that cost growth in the Hospital Insurance program (Medicare Part A) will begin to slow in about twenty-five years, eventually falling to the GDP growth rate in the early 2080s. But this assumption is completely arbitrary.
  • If growth in health care costs does not slow, the rate of growth of Medicare and Medicaid may exceed the discount rate used to compute their present value. Their present value would then be infinite. That would make generational accounting meaningless. Similarly, the discount rate used to calculate the present value of earnings must exceed the growth rate of earnings to avoid infinite values. But that implies that the present value of earnings in, say, 2050 will be lower than today’s earnings. That forces the estimate of future tax rates upward.
  • The choice of a discount rate to use in computing present values is itself contentious. The arithmetic results are extremely sensitive to this choice. The calculations discussed above assume a real rate of 3.9 percent, approximately the historical rate on long-term government bonds. If we care deeply about the welfare of future generations, we may wish to use a lower discount rate. If instead we reflect on the likelihood that they will be considerably richer than us, we may wish to use a higher rate.
  • Another criticism of generational accounting is that it counts only what is easily countable. In particular, it assumes that no benefits accrue to present or future generations from government purchases. Thus, for example, the "greatest generation"-the generation that won World War II-gets no credit for its contribution to the welfare of future generations. At a more mundane level, the long-run benefits of expenditures on education or research are not recorded.
  • But these criticisms do not invalidate the basic point, which is that the current generation is leaving a gigantic burden to unborn generations. Whether net taxes will have to increase by 50 percent, 100 percent, or 200 percent is almost beside the point. The results are frightening no matter how one does the calculations, and they suggest that current fiscal policy is not sustainable.
 
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   Entry 5 of 8