Dimensions: 8.25'' x 5.50'' AEI Press  (Washington) Publication Date: July 2003 Paperback ISBN: 0-8447-7167-8 Price: $ 15.00 Add to Cart   Examination Copies

August 2003
Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities
By Jagadeesh Gokhale and Kent Smetters

Current accounting measures fail to weigh the future economic impact of government policies or their varied impact over generations. This book proposes two new measures, Fiscal Imbalance and Generational Imbalance, which would allow policymakers to take account of the full effect of reform proposals.

Jagadeesh Gokhale is a visiting scholar at the American Enterprise Institute and a senior economic advisor to the Federal Reserve Bank of Cleveland. Kent Smetters was deputy assistant secretary for economic policy at the U.S. Department of Treasury from 2001 to 2002. He is currently an assistant professor at the University of Pennsylvania.

The Office of Management and Budget and the Congressional Budget Office periodically report federal budget projections looking a few years into the future. The projections from the Office of Management and Budget's Mid-Session Review for 2003 show large budget deficits and growing public debt. To be sure, these estimates are bad news for U.S. fiscal policymakers. But do they really provide a full accounting of the federal government's fiscal policy position?

Gokhale and Smetters argue that traditional fiscal measures, such as deficits and debt, are now inadequate measures of fiscal policy. These two measures only describe past federal tax and spending choices. They were useful in the past when most government outlays involved only short-term spending commitments. During the coming decades, however, long-term entitlement outlays, including Social Security and Medicare, are expected to dominate the fiscal landscape. Hence, traditional budget measures such as debt and deficits need to be complemented with new measures that account for future outlay obligations relative to the resources available to meet them under current laws. Such measures are needed to assess the size of policy changes required to place U.S. fiscal policy on a sustainable path and to evaluate tradeoffs in terms of the sacrifices made by different generations to achieve fiscal sustainability.

Fiscal and Generational Imbalances

The authors propose a pair of complementary budget measures that they argue more accurately describe the true fiscal situation facing the United States today. They call these measures the "Fiscal Imbalance" and the "Generational Imbalance." The Fiscal Imbalance adds the current level of debt held by the public and the present value of projected federal outlays under current policies and then subtracts the present value of the future revenues that the government is projected to receive. A zero Fiscal Imbalance indicates that revenues collected from all generations, past, present, and future, are sufficient to cover the government's past and projected outlays. However, as explained below, U.S. fiscal policy is far from sustainable.

While the Fiscal Imbalance encompasses the federal government's financial shortfall on account of all generations--past, present, and future--the complementary Generational Imbalance measure indicates the amount of the existing Fiscal Imbalance contributed by past and living generations. The Generational Imbalance serves two important and related purposes. First, it helps policymakers decide between different policy options that could be used to eliminate the Fiscal Imbalance and, therefore, return U.S. fiscal policy to sustainability. Second, the Generational Imbalance measure reveals otherwise hidden transfers of resources between generations that are not indicated by either the Fiscal Imbalance measure or traditional budget measures such as debt and deficits. Such resource transfers arise when the government implements "pay-as-you-go" expansions in entitlement benefits, such as a new retirement benefit financed by increasing payroll taxes on workers, which provides a windfall to retirees and those about to retire at the expense of current and future workers. Such resource distributions are not hidden from the Generational Imbalance, which reflects the gains or losses accruing to living generations from tax and spending policy changes. The Fiscal Imbalance remaining after subtracting the Generational Imbalance indicates the projected contribution by future generations to the Fiscal Imbalance.

This book estimates that the U.S. federal government currently faces a Fiscal Imbalance exceeding $44 trillion as of fiscal year-end 2002. If the government enacts no policy changes within the next five years, the Fiscal Imbalance is projected to climb to almost $54 trillion by fiscal year-end 2008--or by about $1.6 trillion per year.

The $44 trillion Fiscal Imbalance results from a present value calculation: it equals the amount of money that the federal government must have in hand today to sustain today's tax and spending policies indefinitely. Of course, since the government does not have an extra $44 trillion today, it will need to acquire it by imposing additional taxes or spending cuts in future years. However, because the Fiscal Imbalance continues to increase over time, this delay involves additional cost: the required tax hikes or spending cuts would have to cumulatively add up to more than $44 trillion to reduce the Fiscal Imbalance to zero. This shows the dismal economic arithmetic facing policymakers: the more such fiscal adjustments are postponed, the larger the size of the required adjustments becomes.

Today's $44 trillion Fiscal Imbalance is over ten times the level of debt held by the public as of the end of fiscal year 2002. The reason for the sizeable difference is that the government's official measure of the nation's debt reflects only past overspending while the Fiscal Imbalance includes both past and projected overspending. Hence, a policy change that eliminates only current debt would still leave the federal government far from being financially solvent.

Similarly, the $1.6 trillion per year growth in the Fiscal Imbalance is substantially larger than the deficit that the government officially projects for the current fiscal year. The reason is that the government's official deficit indicates only the annual change in its narrowly defined official debt measure. Both of these measures exclude projected revenue shortfalls relative to the government's future spending commitments.

The Fiscal and Generational Imbalance estimates reported in this book are based on the economic assumptions and policies contained in the Budget of the United States for fiscal year 2004. They rely on long-term projections provided by the Office of Management and Budget. Using detailed microeconomic data sets, the authors constructed "age-sex" profiles for all major tax and outlay categories, encompassing the entire budget. These profiles were then used, together with demographic projections provided by the Social Security Administration, to break down and extend OMB projections for many years into the future. (The methodology is described in several appendixes.)

Of the $44 trillion Fiscal Imbalance, Medicare contributes almost $36 trillion and Social Security about $7 trillion. The rest of federal operations add about $0.5 trillion--a formidable amount of money, to be sure, but not much more than 1 percent of the total.

The book measures the scale of alternative policies that would be required to eliminate the entire Fiscal Imbalance. For example, taxes on wages would have to be increased by 16.6 percentage points immediately and perpetually. This would more than double the payroll taxes being paid today by workers and employers. Alternatively, all Social Security and Medicare benefits would have to be cut by 45 percent immediately and perpetually. Such policy changes would, of course, be counterproductive because they would harm economic growth. Hence, these estimates should be viewed as alternative measures of the size of the Fiscal Imbalance facing the United States and not as policy recommendations by the authors. They point to the urgent need for reforming the two major entitlement programs--Medicare and Social Security.

The Generational Imbalance for Social Security is $8.7 trillion. That is, under current payroll tax and benefit policies, past and living generations will receive $8.7 trillion more in present value of Social Security benefits than the present value of their Social Security payroll taxes. Future generations, on the other hand, are projected to pay $1.7 trillion more in present value of taxes than the benefits they are scheduled to receive. However, that overpayment is not enough to overcome the $8.7 trillion "overhang" from past and current generations, thereby leaving a Social Security Fiscal Imbalance of $7 trillion.

One way to restore sustainability to Social Security (that is, make its Fiscal Imbalance zero) would be to increase the tax payments of future generations by $7 trillion in present value. Thus, their total excess tax payments would then equal $8.7 trillion, matching the $8.7 trillion Generational Imbalance on account of past and living generations. Alternatively, the Generational Imbalance must be reduced by $7 trillion--that is, living generation's benefits must be cut, or taxes increased, by this amount so that the Generational Imbalance becomes $1.7 trillion--matching the net present value of contributions by future generations of $1.7 trillion. Yet another option would combine these two changes so that living and future generations collectively contributed an extra $7 trillion in present value to Social Security's finances.

Medicare's Generational Imbalance equals $15 trillion, meaning that past and current generations are projected to receive $15 trillion more in benefits in present value than they will have paid in taxes. Future generations contribute another $21 trillion to Medicare's Fiscal Imbalance, bringing Medicare's total Fiscal Imbalance to $36 trillion. Past and living generations contribute a smaller share of Medicare's Fiscal Imbalance relative to future generations because much of Medicare's Fiscal Imbalance arises from a projected rapid increase in health care costs per capita. Similar to Social Security, restoring Medicare's Fiscal Imbalance to zero involves imposing additional sacrifices to the tune of $36 trillion on living and future generations collectively. Moreover, these calculations are based on very optimistic assumptions. In particular, they reflect the Center of Medicare and Medicaid Services' methodology, which results in a much more conservative health care growth assumption than experience since 1980 would suggest. The monograph shows that Medicare's Fiscal Imbalance alone exceeds $50 trillion if the assumed health care costs are closer to, but still below, those seen during the past two decades.

A Powerful Tool Set

If Social Security and Medicare face such large fiscal problems why have policymakers not done more to address them? Not only do traditional fiscal measures of debt and deficits considerably understate the federal government's financial shortfall, focusing exclusively on them introduces a policy bias: some policies that could improve the government's overall fiscal position appear unattractive to policymakers because they cause larger deficits and debt in the near term. For example, many potential policy reforms to the Social Security system would produce more debt in the short run. These reforms, though, would also decrease Social Security's future obligations by more than the increase in debt. Social Security's Fiscal Imbalance would be reduced by prefunding the program, but current budget accounting conventions would only report the increase in debt over the short term while the reduction in Social Security's future obligations would remain hidden.

The book also provides an extended discussion of the desirable properties of the Fiscal and Generational Imbalance measures relative to alternative fiscal measures, including traditional debt and deficit measures, accrual based measures, and measures based on generational accounting. They contend that, unlike the Fiscal and Generational Imbalance measures, these alternative measures do not possess all of the properties desirable in a fiscal measure.

Shifting lawmakers' and the public's  focus to the Fiscal Imbalance and Generational Imbalance measures and away from traditional debt and deficit measures would eliminate two important shortcomings in policy evaluation and decisions. First, official reports would no longer significantly understate the true extent of the federal government's financial shortfall under current policies. The adoption of these measures in official budget reports might consequently make it easier to undertake entitlement reforms. Second, adopting the Fiscal and Generational Imbalances measures would enable a proper evaluation of reform alternatives because it would reflect the reforms' full impact on the federal government's overall fiscal position--rather than on just one component of it. Together, the integrated Fiscal and Generational Imbalance measures provide lawmakers with a parsimonious but powerful tool set: they would help policymakers select those policies most suitable for meeting the economic challenges posed by the retirement and health care needs of the nation.

 Available in Adobe Acrobat PDF Format.