Front Matter

Author(s):
Peter Heller
Published Date:
November 2003
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    © 2003 International Monetary Fund

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    Cover design: Dale Glasgow

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    Heller, Peter S.

    Who will pay?: coping with aging societies, climate change, and other long-term fiscal challenges / Peter S. Heller with a foreword by Jeffrey D. Sachs — [Washington, D.C.]: International Monetary Fund, [2003].

    p. cm.

    Includes bibliographical references and index

    1. Fiscal policy. 2. Aging—Economic aspects. 3. Climatic changes—Economic aspects. I. International Monetary Fund. HJ192.5.H35 2003

    ISBN 9781589062238

    Price: $28.00

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    Here’s what the experts are saying about:

    Who Will Pay?

    Coping with Aging Societies, Climate Change, and Other Long-Term Fiscal Challenges

    By Peter S. Heller

    “Peter Heller has made a critical contribution with this book. Political leaders in this day are perilously short-sighted. This book helps us all see into a troublesome future, but with a perspective that can help policymakers avoid the worst that might lie ahead.”

    —John J. Hamre

    President and CEO, Center for Strategic and International Studies

    “For too long, politicians, civil servants, and international organizations have had an obsessively myopic focus on this year’s budget spending, revenues, and deficits. Peter Heller brings a breath of fresh air to this claustrophobic debate, arguing that we need to look ahead to the looming budgetary challenges posed by aging populations, global warming, AIDS, and other crises with severe fiscal implications. He sounds the alarm that failing to anticipate the long-run challenges will leave both present and future generations at risk of punitive tax hikes and/or arbitrary losses of benefits and essential public services as catastrophic spending crowds out everything else. Sound the call in Washington and around the world: listen to Heller!”

    —William Easterly

    Professor of Economics, New York University and Senior Fellow, Center for Global Development

    “Peter Heller’s volume offers a sweeping survey of what may well prove to be the key issue of fiscal design over the coming decades—how to secure a sustainable fiscal policy, given the massive outside uncertainties which confront it. Yet we must try. Proceeding in that spirit, Heller examines the potential impact of structural changes—demographic, environmental, and political—each doubly uncertain when the interdependence of their impacts is considered. Drawing on a rich literature, old approaches are found insufficient and new techniques are offered. This is a splendid contribution to a most timely theme.”

    —Richard A. Musgrave

    H.H. Burbank Professor of Political Economy, Emeritus, Harvard University

    “Peter Heller’s book on the long-run fiscal challenges facing industrial and Third World nations is right on target: timely, comprehensive, and important. While there are many books which address the crises facing the public pension programs of the industrial nations, this book addresses the fiscal crisis in a much more comprehensive way, and there is none other like it. This book is distinguished from others by its careful attention to a broader array of problems including not only population aging, but rising expenditures on health and climate change as well. It carefully considers the uncertainty surrounding these long-run challenges and how long run plans should be formulated in the context of such uncertainty. It considers the international dimension of these issues, and pays careful attention to the institutional context of policy formation.”

    —Ronald Lee

    Professor of Demography and Economics, University of California-Berkeley

    “This book is an analytic tour de force—it brings together state-of-the-art thinking from many disparate fields to show the importance of a long-term fiscal policy viewpoint. It persuasively challenges both experts and policymakers to do a far better job of addressing the future.”

    —Stanford G. Ross,

    Former U.S. Commissioner of Social Security

    “In this well-written and thought-provoking book, Peter Heller looks at the main challenges for government finances in the long term such as population aging, climate change, deadly diseases, and growing security problems. He provides an overview of the state-of-the-art thinking on these challenges, what analysts and governments currently do to understand and prepare for them, and why policymakers rather prefer to delay appropriate action. Moreover and most importantly, the book provides a road map for change via better analysis, more transparency, and reformed budget processes that are conducive to long-term planning.

    The book is, therefore, a must-read for all those who are interested in learning about long-term policy challenges and their fiscal implications, in filling our knowledge gaps about them and in inducing societies to demand policymakers to undertake sufficient preparatory action.”

    —Ludger Schuknecht

    Principal Economist, European Central Bank

    “Stimulating, provocative, and well-researched reading for those interested in international finance, business, and sustainable development. In our era of pre-occupation with quarterly balance sheets, Peter Heller challenges our short-sightedness with penetrating and convincing analyses of long-term demographic, environmental, and economic changes that will inevitably impact upon fiscal policy. His prescription of a multi-pronged approach to fiscal risk management to meet these powerful forces contains much wisdom, backed by solid research.”

    —Lincoln C. Chen

    John F. Kennedy School of Government, Harvard University (formerly Executive Vice President, The Rockefeller Foundation)

    “The potential for profound developments over coming decades driven by demographic change, technological advance, and globalisation will provide challenges for policy and have potentially significant fisal implications…. It would be a grave mistake to defer addressing the emerging risks. Countries that fail to begin adjusting early may find they pay a significant penalty, requiring excessive adjustment in a short period or experiencing a loss of financial market confidence. The ramifications for policy of these developments, and of continuing closer global economic integration, also highlights the importance of effective, credible, and authoritative IMF surveillance. [This] book makes a timely and valuable contribution in highlighting the need to begin building the capacity to respond to these demographic and other structural developments.”

    —Peter Costello

    Treasurer of the Commonwealth of Australia

    Contents

    Foreword

    Peter Heller emphasizes one overriding theme in this important new book: think ahead in managing public sector budgets. One might suppose such a message to be superfluous. After all, do we really need reminding that our actions today affect our choices tomorrow, whether in our personal decisions or in our collective decisions regarding a national budget? Yet Heller is thoroughly persuasive in demonstrating that current fiscal practices around the world fall far short of the necessary intertemporal logic and rigor. He goes far to explain why that is so, and why thinking ahead in fiscal affairs is much harder than it looks. Even more important, he shows how governments can improve their fiscal policymaking by adopting new tools for intertemporal analysis and budget implementation. The lessons are so powerful, indeed, that they would do much to transform the practices of Heller’s own institution, the International Monetary Fund, in its role of helping countries escape the trap of extreme poverty.

    The intertemporal constraints on fiscal policy can be summarized by a government’s long-term budget constraint. In one version of this measure, the discounted present value of government spending on goods and services starting today and continuing until the distant future cannot exceed the discounted value of government revenue less the current stock of net government debt to the public. If the government commits to a new program involving increased spending today and in the future, it must pay for that by making offsetting cuts in other areas of spending today or in the future, or by increasing the net present value of its revenue, perhaps through tax rate increases. If these choices are not planned sensibly, a government may well someday find itself resorting in desperation to inflationary financing, which is a tax on holders of the national money, collected without explicit public approval as the government “borrows” from the central bank. Or the government might be pushed into abrupt cuts in future programs or even to a default on its debt servicing, with all of the painful consequences likely to ensue from the collapse of the government’s financial credit and credibility. Similarly, if a government accumulates debt in the short term by running budget deficits, it will eventually have to service that debt by increased revenue in the future or by offsetting cuts in the discounted value of its spending. Debt financing may postpone hard choices, but it does not eliminate them.

    Heller stresses the complexities that arise naturally from these long-term considerations. Government spending is typically set in programmatic terms, not in fixed dollar amounts determined in advance over several years. The annual flows attached to long-term programs are then appropriated in annual budgets. A government may be committed to providing a certain amount of health coverage without knowing precisely the future demands for health services as the population ages or as health care risks and costs change. A government may be committed to providing a given level of retirement security yet lack a clear sense of the changing age distribution of the workforce and the timing of retirement decisions. Or a government may be committed to a program of income support, for example the purchase of farm outputs at a predetermined price, without knowing how fluctuations in the weather, world market prices, and myriad other factors will affect crop yields and the supply of outputs to government purchase programs. In short, outlays associated with long-term government programs are likely to be highly uncertain. The time path of revenue associated with a given tax system is at least as complex.

    The complexities multiply when we set the short-term electoral cycle alongside the long-term fiscal constraints and uncertainties. Politicians notoriously support short-run tax cuts or spending increases for the electoral boost that they offer, without giving their constituents much insight into the longer-term implications. Hard choices are pushed off until after the election, at which point a new election is on the horizon. And it is hard enough for the general public to get a rough sense of the budget at any given moment in time, much less to be able to factor in the consequences of today’s budgetary decisions for the distant future.

    Heller’s book is particularly powerful in reminding us of some of the key drivers of longer-term change in the world economy today—from population dynamics, to climate change, to geopolitical shocks such as global terrorism—and how systematic thinking about those forces can intelligently be incorporated into budgetary debate, planning, and implementation. He reviews in detail how various governments around the world have begun to grapple with the forecasting uncertainties and the politics of intertemporal budgetary planning. And he asks the right questions. How can the public become informed of the relevant long-term trade-offs, so that these can be considered in a democratic manner? What are the best summary statistics with which to convey that information? How useful are novel tools such as generational accounts, which measure the long-term income transfers between generations? And what kinds of institutional constraints (budget rules, reporting rules, or other procedures) are best at limiting the manipulation of long-term budgets for the sake of short-term electoral considerations?

    Three issues jump to mind that cry out for Heller’s approach. The first is the increasingly erratic performance of U.S. fiscal policy. In just three years—as a result of massive tax cuts, unexpected shortfalls in tax revenue, the bursting of a financial bubble, and the aftermath of September 11—the U.S. budget has gone from projections of unending and massive surpluses to projections of massive deficits for years to come. The overall swings are mind-boggling. In January 2001, just as President George W. Bush was coming into office, the U.S. Congressional Budget Office projected a cumulative “on-budget” surplus (that is, excluding Social Security) of $3,122 billion over 2002-11. By March 2003 the 10-year forecast had shifted to a cumulative on-budget deficit of $1,678 billion. Thus in just two years we have seen an astounding, indeed unprecedented, swing of nearly $5 trillion! The projected deficits might indeed be much larger under some plausible assumptions about future policies. One feels, strongly, that the U.S. public has not been fully informed about the implications of the federal government’s budget choices in recent years. How are the cumulative deficits to be handled in the future? Will cuts in popular programs be necessary? Will taxes have to be raised again? The issues have hardly yet been joined in public debate, and the multiyear tax cuts have been peddled as short-run stimulus measures.

    A second and pervasive fiscal phenomenon is the strain on retirement and health financing as a result of population aging. Most countries rely on pay-as-you-go financing for some or all of their public pension and health systems. As populations age, the ratio of beneficiaries of social support to contributors will rise markedly, putting huge strains on the public financing of these programs. Indeed, the strains are already in evidence. One recent study of the United States, discussed by Heller, suggests that the net difference between government commitments and revenue (net of public debt) is on the order of $44 trillion, suggesting that massive spending cuts or tax increases will be required in the future. The bulk of the shortfall revolves around the costs of pensions and, especially, health care. Although Heller is right to underscore the uncertainties of such calculations, there is no doubt that a first-order fiscal adjustment lies ahead, yet the broad public is mostly unaware of this. The situation in many of the countries of Europe, with generous yet partly or wholly unfunded retirement and health systems, is comparable or even worse.

    The third area crying out for Heller’s approach is the work of the IMF and the World Bank in the poorest countries, as those countries strive to meet the Millennium Development Goals of poverty reduction. Heller’s approach would call upon both institutions to take a much more detailed look at the medium- and long-term fiscal implications of ambitious programs of poverty reduction. The world has committed to helping the poorest countries escape the trap of extreme poverty. That will require massive public investments in roads, energy systems, water treatment facilities, health systems, and education—investments far exceeding any currently being undertaken (thus helping explain why many countries are still mired in extreme poverty). Indeed, the investments required will far exceed the capacity of these governments to finance them out of national revenue. A greatly increased transfer of fiscal resources from the richest countries to the poorest is needed, much closer to the internationally accepted and lauded target of 0.7 percent of donor GNP each year in development aid (the current level is roughly 0.22 percent).

    Heller’s approach would urge the IMF and the World Bank to prepare fiscal scenarios in line with these required increases. In doing so, these institutions would gain much more clarity about the need to finance such transfers in the form of grants as opposed to loans, and about the need to support much deeper cuts in existing debt. The longer-term implications of bold poverty reduction programs are obscured by the typical three-year framework in which such programs are discussed, and by the lack of recognition so far by many of the richest countries of the need for greatly increased transfers to the poorest. Yet that recognition is likely to come, and Heller’s admonitions for long-term planning will then be exactly what is needed.

    In short, this is a book to be read, and then to be applied. Thinking ahead is a first and critical step to building a sounder economic future.

    Jeffrey D. Sachs

    Director

    Earth Institute of Columbia University

    New York City

    August 2, 2003

    Acknowledgments

    This book has benefited from the comments and the perspectives of many. Particular thanks for many insights and useful references during its formative stages go to Barry Anderson, Orazio Attanasio, Ian Ball, James Banks, Nicholas Barr, Charles Bean, Peter Birch-Sorenson, Richard Blundell, Roger Bootle, Ralph Bryant, Robert Buckles, Marco Buti, Wendy Carlin, John Creedy, Thomas Dalsgaard, Nick Davis, Michael Devereux, Andrew Dilnot, Richard Disney, Frank Eich, Carl Emmerson, Neils Kleis Frederiksen, Richard Hemming, Richard Higgott, William Hsiao, John Janssen, Kirsten Jensen, Giles Keating, Andrew Kilpatrick, Mervyn King, Joslin Landell-Mills, Pierre Landell-Mills, Ben Lockwood, Warwick McKibbin, Costas Meghir, David Miles, Marcus Miller, Carin Norberg, Jonathan Ostry, David Pearce, Barry Potter, Lionel Price, Grant Scobie, Andrew Scott, Stephen Smith, Tim Swanson, Vito Tanzi, Carl Tham, Robert Watson, Nigel Wicks, and Martin Wolf. Valuable comments were received on early drafts of the manuscript from Henry Aaron, George Abed, Montek Ahluwahlia, Mukul Asher, Tamim Bayoumi, Elliot Berg, Steven Dunaway, Robert Gillingham, Edward Gramlich, Leslie Harris, Oleh Havrylyshyn, Yusuke Horiguchi, Edward Packard, Rudolph Penner, Lorenzo Perez, Murray Petrie, Stanford Ross, Allen Schick, Marcelo Selowsky, Eugene Steuerle, Alan Tait, Teresa Ter-Minassian, and Sarah Walton. The manuscript also benefited from the insightful editorial assistance of Michael Treadway, the vital secretarial assistance of Barbara Lissenburg, and source checking by Deidre Shanley.

    The author acknowledges with great appreciation the support of the International Monetary Fund in providing financing, under its Independent Study Leave Program, for carrying out this research. Substantial intellectual and logistical support was provided by the Economics Department of the University College, University of London; The Centre for the Study of Globalisation and Regionalisation, University of Warwick; The New Zealand Treasury; the Economic Policy Research Unit, University of Copenhagen; and The Ross Institute, East Hampton, New York. I am also indebted to the External Relations Department of the IMF and, in particular, Jeanette Morrison and Sean M. Culhane, for their vital encouragement in the transformation of a manuscript into this volume.

    List of Abbreviations

    AIDS

    Acquired immune deficiency syndrome

    CSIS

    Center for Strategic and International Studies

    EC

    European Commission

    EcoFin

    Economic and Financial Council of the European Union

    EU

    European Union

    GA

    Generational accounting

    GDP

    Gross domestic product

    GPF

    Government Petroleum Fund (Norway)

    HIV

    Human immunodeficiency virus

    IFAC

    International Federation of Accountants

    IMF

    International Monetary Fund

    IPCC

    Intergovernmental Panel on Climate Change

    NGOs

    Nongovernmental organizations

    NIC

    National Intelligence Council

    NZSF

    New Zealand superannuation fund

    OECD

    Organization for Economic Cooperation and Development

    OLG-GE

    Overlapping-generation multicountry general-equilibrium modeling

    PAYGO

    Pay-as-you-go pension scheme

    SARS

    Severe acute respiratory syndrome

    SCP

    Stability and Convergence Programme

    SGP

    Stability and Growth Pact

    SWF

    Social welfare function

    UN

    United Nations

    U.S. CBO

    United States Congressional Budget Office

    U.S. CIA

    United States Central Intelligence Agency

    U.S. EPA

    United States Environmental Protection Agency

    U.S. GAO

    United States General Accounting Office

    VaR

    Value at risk

    WMD

    Weapons of mass destruction

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