This chapter quantifies the fiscal adjustment needed to stabilize debt/GDP over the very long run and also examines the generational imbalance (the difference in net taxes faced by current versus future generations). Both the fiscal and generational imbalances are large: we estimate an adjustment between 7 ¾ and 14 ½ percent of every future year’s GDP to restore sustainability and fiscal equity. A permanent cap on the growth of Medicare spending, along with the 2 ¾ percent of GDP adjustment advocated in the Staff Report, would eliminate 40 percent of the fiscal gap. The needed adjustment would rise if delayed.
Appendix 1. Definition of Fiscal and Generational Gaps
Auerbach, A. J., Gokhale, J. and L. J. Kotlikoff, 1991. Generational Accounting: A Meaningful Alternative to Deficit Accounting, NBER Chapters in Tax Policy and the Economy, Volume 5, pages 55-110 National Bureau of Economic Research, Inc.
CBO (2010c), “An Analysis of the President's Budgetary Proposals for Fiscal Year 2011”, Congressional Budget Office, March 2010.
Gokhale, J. B. R. Page and J. Sturrock (1999), “Generational Accounts for the United States: An Update”, in Generational Accounting Around the World, A. J. Auerbach, L. J. Kotlikoff and W. Leibfritz (eds).
Gokhale, J. and K. Smetters (2003). “Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities”, AEI Press, Washington, D.C.
Prepared by Nicoletta Batini, Giovanni Callegari and Julia Guerreiro. Laurence Kotlikoff served as a consultant on this project.
Technically, the ratio of the fiscal gap to the present discounted value of GDP shows how much of the gap adjustment can be apportioned to each year from now to infinity to ensure intertemporal solvency.
A higher discount rate indicates a low propensity to save now for future consumption, a form of spending impatience, implying that the current government attaches more weight to the welfare of current generations relative to the welfare of future generations. In this sense, the discount rate is different than the cost of financing government borrowing that is embedded in our two fiscal scenarios. In general, the higher the discount rate, the lower the present value of future cash flows—hence a lower fiscal gap.
This number is close to the figure (8¾ percent of GDP) derived by CBO (2010) using a 75-year-horizon. The small difference is due to the fact that the CBO calculations employ a variable real interest rate, while Fund staff uses a constant rate throughout.
Population aging is also an important driver but far less than the increase in healthcare costs; the increase in healthcare costs is in turn due to various factors, the more important of which is technological change. This factor is summarized in CBO’s “excess growth component” of health-care costs growth (see CBO, 2010).
To assess the impact of the crisis, individual and capital income taxes are set at the pre-crisis GDP ratio level for 2009–11. Unemployment compensation and food stamps are set at the pre-crisis GDP ratio for 2009–14. Discretionary spending is reduced in order to exclude fiscal stimulus and above-the line financial sector support above the line. Relatedly, IMF Staff Position Note SPN 2009/13 calculates that the PV of the impact of the financial crisis in only 7½ percent of the PV of age-related fiscal costs.
As Table 4 indicates, projected transfers to current generations, particularly health care, have become so substantial as to drive the lifetime net tax payment of current generations negative.
However, from a theoretical perspective, the measured deficit need bear no relationship to the underlying intergenerational stance of fiscal policy.