Fiscal and Generational Imbalances: An Update · of implicit debt under current fiscal policy that past and current gener-ations are passing to future generations, who must finance

This PDF is a selection from a published volumefrom the National Bureau of Economic Research

Volume Title: Tax Policy and the Economy, Volume20

Volume Author/Editor: James M. Poterba, editor

Volume Publisher: The MIT Press

Volume ISBN: 0-262-16240-7

Volume URL: http://www.nber.org/books/pote06-1

Conference Date: September 15, 2005

Publication Date: September 2006

Title: Fiscal and Generational Imbalances: An Update

Author: Jagadeesh Gokhale, Kent Smetters

URL: http://www.nber.org/chapters/c0066

6

Fiscal and Generational Imbalances: An Update

Jagadeesh Gokhale, CATO InstituteKent Smetters, Wharton School

Executive Summary

This paper provides an update of the U.S. fiscal and generationalimbalances that we originally calculated in Gokhale and Smetters(2003) and presents the calculations in several alternative ways. Wefind that a lot has changed in just a few years. In particular, thenation's fiscal imbalance has grown from around $44 triffion as of fiscalyear-end 2002 to about $63 trillion, mostly due to the recent adoptionof the prescription drug bill (Medicare, Part D). The imbalance alsogrows by more than $1.5 trillion (in inflation adjusted terms) each yearthat action is not taken to reduce it.

This imbalance now equals about 8 percent of all future gross do-mestic product (GDP) and it could, in theory, be eliminated by morethan doubling the employer-employee payroll tax from 15.3 percent ofwages to over 32 percent immediately and foreverassuming, quitecritically, no reduction in labor supply or national saving and capitalformation. Massive cuts in government spending would also berequired to achieve fiscal balance: the total federal fiscal imbalancenow equals 77.8 percent of nonSocial Security and non-Medicareoutlays.

1. Introduction

The oldest baby boomers will attain Social Security's early retirementage of 62 in 2008, and wifi become eligible for Medicare benefits by2011. As this generation enters retirement, the population share ofretirees will climb rapidly, increasing from about 20 percent today to37 percent by 2035. Projected longevity improvements mean that theretiree population share will continue to increase gradually during the

194 Gokhale and Smetters

remainder of this century. This ongoing and irreversible process of

population aging in the United States will exert tremendous pressureon government budgets in terms of both their size and composition.

Combined with the politically inflexible eligibility and benefit rulesof entitlement programs, population aging wifi induce a shift in federalbudget priorities from discretionary spending such as defense, infra-structure, education, and research and development to mandatory out-lays such as Social Security, Medicare, and Medicaid. If the increase inthese mandatory outlays cannot be controlled, maintaining growth indiscretionary outlays to keep pace with overall economic growth wifirequire higher taxes. An important additional factor that is likely tocause the share of government in the economy to grow is the rapidprojected increase in health-care costswhich have historically grownat a much faster pace than general price inflation.

We have argued elsewhere that fiscal policymaking would becomeeasier if the impending change in federal budget priorities werepreceded by an adjustment in our fiscal vocabularythat is, by adopt-ing new measures to gauge the federal government's fiscal health(Gokhale and Smetters 2003).1 Traditional measuressuch as annualdeficits and debt held by the public projected for a limited number offuture yearsare not adequate for providing lawmakers with the in-formation necessary for enacting new policies in the presence of theage wave. The backward-looking nature of these measures makes itdifficult to gauge whether the future fiscal commitments created bylaws that Congress enacts are affordable or not. These measures also

bias Congress's decisions, inducing rejection of reforms that could im-

prove the nation's long-term fiscal outlook by undertaking a short-term sacrifice.

The two measures that we have proposed in the past are called thefiscal imbalance (Fl) and the generational imbalance (GI) (Gokhale

and Smetters 2003). The most important differences between tradi-

tional fiscal measures and our proposed measures are that the latterare forward-looking and apply a time discount to future dollar flows.The Fl measure equals the current level of debt held by the public (rep-

resenting past overspending) plus the present discounted value offuture federal non-interest expenditures less the present discountedvalue of future federal receipts.2'3 In other words, Fl shows the extentto which current U.S. federal fiscal policy is not sustainable. Fl equals

zero for a sustainable (or balanced) policywherein outstanding debtheld by the public plus future spending commitments are balanced

Fiscal and Generational Imbalances 195

with future receipts in present value. While FT encompasses all federalprograms, it can also be calculated separately for specific federal pro-grams, including Social Security.

The H measure includes all future federal financial shortfalls with-out a time limit. Of course, it can also be calculated under a finite timehorizon. But truncating the calculation in this way could seriously mis-state the size of the total FT because it would ignore the present valueof shortfalls accruing outside the particular choice of budget window.Under current U.S. fiscal policy, our estimates suggest that even if thefederal budget window were extended from the normal five-year orten-year window to seventy-five years (the standard projection win-dow used by the Social Security and Medicare trustees), the projectedshortfall would miss over half of the true present value imbalance.Restricting attention to such truncated calculations of fiscal shortfallscould significantly bias policymaking toward obtaining short-termbenefits at the expense of policies with short-term costs but largerlong-term gains. This short-term policy bias would make current gen-erations better off at the expense of future ones.

Even the FT measure, however, does not fully reflect this policy bias.For example, a strict pay-as-you-go financed retirement benefit has noeffect on either traditional budget measures or on FT since the costs ofsuch a program are, by construction, financed out of contemporaneousreceipts. Still, such a program would transfer resources toward olderpeople who would receive a benefit without having paid much in taxeswhen working. Such a program would reduce national savings and in-crease interest rates, as was pointed out in a seminal work by Feldstein(1974). Under a dynamically efficient economy (one in which thesteady-state interest rate exceeds the growth rate), this transfer to oldergenerations is financed by younger and future generations, who paymore taxes under this program relative to their benefits in presentvalue.

To capture the intergenerational redistributive effects of such pay-as-you-go policies, we also proposed a second, complementary mea-surethe generational imbalance (GI). This measure calculates thecontribution of past and current generations to Fl, that is, the amountof overspending by past and current generations under current law. Inother words, whereas FT shows the extent to which current fiscal policyis not sustainable, GI measures the amount by which benefits to pastand current generations (including prospective benefits of currentgenerations) exceed their tax payments (including prospective tax


payments by current generations) in present value. The GI measure isalso useful in estimating the amount by which such obligations inducea reduction in national saving and capital formation.

The GI measure is calculated under projections of taxes and benefitsand assuming continuation of current policies throughout the lifetimesof current generations. Therefore, GI can be interpreted as the amountof implicit debt under current fiscal policy that past and current gener-ations are passing to future generations, who must finance it throughtax payments in excess of their benefits in present value. The amountof implicit debt can be changed, however, by changing current fiscalpolicy.

Most policy changes wifi affect both GI and FT. As noted earlier,however, a strictly pay-as-you-go-financed programwherein higherbenefits to older generations are fully financed out of higher taxeslevied on working generationswould, by construction, have no im-pact on FT. But such a program would cause a potentially large in-crease in GI. Thus, while GI provides important information on theeffect of fiscal policy on national savings, it also provides a complemen-tary measure of policy sustainability. For instance, one could conceiveof policies that are sustainable in a traditional static-scoring sense (i.e.,for which FT = 0) but involve a very high implicit debt, as reflected in ahigh value of GI, which would produce unrealistically large tax hikesor benefits cuts.

Unfortunately, the GI measure can be cleanly estimated only forcertain federal programs whose benefits and taxes can be easily distrib-uted across the recipient population. For such programs, the GI mea-sure indicates the contribution of past and current generations to theprogram's total FT.

This paper reports updated calculations of the infinite-horizon FT andGI measures. Our calculations are based on long-term federal spendingand revenue projections made for the Budget of the United States Gov-ernment for fiscal year 2005, the latest long-term budget projectionsavailable to us. We report the calculationsparticularly Medicare'sestimatesin several alternative ways, and we report the sensitivity ofour results to different economic assumptions. We also report limited-horizon FT measures over budget windows of five, ten, twenty-five,fifty, and seventy-five years, and we show how those calculationswould potentially severely bias fiscal policy decision-making.

Since the publication of our book (Gokhale and Smetters 2003), thenation's fiscal position has dramatically worsened, even relative to the


alarmingly large estimates that we presented two years ago. In particu-lar, the FT has increased from around $44.2 trillion (expressed in con-stant 2002 dollars) to about $63.3 trillion (expressed in constant 2004dollars). Restating the 2002 estimate of FT in 2004 dollars makes it equalto $45.9 trillion. About $3.4 trillion of the difference between this andFl as of fiscal year-end 2004 ($63.3 trillion) arises from the accrual of in-terest over two years (calculated in inflation adjusted terms). The en-actment in 2003 of the prescription drug benefit (Medicare, Part D)adds $24.2 trillion to FT as of fiscal year-end 2004 (including one year'sinterest cost since enactment). However, the Office of Managementand Budget's (OMB's) more favorable long-term productivity outlookreduced FT on the rest-of-federal-government account by $6.2 triffion,arising mainly from higher non-payroll-tax revenues. The remainingdifference is explained by changes in revenue and outlay projectionsfor Social Security and Medicareespecially reductions in MedicareParts A and B outlays resulting from the introduction of MedicarePart D.

The GI measure indicates massive overspending by past and cur-rent generations in just the Social Security and Medicare programsto the tune of $33.6 trillion. Again, this is under the assumption thatgeneral-revenue transfers are appropriated by the federal governmentfor Medicare Parts B and D. Alternatively, if general-revenue transferswere viewed as dedicated to the Medicare program, the total GI valuefor Social Security and Medicare would equal $26.1 triffion.

Achieving fiscal balance would require either massive tax increases(e.g., more than doubling the employer-employee combined payrolltax immediately and forever) or massive cuts in government outlays,for example, a 77.8 percent immediate and permanent reduction in allnon-Social Security and non-Medicare outlays. Such a sharp increasein taxes would likely send the U.S. economy into a tailspin and, there-fore, pass along to future generations an economy that is in worseshape than the economy that baby boomers inherited from theirparents. A sharp decrease in Social Security, health care, and other ben-efits, however, could entail significant hardship for retirees unless ben-efits could be reduced in a sufficiently progressive manner.

The FT and GI measures have now also been published by SocialSecurity's and Medicare's trustees in their annual reports, starting withSocial Security in 2003 and then both programs in 2004 and 2005.These presentations have been endorsed by the 2003 Social Securityadvisory board's technical panel on assumptions and methods (Social


Security Advisory Board 2003), which is composed of several prom-inent economists and actuaries outside the Social Security Adminis-tration. The calculations reported herein differ from the trustees'estimates because our calculations are based on long-term budgetprojections made under the administration's economic assumptions,whereas the trustees use their own set of assumptions, including asmaller interest rate and a smaller rate of productivity growth. As a re-sult, the imbalances that we report for the Social Security and Medicareprograms are actually somewhat smaller than what they find.

In addition to the Social Security trustees, the Federal AccountingStandards Advisory Board (FASAB) is actively considering ways tobroaden the definition of liabilities associated with social insuranceprograms for purposes of financial reporting by the federal govern-ment. Doing so would be consistent with representing more fullythe future implications of current lawssuch as those of entitlementprogramsthat prescribe criteria for benefit eligibility and benefitamounts payable to those eligible until such time that Congress acts tochange those laws.

Finally, the current administration appears to have endorsed, inprinciple, the formal reporting of future federal obligations andanchoring the legislative budget process on such measures. The fiscalyear 2006 Budget of the United States Government calls for the follow-ing reforms:

First, the Administration proposes a point of order against legislation whichworsens the long-term unfunded obligation of major entitlements. The specificprograms covered would be those programs with long term actuarial projec-tions, including Social Security, Medicare, Federal civilian and military retire-ment, veterans disabifity compensation, and Supplemental Security Income.Additional programs would be added once it becomes feasible to make long-term actuarial estimates for those programs.

Second, the Administration proposes new reporting requirements to high-light legislative actions worsening unfunded obligations. These requirementswould require the Administration, as part of the President's Budget, to reporton any enacted legislation in the past year that worsens the unfunded obliga-tions of the specified programs.4

2. Estimates of U.S. Federal Fiscal Imbalances

This section presents calculations of the U.S. federal government's fis-cal imbalances, using the Office of Management and Budget's long-range projections (made through the year 2080) as a starting point,


that are consistent with the federal budget for fiscal year 2005. Ourlong-range assumptions underlying our projections include an annuallabor productivity growth rate (change in hourly labor compensation)of 1.8 percent per year and a consumer price inflation of 2.5 percentper year. Present values are calculated using a discount rate of 3.65percent per yearconsistent with the rates on outstanding thirty-yearTreasury securities.5

Table 6.1 presents FT estimates for the entire federal government aswell as separately for Social Security, Medicare, and rest-of-federal-government account. The federal government's total fiscal imbalanceamounts to more than $63 trillion in 2004. Social Security contributes"only" $8 trillion to total federal FT.

Total federal FT equals 8 2 percent of the present value of futureGDP. Some analysts prefer this measure of the total imbalance becauseit compares FT to the economy's resource base. However, because onlyabout half of GDP is subject to taxation, the imbalance-to-GDP ratiomeasure severely understates the difficulty in financing such a largefiscal imbalance. Indeed, as shown in table 6.1, Fl equals to 18.0 per-cent of all future uncapped payrollsthe present value of Medicare'stax base, which, unlike Social Security, does not impose a taxablewage ceiling.

In other words, even with a zero labor supply elasticitya heroicassumption that almost all economists would dispute at existing taxratesbalancing the federal government's intertemporal budget con-straint would require more than doubling the employer-employeecombined payroll tax of 15.3 percent to more that 33.3 percent perma-nently and forever. Note, however, that the vast majority of the current15.3 percent tax rate is levied only on earnings below the wage ceiling.In other words, both a large tax rate increase and a base broadeningwould be required to achieve fiscal balance under this hypotheticalpolicy scenario.

More realistically, of course, labor supply would sharply fall inresponse to such a tax increase (Feldstein 1996, Prescott 2004). We con-jecture that federal tax increases alone could never be successful inreducing the federal FT to zero. This view is only strengthened whenwe consider that many states are facing budget crises of their own dueto rising Medicaid costsfiscal imbalances that the calculationsreported here ignore.6'7 The extent to which federal taxes can beincreased are therefore further limited by the need to increase revenuesfrom the same tax base for state balancing budgets. That suggests

Tab

le 6

.1U

.S. F

eder

al F

isca

l Im

bala

nce

and

Its

Com

pone

nts

Und

er A

ltern

ativ

e A

ssum

ptio

ns

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Pres

ent V

alue

s in

Bill

ions

of

Con

stan

t 200

4 D

olla

rs

Tot

al f

isca

l im

bala

nce-

U.S

. fed

eral

gov

ernm

ent

63,2

8465

,928

68,6

3371

,317

73,9

6876

,648

79,4

17

Soci

al S

ecur

ity8,

006

8,35

28,

709

9,06

79,

422

9,78

410

,158

Pane

l A: g

ener

al r

even

ue tr

ansf

ers

are

annu

ally

app

ropr

iate

dfo

r M

edic

are

Part

s B

and

D

Med

icar

e60

,886

63,3

8165

,875

68,3

2170

,717

73,1

2275

,599

Res

t of

fede

ral g

over

nmen

t-5

,608

-5,8

05-5

,951

-6,0

71-6

,171

-6,2

58-6

,339

Pane

l B: g

ener

al r

even

ue tr

ansf

ers

are

dedi

cate

d to

Med

icar

ePa

rts

B a

nd D

Med

icar

e17

,997

18,7

6819

,554

20,3

3321

,101

21,8

7622

,676

Res

t of

fede

ral g

over

nmen

t37

,282

38,8

0840

,369

41,9

1743

,445

44,9

8846

,583

As

a Pe

rcen

tage

of

the

Pres

ent V

alue

of

GD

P

Tot

al f

isca

l im

bala

nce-

U.S

. fed

eral

gov

ernm

ent

8.2

8.3

8.4

8.5

8.6

8.8

8.9

Soci

al S

ecur

ity1.

01.

11.

11.

11.

11.

11.

1

Pane

l C: g

ener

al r

even

ue tr

ansf

ers

are

annu

ally

app

ropr

iate

dfo

r M

edic

are

Part

s B

and

D

Med

icar

e7.

98.

08.

18.

28.

38.

48.

5

Res

t of

fede

ral g

over

nmen

t-0

.7-0

.7-0

.7-0

.7-0

.7-0

.7-0

.7

Pane

l D: g

ener

al r

even

ue tr

ansf

ers

are

dedi

cate

d to

Med

icar

ePa

rtsB

andD

Med

icar

e2.

32.

42.

42.

42.

52.

52.

5

Res

t of

fede

ral g

over

nmen

t4.

84.

95.

05.

05.

15.

15.

2

Mem

o: P

rese

nt V

alue

of

GD

P (b

illio

ns o

f co

nsta

nt 2

004

dolla

rs)

772,

260

790,

733

812,

819

834,

656

855,

240

874,

525

893,

283

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

As

a Pe

rcen

tage

of

the

Pres

ent V

alue

of

(Unc

appe

d) P

ayro

lls

Tot

al f

isca

l im

bala

nce-

U.S

. fed

eral

gov

ernm

ent

18.0

18.3

18.5

18.7

19.0

19.2

19.5

Soci

al S

ecur

ity2.

32.

32.

32.

42.

42.

52.

5Pa

nel E

: gen

eral

rev

enue

tran

sfer

s ar

e an

nual

ly a

ppro

pria

ted

for

Med

icar

e Pa

rts

B a

nd D

Med

icar

e17

.317

.617

.818

.018

.118

.418

.6R

est o

f fe

dera

l gov

ernm

ent

-1.6

-1.6

-1.6

-1.6

-1.6

-1.6

-1.6

Pane

l F: g

ener

al r

even

ue tr

ansf

ers

are

dedi

cate

d to

Med

icar

ePa

rtsB

andD

Med

icar

e5.

15.

25.

35.

35.

45.

55.

6R

est o

f fe

dera

l gov

ernm

ent

10.6

10.8

10.9

11.0

11.1

11.3

11.5

Mem

o: P

rese

nt v

alue

of

unca

pped

pay

rofl

s (b

illio

ns o

f co

nsta

nt35

2,52

936

0,87

537

0,81

038

0,58

638

9,75

039

8,30

240

6,60

420

04 d

olla

rs)

Sour

ce: A

utho

rs' c

alcu

latio

ns.


federal spending reductions will have to play an important role inresolving the federal government's fiscal imbalance.

2.1 Alternative Presentations of Medicare's Portion of F!In our book, Gokhale and Smetters (2003), we presented Medicare'sportion of the total FT by ignoring the general revenue transfersreceived by Medicare Part B (Supplementary Medical Insurance).About 75 percent of Medicare Part B's outlays are financed out of gen-eral revenues. Moreover, Medicare Part D (prescription drug cover-age), which was enacted after the publication of our book, is entirelyfinanced out of general revenue transfers. Some commentaries cor-rectly disputed our representation of the entire burden of Medicare'sgeneral revenue financing as Medicare's fiscal imbalance. That's be-cause Medicare Parts B and D are not intended to be fully financedfrom dedicated federal receipts; to ignore general revenue contribu-tions is to essentially ignore this aspect of current law and therefore todisregard the explicit intent of the U.S. Congress to partly financeMedicare out of general revenues. Auerbach, Gale, and Orszag (2004),for example, consider several alternative methods of presenting Medi-care's shortfalls.

We stifi believe that the best way of presenting Medicare's shortfallsis to offset outlays by only its dedicated payroll taxes. The reason forthisbased on budget accounting principles and not political or eco-nomic onesis that the reported contribution of any program to thefederal government's overall FT should reflect the budgetary savings(reduction in Fl) generated by eliminating that program. Of course, weare not advocating Medicare's elimination. Rather, we favor accountingfor Medicare's contribution to the FT by measuring the total amount ofburdens generated by that program. Otherwise, the purpose of the cal-culations (measuring budgetary costs arising from operating federalprograms) would become unclear.

Nonetheless, for the sake of completeness and to acknowledge thatCongress intended Medicare to be partly financed out of general reve-nues, we present Medicare's contribution to total federal FT under twoalternative views. Firstand the approach we prefergeneral reve-nue transfers are ignored by assuming that these transfers are annuallyappropriated for Medicare Parts B and D. Medicare's FT in 2004 isabout $61 trillion under this perspective. Under the second view, weinclude general revenue transfers by assuming that they are dedicatedto these two subprograms, in which case Medicare's FT is substantiallylower$18 trillion.


Regardless of one's view of how Medicare's finances should be rep-resented, however, total federal FT remains unchanged at $63 trillion,as shown in table 6.1. When general revenue transfers are included aspart of Medicare's finances, the contribution to FT by the "rest of fed-eral government" simply increases by about $43 trillion, the differencebetween the two alternative measures of Medicare's FT.8

2.2 A Growing Fiscal ProblemTable 6.1 also shows that the fiscal imbalance is growing by about $2triffion each year, or by about 20 percent of this year's GDP. Like a cor-pus of debt, an outstanding total federal Fl accrues interest over time.9Under current estimates, its value wifi grow from $63.3 trillion at year-end 2004 to $79.4 trillion by year-end 2010 if policies and projectionsremain unchanged in the interim. However, a seemingly more optimis-tic view, also shown in table 6.1, indicates that the imbalance growsfrom 8.2 percent of all future GDP in 2004 to 8.3 percent of all futureGDP in 2005. Relative to all future uncapped payroll, FT grows from18.0 percent in 2004 to 18.3 percent in 2005.

The advantage of dividing Fl by the present value of all future GDPor uncapped payroll is that this measure accounts for the fact that notonly does FT grow over time but GDP and uncapped payrolls grow aswell. Indeed, if the economy's capital stock were exactly at or abovethe golden rule levelimplying that the economy's interest rate is lessthan or equal to the economy's growth ratethe ratio of FT relative toall future GDP (or uncapped payrolls) would not grow over time (seethe discussion in the appendix). In that case, of course, federal deficitswould not matter eitherin fact, reducing national saving would bePareto improving. The U.S. economy would be in Paul Samuelson's(1958) hypothetical world in which Ponzi games are feasible in thelong run. Empirical studies, however, have rejected the hypothesisthat the U.S. economy is dynamically inefficient (e.g., Abel et al. 1989).

The time-path of the ratio of FT to GDP or payrolls shown in table 6.1indicates the trade-off available to policymakers between adoptingsmaller policy changes (tax increases or benefit reductions) effectiveimmediately, or larger ones that would become effective after someyears have passed.

Nonetheless, exactly how to report FT's growth over timewhetheras a dollar figure or relative to the present value of GDP or uncappedpayrollhas generated a heated debate. For example, Dr. PaulKrugman, a well-known economist and colunmist at the New YorkTimes, has repeatedly criticized President Bush for claiming that Social


Security's contribution to FT worsens by about $600 billion each year,as now estimated by the Social Security trustees.'° Dr. Krugman's ar-gument apparently rests on the fact that the growth of Social Security'sFT relative to the present value of future GDP or payroll does not appearas alarming.11

However, Dr. Krugman can only reject the $600 billion figure if healso rejects the budget accounting system currently being used by thefederal government in favor of the FT and GI metrics. But elsewhere,Krugman has referred to Social Security's FT estimate, which is nowbeing produced by the Social Security trustees, as a scare tactic.'2 Hispositions, therefore, seem inconsistent to us. Indeed, the president'sclaim that Social Security's problem worsens by $600 billion each yearis consistent with the standard deficit language that indicates the dollaramount that the national debt grows each year. The president's mes-sage simply emphasizes the need to look ahead rather than restrictattention to conventional cash-flow deficit as a guidepost for fiscalpolicymakers.

3. Social Security's Fiscal and Generational Imbalances

Table 6.2 shows a decomposition of Social Security's FT into two com-ponentsGI, which shows the contribution to FT on account of pastand current generations (those age 15 and older during the fiscal yearbeing considered), and FT minus GI, which shows the contribution toFT that future generations are scheduled to make under current poli-cies. The first row of table 6.2 repeats Social Security's FT shown intable 6.1 (in constant 2004 dollars) for the sake of comparison.

The second row of table 6.2 shows the generational imbalance onaccount of Social Security. As it turns out, Social Security's GI is largerin present value than its Fl, indicating that more than 100 percentof this program's FT is accounted for by the excess of benefits over pay-roll taxes in present value scheduled to be awarded to past and livinggenerations.

The third row of table 6.2 shows that Social Security's GI can bedecomposed into two parts: the first part is the present value of pro-spective excess benefits over payroll taxes that those age 15 and olderwifi receive. As of fiscal year-end 2004, this part equals $11.2 triffion.The second part is the accumulated (present) value of excess benefitspaid in the past compared to payroll taxes received by the Social Secu-rity system. It includes the present value of excess benefits over payroll

a T

hose

bor

n 15

yea

rs a

go a

nd e

arlie

r. I

n th

e ye

ar 2

004,

for

exa

mpl

e, th

is c

ateg

ory

incl

udes

peo

ple

born

bef

ore

1990

.1'

Tho

se b

orn

14 y

ears

ago

and

late

r. I

n th

e ye

ar 2

004,

for

exa

mpl

e, th

is c

ateg

ory

incl

udes

peo

ple

born

dur

ing

1990

and

late

r.I'.

)

01

Tab

le 6

.2So

cial

Sec

urity

's F

isca

l and

Gen

erat

iona

l Im

bala

nces

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Pres

ent V

alue

s in

Bill

ions

of

Con

stan

t 200

4 D

olla

rs

Tot

al f

isca

l im

bala

nce

in S

ocia

l Sec

urity

8,00

68,

352

8,70

99,

067

9,42

29,

784

10,1

58Pa

st a

nd li

ving

gen

erat

ions

(G

I)9,

549

9,89

910

,256

10,6

0910

,958

11,3

1011

,676

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

11,1

8211

,686

12,2

0512

,729

13,2

5513

,787

14,3

38T

rust

fun

d-1

,634

-1,7

87-1

,949

-2,1

20-2

,297

-2,4

76-2

,662

Futu

re g

ener

atio

ns1'

-1,5

43-1

,547

-1,5

47-1

,543

-1,5

35-1

,527

-1,5

18A

s a

Perc

enta

ge o

f th

e Pr

esen

t Val

ue o

f G

DP

Tot

al f

isca

l im

bala

nce

in S

ocia

l Sec

urity

1.04

1.06

1.07

1.09

1.10

1.12

1.14

Past

and

livi

ng g

ener

atio

ns (

GI)

1.24

1.25

1.26

1.27

1.28

1.29

1.31

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

1.45

1.48

1.50

1.53

1.55

1.58

1.61

Tru

st f

und

-0.2

1-0

.23

-0.2

4-0

.25

-0.2

7-0

.28

-0.3

0Fu

ture

gen

erat

ions

1'-0

.20

-0.2

0-0

.19

-0.1

8-0

.18

-0.1

7-0

.17

As

a Pe

rcen

tage

of

the

Pres

ent V

alue

of

(Unc

appe

d) P

ayro

lls

Tot

al f

isca

l im

bala

nce

in S

ocia

l Sec

urity

2.27

2.31

2.35

2.38

2.42

2.46

2.50

Past

and

livi

ng g

ener

atio

ns (

GI)

2.71

2.74

2.77

2.79

2.81

2.84

2.87

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

3.17

3.24

3.29

3.34

3.40

3.46

3.53

Tru

st f

und

-0.4

6-0

.50

-0.5

3-0

.56

-0.5

9-0

.62

-0.6

5Fu

ture

gen

erat

ions

1'-0

.44

-0.4

3-0

.42

-0.4

1-0

.39

-0.3

8-0

.37

Sour

ce: A

utho

rs' c

alcu

latio

ns.


taxes paid to those alive today (age 15 and older) and those no longeralive since the system's inception in 1935. As of 2004, this value is nega-

tive $1.6 trillion, indicating past accruals of payroll tax surpluses in theSocial Security Trust Fund. Adding these two parts yields the fiscalyear-end 2004 value of GI$9.5 trfflion.

Because Social Security's FT is smaller than its GI, the difference, FTminus GI, is negative. Thus, under current policies, future generations(those age 14 and younger and those that wifi be born in the future)wifi pay more in the present value of payroll taxes compared to thepresent value of their Social Security benefits. The present value offuture generations' excess payroll tax payments equals $1.5 trillion. De-spite this overpayment, they will be asked to pay even more (or receiveeven less)about $8 trillion morein order to produce a sustainablesystem unless Social Security is refonned soon.

4. Medicare's Fiscal and Generational Imbalances

In the following discussion we will adopt the convention of represent-ing Medicare's imbalance under our preferred perspective, which doesnot assume that general revenue transfers represent a free revenuesource to Medicare. Table 6.3 shows FT and GI values for Medicareand its component programs [hospital insurance (Part A), supplemen-tary medical insurance (or Part B), and the prescription drug benefit(Part D)].

Medicare's overall imbalance equals $60.9 trillion under currentpolicies. Similar to the procedure used by the Center for Medicare andMedicaid Services in making long-range health care projections, theOffice of Management and Budget's long-range budget projectionsassume that future federal health care outlays per capita wifi growabout 1 percent faster than GDP per capita through the next 75 years.Thereafter, this growth rate wedge is tapered down to equal GDPgrowth per capita.13 Table 6.4 shows, however, that total (economy-wide) medical spending per capita has increased by 1.6 percent peryear since 1980 and federal health-care outlay growth has averaged 1.8percent (calculated exponentially) during the same period. This ismuch faster than assumed in official long-range federal budget projec-tions used to calculate the FT and GI values of table 6.3. That makesthe FT and CI estimates reported here considerably more conservativecompared to those that would be obtained under a health care growthassumption closer to its historical average.


We estimate Medicare's overall FT to be $60.9 triffion as of fiscal year-end 2004. That equals 79 percent of GDPalmost equaling the entirefederal FT of 8.2 percent. Medicare's Fl equals 17.3 percent of the pres-ent value of uncapped payrolls. Despite the very conservative assump-tion about health care outlay growth, that's more than seven timeslarger than Social Security's FT.

Waiting until 2010 to change policies on Medicare's revenues or ben-efits would increase the program's FT to $75.6 trillionincreasing it asa share of GDP to 8.5 percent. Viewed alternatively, the additionalresources required through policy changes in 2010 would be equiva-lent to imposing a tax of 18.6 percent of uncapped payrolls instead of17.3 percent were the policy change undertaken immediately.

Table 6.3 also decomposes Medicare's FT into those computed onaccount of its sub-programs. Medicare Part A's and Part B's FIs are al-most identicalbetween $18.0 and $19.0 trillion each as of fiscal year-end 2004. The Medicare prescription drug program's FT is larger by 25percentvalued at $24.0 trillion.

A noteworthy difference between Social Security and Medicare isthat GT constitutes a much smaller share in FT for Medicare than for So-cial Security.'4 Recall that more than 100 percent of Social Security's FTis accounted for by generous benefits awarded to past and scheduledfor current generations compared to their payroll taxes, whereas futuregenerations are projected to pay more in Social Security payroll taxesthan they will receive in benefits. In contrast, Medicare's GT contributesonly two-fifths of its total FT of $60.9 trillion and, under current Medi-care tax and benefit rules, future generations are projected to receive$36.8 triffion more in future health care benefits than they wifi pay inpresent value of taxes. This result arises because much of Medicare'slarge FT is caused by rapid growth in future health care costs and out-lays. Indeed, the conservative assumptions used in making futurehealth care outlay projections suggest that these estimates may signifi-cantly understate Medicare's FT and significantly overstate the percent-age contribution of Medicare's GI to its FT.

5. Comparison with Estimates by the Social Security and MedicareTrustees

Table 6.5 compares this paper's FT and GI estimates with those of So-cial Security and Medicare's trustees that are published in their 2005annual reports. The Social Security program's FT is estimated at $11.1

Tab

le 6

.3M

edic

are'

s Fi

scal

and

Gen

erat

iona

l Im

bala

nces

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Pres

ent V

alue

s in

Bill

ions

of

Con

stan

t 200

4 D

olla

rs

Tot

al f

isca

l im

bala

nce

in M

edic

are

(Par

ts A

, B, a

nd D

)60

,886

63,3

8165

,875

68,3

2170

,717

73,1

2275

,599

Past

and

livi

ng g

ener

atio

ns24

,094

25,4

3126

,778

28,1

3129

,485

30,8

6232

,289

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

n?24

,376

25,7

2627

,098

28,4

6629

,835

31,2

2732

,670

Tru

st f

und

-282

-295

-320

-335

-350

-366

-381

Futu

re g

ener

atio

ns"

36,7

9137

,951

39,0

9740

,190

41,2

3242

,261

43,3

10

Med

icar

e Pa

rt A

Fisc

al im

bala

nce

18,0

9018

,866

19,6

5820

,441

21,2

1321

,992

22,7

97

Past

and

livi

ng g

ener

atio

ns7,

462

7,86

98,

292

8,72

29,

155

9,59

910

,062

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

7,72

28,

136

8,57

29,

014

9,46

19,

918

10,3

94T

rust

fun

d-2

61-2

68-2

79-2

92-3

06-3

19-3

33Fu

ture

gen

erat

ions

"10

,629

10,9

9811

,365

11,7

1912

,058

12,3

9312

,735

Med

icar

e Pa

rt B

Fisc

al im

bala

nce

18,6

1019

,295

19,9

8320

,665

21,3

2821

,992

22,6

74

Past

and

livi

ng g

ener

atio

ns7,

447

7,78

78,

136

8,49

48,

850

9,20

99,

580

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

7,46

77,

815

8,17

78,

537

8,89

49,

255

9,62

9

Tru

st f

und

-21

-28

-41

-43

-45

-46

-49

Futu

re g

ener

atio

ns"

11,1

6311

,507

11,8

4712

,171

12,4

7912

,783

13,0

94

(con

tinue

d)

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Med

icar

e Pa

rt D

Fisc

al im

bala

nce

24,1

8625

,220

26,2

3427

,216

28,1

7629

,138

30,1

28

Past

and

livi

ng g

ener

atio

ns9,

186

9,77

510

,349

10,9

1511

,480

12,0

5412

,647

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

9,18

69,

775

10,3

4910

,915

11,4

8012

,054

12,6

47

Tru

stfu

nd0

00

00

00

Futu

re g

ener

atio

ns"

15,0

0015

,446

15,8

8516

,301

16,6

9517

,084

17,4

80

Perc

enta

ge o

f th

e Pr

esen

t Val

ue o

f G

DP

Tot

al f

isca

l im

bala

nce

in M

edic

are

(Par

ts A

, B, a

nd D

)7.

888.

028.

108.

198.

278.

368.

46

Past

and

livi

ng g

ener

atio

ns3.

123.

223.

293.

373.

453.

533.

61

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

n?3.

163.

253.

333.

413.

493.

573.

66

Tru

st f

und

-0.0

4-0

.04

-0.0

4-0

.04

-0.0

4-0

.04

-0.0

4

Futu

re g

ener

atio

ns"

4.76

4.80

4.81

4.82

4.82

4.83

4.85

Med

icar

e Pa

rt A

Fisc

al im

bala

nce

2.34

2.39

2.42

2.45

2.48

2.51

2.55

Past

and

livi

ng g

ener

atio

ns0.

971.

001.

021.

041.

071.

101.

13

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

n?1.

001.

031.

051.

081.

111.

131.

16

Tru

st f

und

-0.0

3-0

.03

-0.0

3-0

.03

-0.0

4-0

.04

-0.0

4

Futu

re g

ener

atio

ns"

1.38

1.39

1.40

1.40

1.41

1.42

1.43

I

Tab

le 6

.3(c

ontin

ued)

I'.)

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Med

icar

e Pa

rt B

Fisc

al im

bala

nce

2.41

2.44

2.46

2.48

2.49

2.51

2.54

Past

and

livi

ng g

ener

atio

ns0.

960.

981.

001.

021.

031.

051.

07Fu

ture

net

ben

efits

of

livin

g ge

nera

tions

a0.

970.

991.

011.

021.

041.

061.

08T

rust

fun

d0.

000.

00-0

.01

-0.0

1-0

.01

-0.0

1-0

.01

Futu

re g

ener

atio

n&'

1.45

1.46

1.46

1.46

1.46

1.46

1.47

Med

icar

e Pa

rt D

Fisc

al im

bala

nce

3.13

3.19

3.23

3.26

3.29

3.33

3.37

Past

and

livi

ng g

ener

atio

ns1.

191.

241.

271.

311.

341.

381.

42Fu

ture

net

ben

efits

of

livin

g ge

nera

tions

a1.

191.

241.

271.

311.

341.

381.

42T

rust

fun

d0.

000.

000.

000.

000.

000.

000.

00Fu

ture

gen

erat

ions

1'1.

941.

951.

951.

951.

951.

951.

96

Perc

enta

ge o

f th

e Pr

esen

t Val

ue o

f L

Jnca

pped

Pay

rolls

Tot

al f

isca

l im

bala

nce

in M

edic

are

(Par

ts A

, B, a

nd D

)17

.27

17.5

617

.77

17.9

518

.14

18.3

618

.59

Past

and

livi

ng g

ener

atio

ns6.

837.

057.

227.

397.

577.

757.

94C

)C

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

6.91

7.13

7.31

7.48

7.65

7.84

8.03

Tru

st f

und

-0.0

8-0

.08

-0.0

9-0

.09

-0.0

9-0

.09

-0.0

9Fu

ture

gen

erat

ions

b10

.44

10.5

210

.54

10.5

610

.58

10.6

110

.65

a T

hose

bor

n 15

yea

rs a

go a

nd e

arlie

r. I

n th

e ye

ar 2

004,

for

exa

mpl

e, th

is c

ateg

ory

incl

udes

peo

ple

born

bef

ore

1990

.bT

hose

bor

n 14

yea

rs a

go a

nd la

ter.

In

the

year

200

4, f

or e

xam

ple,

this

cat

egor

y in

clud

es p

eopl

e bo

rn d

urin

g 19

90 a

nd la

ter.

Fisc

al Y

ears

2004

2005

2006

2007

2008

2009

2010

Med

icar

e Pa

rt A

Fisc

al im

bala

nce

5.13

5.23

5.30

5.37

5.44

5.52

5.61

Past

and

livi

ng g

ener

atio

ns2.

122.

182.

242.

292.

352.

412.

47

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

2.19

2.25

2.31

2.37

2.43

2.49

2.56

Tru

st f

und

-0.0

7-0

.07

-0.0

8-0

.08

-0.0

8-0

.08

-0.0

8

Futu

re g

ener

atio

ns"

3.01

3.05

3.07

3.08

3.09

3.11

3.13

Med

icar

e Pa

rt B

Fisc

al im

bala

nce

5.28

5.35

5.39

5.43

5.47

5.52

5.58

Past

and

livi

ng g

ener

atio

ns2.

112.

162.

192.

232.

272.

312.

36

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

2.12

2.17

2.21

2.24

2.28

2.32

2.37

Tru

st f

und

-0.0

1-0

.01

-0.0

1-0

.01

-0.0

1-0

.01

-0.0

1

Futu

re g

ener

atio

ns"

3.17

3.19

3.19

3.20

3.20

3.21

3.22

Med

icar

e Pa

rt D

Fisc

al im

bala

nce

6.86

6.99

7.07

7.15

7.23

7.32

7.41

Past

and

livi

ng g

ener

atio

ns2.

612.

712.

792.

872.

953.

033.

11

Futu

re n

et b

enef

its o

f liv

ing

gene

ratio

nsa

2.61

2.71

2.79

2.87

2.95

3.03

3.11

Tru

st f

und

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Futu

re g

ener

atio

ns"

4.25

4.28

4.28

4.28

4.28

4.29

4.30

Sour

ce: A

utho

rs' c

alcu

latio

ns.


Table 6.4Growth in Health Care Expenditures per Capita, 1980 and 2003

Source: Authors' calculations based on data from the Centers for Medicare and MedicaidServices (see http://www.cms.hhs.gov/statistics/nhe/l-iistorical/tl.asp). Figures for theConsumer Price Index (CPI-U, current series) are taken from the Bureau of Labor Statis-tics' web site.

Table 6.5Comparison with Official Estimates for Social Security and Medicare (Present Values inTrillions of Constant 2004 Dollars)

1980 2003

Exponential GrowthRate (percent)

Nominal Real

National health expenditures $1,067 $5,670 3.2 1.6

Private 612 3,084 3.1 1.5

Public 455 2,586 3.3 1.8

Federal 310 1,829 3.4 1.8

State and local 146 757 3.2 1.6

Prescription drugs 52 605 4.7 3.2

Memo items:

GDPpercapita 12,130 37,176 2.1 0.6

Consumer Price Index 82.4 188.9 1.6

OursSocial Security andMedicare Trustees

Social Security

Fl 8.0 11.1

CI 9.5 12.0

Medicare Part A

Fl 18.1 24.1

GI 7.5 9.4

Medicare Part B

Fl 18.6 25.8

CI 7.4 9.7

Medicare Part D

Fl 24.2 18.2

GI 9.2 6.7


trillion by the trustees, whereas it is just $9.5 trillion under the eco-nomic assumptions of the Office of Management and Budget. Whenwe lower the discount rate from 3.65 percent to 3.30 percent, SocialSecurity's FT increases to $11.5 triffionhigher than the trustees' esti-mate. That is, adopting the trustees' discount rate assumption wouldresult in an even higher estimate of that program's unfunded obliga-tion. Why the difference? The answer is OMB's higher productivitygrowth rate assumption-1.8 percent per year compared to 1.6 per-cent. Faster economic growth results in higher future tax revenues butalso larger benefit obligations because of Social Security benefits. Asit turns out, faster economic growth increases rather than reduces So-cial Security's unfunded obligations. In the words of the program'strustees:

While faster real wage growth. . results in increased tax revenue somewhatbefore it increases benefit levels, the cumulative additional growth in wagelevels eventually results in greater dollar increases in the relatively large pro-jected cost of the OASDI [Old Age, Survivors, and Disability Insurance] pro-gram than in the smaller projected tax revenues. Thus, eventually, faster realwage growth, alone, results in an increase in the unfunded obligation of theprogram.15

The Medicare trustees' estimate of the infinite horizon unfundedobligations for Medicare Part A (hospital insurance) equals $24.1 tril-lion, much higher than our estimate of $18.1 trillion. However, the pro-portion of FT contributed by GI is about 40 percent under both sets ofestimates. For Medicare Part B, the trustees report an unfunded obliga-tion of zero. That's because their reporting convention counts generalrevenue transfers to Medicare Part B as dedicated rather than appro-priated for the program. Using our preferred approach of viewing gen-eral revenue transfers as appropriated, Medicare Part B's unfundedobligation equals $25.8 triffion. Again, GI contributes just under 40percent of Medicare Part B's unfunded obligations under both sets ofestimates.

Estimates of Medicare Part D (prescription drug coverage), shown intable 6.5, differ considerably. The trustees' estimate is smaller at $18.2triffion, whereas ours is $24.2 trillion. Our estimate is based on OMB'sprojections of growth in prescription drug outlays. Reportedly, theseprojections are based on higher growth rates through 2040, as seen infigure b.1. Agam, nowever, the ratios or (iiI to F! are quite similar uncterboth sets of estimates.


0.02005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080

Year

Figure 6.1Medicare Part D's Projected Outlays as a Percentage of Projected GDP

Except for the magnitude of Medicare Part D outlay projections,the comparison of the two sets of estimates suggests broad agreementregarding the future projections for Social Security and Medicare andtheir allocation across past and current versus future generations. Thisis not, of course, surprising because 0MB usually receives projectionsfor both programs' revenues and outlays from their respective admin-istrative agencies based on OMB's economic assumptions. For Medi-care Part D expenditures projected in the fiscal year 2005 budget, 0MBstaff assumed higher outlay growth through the year 2040 (see figure6.1).16 These growth rates appear to be consistent with historicalgrowth in economy-wide prescription drug expenditures (see table6.4).

6. Estimates Under Alternative Budget Windows

Table 6.6 shows FT for selected budget windows. The last column oftable 6.6 repeats the infinite horizon FT measure. It is clear from thenumbers that calculating FT over short budget windows significantlyunderstates the financial shortfall that the federal government faces.For example, the regularly reported budget window for the 0MBis five years into the future. Over this period, the sum of Social Secu-rity's, Medicare's, and the rest of the federal government's fiscal im-balances amounts to $4.5 trillion. Over the Congressional BudgetOffice's (CBO's) regular budget-reporting horizon of ten years, the total

00MB FY'05 BudgetA Medicare Trustees March 2005

00

o

ri0

0

00

0

AA

0

A AA A

AA

0A

AA

7.0

6.0

5.0

.1

4.0

23.0

2.0

1.0


Table 6.6Fiscal Imbalances for Selected Budget Windows as of Fiscal Year-End 2004 (Billions ofDollars)

Source: Authors' calculations.

federal imbalance equals $4.1 trillion. Longer horizon fiscal imbalancesare larger. For example, over the next fifty years, total federal FT equals$13.5 trillion. The short-term estimates of FT are much smaller becausethey ignore financial shortfalls accruing after the budget window'sterminal year. Even the seventy-five-year FT estimate for the entire fed-eral government equals only about one-third of the FT calculated inperpetuity.

7. Fl and CI Estimates Under Alternative Productivity GrowthAssumptions

Table 6.7 shows estimates of FT for fiscal year 2004 under alterna-tive assumptions of productivity growth and discount rates. Variationaround the labor-productivity growth assumption equals ±50 basispoints. Thus, the "high" and "low" productivity growth estimatescorrespond to labor productivity growth rates of 2.3 percent and 1.3percent per year, respectively. Variation around the discount rate as-sumption equals ±25 basis points per year. Thus, estimates under highand low discount rates reflect discounting at 3.9 and 3.4 percent peryear, respectively. Finally, variation around the health care growthwedge assumption equals ±50 basis points: estimates under the highand low assumptions reflect health care growth rate wedges of 1.5 and0.5 percentage points, respectively.

5Years

10

Years25Years

50Years

75Years

InfiniteHorizon

Total federal government 4,593 4,125 5,185 13,568 23,580 63,284

Social Security -2,051 -2,430 -2,136 -45 1,742 8,006

Medicare 405 1,178 4,978 15,010 25,282 60,886

Rest of federal government 6,239 5,377 2,343 -1,397 -3,444 -5,608Rest of federalgovernment-outlays 6,034 11,244 24,416 41,048 52,900 81,323

Rest of federalgovernment-revenues -6,131 -12,203 -28,408 -48,781 -62,680 -93,266

Federal liabilities toSocial Security 1,915 1,915 1,915 1,915 1,915 1,915

Debt held by the public 4,421 4,421 4,421 4,421 4,421 4,421

Tab

le 6

.7Se

nsiti

vity

of

Fisc

al I

mba

lanc

es T

o E

cono

mic

Ass

umpt

ions

(Pr

esen

t Val

ues

in B

illio

ns o

f C

onst

ant 2

004

Dol

lars

)

Bas

elin

eA

ssum

ptio

ns

Dis

coun

t Rat

ePr

oduc

tivity

Gro

wth

Exc

ess

Hea

lth C

are

Out

lay

Gro

wth

per

Cap

ita

Hig

hL

owH

igh

Low

Hig

hL

ow

Tot

al f

isca

l im

bala

nce-

U.S

. fed

eral

gove

rnm

ent

63,2

8449

,356

84,2

3685

,795

47,2

7875

,819

52,4

23

Soci

al S

ecur

ity8,

006

5,67

911

,506

12,6

975,

482

8,00

68,

006

Med

icar

e60

,886

48,0

5479

,794

89,4

8941

,951

70,5

3952

,530

Res

t of

fede

ral g

over

nmen

t-5

,608

-4,3

78-7

,064

-16,

391

-156

-2,7

26-8

,113

PV o

f ex

cess

of

outla

ys o

ver

rece

ipts

-11,

943

-10,

713

-13,

400

-22,

722

-6,4

97-9

,061

-14,

449

Lia

bilit

y to

Soc

ial S

ecur

ity a

nd M

edic

are

1,91

51,

915

1,91

51,

915

1,91

51,

915

1,91

5

Deb

t hel

d by

the

publ

ic4,

421

4,42

14,

421

4,42

14,

421

4,42

14,

421

Mem

o:

Pres

ent v

alue

of

GD

P77

2,26

066

5,83

391

8,26

799

9,29

562

6,71

177

2,26

077

2,26

0

Pres

ent v

alue

of

payr

olls

348,

416

305,

153

416,

991

451,

181

288,

189

352,

529

352,

529

Sour

ce: A

utho

rs' c

alcu

latio

ns.


The FT for fiscal year 2004 is quite sensitive to variations in the dis-count rate. It is estimated to be $84 trillion under the low discount rate(3.4 percent) and $49 trillion under the high one (3.9 percent). The widevariation in FT estimates for small changes in the discount rate is onlyto be expected because a large share of total federal FT accrues afterseveral decades have passed.

Normally, such wide variations in Fl arising from small changes inthe discount rate are taken as an indication that the FT measure is notreliable or useful. However, as we have argued in Gokhale and Smet-ters (2003), wide variations in FT triggered by discount rate changesconfirm the need to adopt longer-term calculations because they indi-cate that a large fraction of the imbalance accrues after several decadeshave passeda component that would be ignored under truncatedhorizons. For example, table 6.6 shows that about two-thirds of the to-tal federal FT would arise under current policies after another seventy-five years have passed, and it is well known that a given change in theinterest rate imposes a larger discount effect on fund flows that occurfurther out into the future.

Table 6.7 shows that FT equals $85.7 trillion under the high produc-tivity growth rate assumption (2.3 percent). Social Security's fiscal im-balance increases from $8.0 triffion under baseline assumptions to$12.7 triffion when high productivity growth assumption is intro-duced. A considerable increase in FT also emerges in Medicare underthe high productivity growth assumption. Note that increasing pro-ductivity growth also leads to higher growth in federal health care out-lays because those outlays are assumed to grow 1 percentage pointfaster than growth in output per worker. The opposite result obtainswhen productivity growth is lowered to 1.3 percent per year. In thatcase, Medicare's FT is estimated to be $41.9 trillion.

Increasing or reducing the health-care growth wedge also consider-ably affects the total federal FT. Increasing the wedge by 50 basis points(from 1 percentage point to 1.5 percentage points) increases total fed-eral FT by more than $12 triffion, to $75.8 trillion, and reducing thewedge by 50 basis points (to 0.5 percentage point) reduces federal FTto $52.4 trillion.

These wide variations in dollar estimates of FT may make this mea-sure appear to be unsuitable as a guide for policymakers. However, amore stable measure of the size of the federal government's financialshortfall under current policies may be to view it as a ratio to GDP or


Table 6.8Sensitivity of Total Federal Fiscal Imbalance as a Percentage of the Present Values ofTotal Payrolls and GDP

Discount rate

Productivity growthper capitaHealth care outlaygrowth per capita

Source: Authors' calculations.

a tax base. When expressed relative to the present value of taxes, thisratio shows the size of the tax increase that would be needed to createa sustainable fiscal federal policy.

Table 6.8 shows federal FT in perpetuity as a ratio, alternatively,to the present value of GDP and the present value of total payrolls.These ratios exhibit less volatility than dollar estimates because thedenominator (the present value of GDP or payrolls) changes in thesame direction as does FT in response to changes in each of the threeassumptions. For example, although FT under high productivitygrowth ($85.8 trillion) is roughly double its size under the low produc-tivity assumption ($47.3 trillion), the difference in its ratio to GDP ismuch less divergent-8.6 under the high-productivity assumption and7.5 under the low-productivity assumption. Table 6.8 shows that, as aratio of the present value of payrolls, FT ranges between 16.2 and 19.0percent in response to the changes in productivity and discount rateassumptions considered here. In sum, while FT expressed in dollars issensitive to the choice of interest rate and productivity, the size of thepolicy change itself that is necessary to eliminate the imbalance is fairlystable.

The variation in this ratio, however, is much larger under alternativeassumptions on the size of the health-care growth rate wedge. Werehealth care outlays to grow 50 basis points faster immediately andpermanentlysomething that the historical evidence on health caregrowth suggests is quite feasible (see table 6.4)resolving the federalfiscal imbalance would require appropriating 21.5 percent of all futurepayroll. In contrast, were it possible to reduce the growth of health-care costs by 50 basis points, 14.9 percent of future payroll would stillbe needed to create a sustainable fiscal system.

GDP Total Payrolls

Baseline High Low Baseline High Low

8.2 7.4 9.2 18.0 16.2 20.2

8.2 8.6 7.5 18.0 19.0 16.4

8.2 9.8 6.8 18.0 21.5 14.9


There is an interesting difference between the estimates reportedin table 6.8 and those reported in Gokhale and Smetters (2003). Tnour 2003 book, FT as a share of the present value of payrolls wassmaller compared to the baseline when productivity growth wasassumed to be faster and, symmetrically, was larger when productivitygrowth was assumed to be slower. However, the estimates reportedin Gokhale and Smetters (2003) were made prior to the enactment ofsizable additional benefits made available through the Medicare pre-scription drug law (Medicare Part D). The estimates reported here,however, include the effects of that law. With the addition of the drugbenefits, the higher health-care growth rate accompanying the assump-tion of higher overall productivity growth results in a larger increase inprojected benefit outlays compared to the increase in total projectedpayrolls. The reason is that the prescription drug benefit wifi beginpaying benefits more quickly than the rate at which the payroll taxbase grows.

Conclusion

This paper updates calculations of U.S. federal fiscal and generationalimbalances. The result published in Gokhale and Smetters (2003) of a$44 trillion total federal fiscal imbalance as of fiscal year-end 2002 isnow revised to $63 trillion. A small part of the increase arises from theaccrual of interet on the existing fiscal imbalance. A large part of theincrease comes from the enactment of significant additional Medicarebenefits through the new prescription drug benefit. That law aloneaccounts for an increase in FT by $24 trillion.

The nation faces an extremely difficult challenge in implementing fis-cal adjustments to reduce the fiscal imbalance built into today's fiscalpolicies. Given the large magnitude of the overall fiscal imbalance, itsresolution from higher taxes alone is likely to trigger negative eco-nomic effects and does not appear to be feasible. Hence, a sizable partof the adjustment wifi be required through cuts in discretionary federaloutlays and reductions in future entitlement obligations.

Appendix

This Appendix shows how the ratio of Fiscal Tmbalance relative to GDPas well as the ratio of Generational Imbalance relative to GDP changeover time when there are no changes in fiscal policy and projections.


9.1 Ratio of Fiscal Imbalance to the Present Value of GDPIn Appendix A of Gokhale and Smetters (2003) we show [in equation(6.1)1 that absent changes in fiscal policies and budget projections, thefiscal imbalance measure grows at a rate equal to the rate of interest.That is:

= FIR1 (6.1)

Here, Fit stands for the fiscal imbalance calculated as of time period t,and R = 1/(1 + r) stands for the discount factor, with r as the annualinterest rate on long-term government debt.

Let Yt stand for the discounted present value of GDP as of period t.If annual GDP in year t, y, grows at rate g per year, and G representsthe growth factor 1/(1 + g), we can write:

Yt =

Therefore:

= s1 Yt+i ()

/R" s(t+1)YtG()

s=t

s(t+1)

(6.2)

= G1Y (6.3)

Divide both sides of equation (6.1) by Ysion by using equation (6.3) to get:

Fit+i Fi (Ri1 (64)- Y kG)

Under normal conditions the economy is dynamically efficientthatis, g < r, implying that G > R. Hence, we can specify in general that:

Flt±1 Fit(6.5)

and manipulate the expres-


That is, absent changes in policy and projections, the ratio of the fiscalimbalance to GDP grows larger over time. Thus, the share of GDP thatmust be devoted to resolving the fiscal imbalance increases if correc-tive policy changes are postponed.

9.2 Ratio of Generational Imbalance to the Present Value of GDPIn equation (A9) of our book (Gokhale and Smetters 2003), we showthat:

RGI+j GI' =RNT+i (6.6)

Here, GI stands for the generational imbalance in period t, and NTrepresents the present value lifetime net transfers to those born in pe-riod t as scheduled under current fiscal policies. Written alternatively:

GI+1 = GIR1 + NT+i (6.7)

Equation (6.7) says that next period's GI equals this period's GI accu-mulated at the rate of interest plus the present value of the lifetime nettransfer scheduled to be awarded to next period's newborn cohortunder current fiscal policies.

Dividing both sides of equation (6.7) by Y and using equation (6.3)to manipulate the expression, we get:

G1 (R1+

NT+iYt+i Y \\G) Yt+l

That is, whether the ratio of GI to GDP grows faster, just as fast, orslower than the ratio of Fl to GDP depends on whether NTt+i 0.

Notes

The authors thank James Poterba for very helpful comments. The opinions and con-clusions expressed are solely those of the authors and do not necessarily represent theopinions of the Cato Institute or The Wharton School. The authors thank the Office ofManagement and Budget for providing long-term budget projections and Felicitie Bell ofthe Social Security Administration for providing demographic projections and relatedunderlying assumptions.

Others, for example, Auerbach et al. (2004), have also called for adopting fiscal mea-sures based on a forward-looking accounting for the federal budget.

This measure has also been used by Auerbach, Gale and, Orszag (2004) and has beenadvocated by Alan Auerbach for over a decade now (e.g., Auerbach 1994). A key differ-ence with our FT measure is that we focus on the implications of current law using amicro-based estimation model. In contrast, these authors alter future policy in directionsthey regard as realistic by extending aggregate Congressional Budget office projections.

(6.8)


The FT measure is also different from the generational balance measure first developedby Auerbach, Gokhale, and Kotlikoff (1991). The generational balance concept involves ahypothetical policy whereby future generations are arbitrarily assigned equal additionalfiscal burdens except for an adjustment for economic growth. That hypothetical policybalances the government's intertemporal budget but, unlike the Fl measure, is not consis-tent with a budget conceptthat is, it does not reflect the implications of continuing cur-rent fiscal policies.

See the Analytical Perspectives, Budget of the United States Government, fiscal year2006, Chapter 15.

For technical details of our micro-data-based projections and other details, refer toGokhale and Smetters (2003). Although OMB's projected long-term interest rates in thefiscal year 2005 budget are slightly higher, we use a 3.65 percent annual rate to makepresent value estimates comparable with those published in Gokhale and Smetters(2003).

See, for example, Baker, Besendorfer, and Kotlikoff (2002). The fiscal problems thatthey measured, however, have likely worsened quite dramatically since their study be-cause economic growth forecasts have been reduced and Medicaid cost forecasts haverisen.

Our calculations only include the federal share of Medicaid costs (under "rest of fed-eral government" in the calculations reported later).

We are currently developing the methodology for decomposing the "rest of federalgovernment" account into GI and FT minus GI components, including defense, transpor-tation, Medicaid, etc. We intend to present those results in a new paper.

The effective interest accrual on the total federal Fl is a combination of the interest ac-cruing on outstanding government debt, Social Security and Medicare trust funds, andthe interest rates assumed to prevail during future years. As mentioned earlier, we use inthis calculation the Office of Management and Budget's fiscal year 2004 assumption of a3.65 percent interest rate on the longest-maturity Treasury securities outstanding.

For the most recent instance of this criticism, see Paul Krugman "Social Security Les-sons," New York Times, August 15, 2005, page 17.

Karnin and Kogan (2005) offer a more thoughtful critique, which likely influencedKrugman's thinking.

See Paul Krugman, "The $600 Billion Man," New York Times, March 15, 2005, page 25.

This does not necessarily imply that aggregate Medicare outlays wifi grow no fasterthan GDP since one of the factors driving Medicare and GDP is demographic change. Tothe extent that the Medicare beneficiary population continues to grow faster than the pro-ductive population, aggregate Medicare spending would continue to increase at a fasterpace relative to GDP. Our calculations indicate that the difference in the growth rates ofthe two aggregates is extremely small after the first seventy-five years and makes littledifference to FT and GT estimates.

This assertion is based on the assumption that general revenue transfers are appro-priated by Congress for Medicare each year and these funds are not dedicated to theprogram.

See the Social Security Trustees' (2005) Annual Report, Chapter IV.B.5, paragraph a.


16. Based on a phone conversation with a staff member of the Office of Management andBudget.

References

Abel, Andrew B., N. Gregory Mankiw, Lawrence H. Summers, and Richard J. Zeck-hauser (1989). "Assessing Dynamic Efficiency: Theory and Evidence," Review of EconomicStudies, 56(January):1-20.

Auerbach, Alan J. (1994). "The U.S. Fiscal Problem: Where We Are, How We Got Here,and Where We're Going," in Stanley Fischer and Julio Rotemberg (eds.), NBER Macroeco-nomics Annual, National Bureau of Economic Research. Cambridge, Mass.: MIT Press.

Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff (1991). "GenerationalAccounting: A Meaningful Alternative to Deficit Accounting," Tax Policy and the Econ-omy, 5:55-110.

Auerbach, Alan J., Wffliam G. Gale, and Peter R. Orszag (2004). "Sources of the Long-Term Gap," Tax Notes, May 24:1049-1059.

Baker Bruce, Daniel Besendorfer, and Laurence J. Kotlikoff (2002). "Intertemporal StateBudgeting," NBER working paper no. 9067.

Centers for Medicare and Medicaid Services (2005). National Health Expenditures tablesavailable at http://www.cms.hhs.gov/statistics/nhe/historical/default.asp.

Feldstein, Martin (1974). "Social Security, induced Retirement and Aggregate Capital Ac-cumulation," Journal of Political Economy, 82:905-926.

Feldstein, Martin (1996). "The Missing Piece in Policy Analysis: Social Security Reform,"The Richard T. Ely Lecture, American Economic Review, 86(2):1-14.

Gokhale, Jagadeesh, and Kent Smetters (2003), "Fiscal and Generational Imbalances: NewBudget Measures for New Budget Priorities," pamphlet, Washington, D.C.: American En-terprise Institute.

Kamin, David, and Richard Kogan (2005). "The Administration's Misleading $600 BillionEstimate of the Cost of Waiting to Act on Social Security," Washington, D.C.: Center onBudget and Policy Priorities.

Prescott, Edward (2004). "Why Do Americans Work More Than Europeans?" Federal Re-serve Bank of Minneapolis Quarterly Review, 28(1):2-13.

Samuelson, Paul (1958). "An Exact Consumption-Loan Model of Interest with or Withoutthe Social Contrivance of Money," Journal of Political Economy, 66(5):467-482.

Social Security Advisory Board (2003). "The 2003 Technical Panel on Assumptions andMethods Report," available at http://www.ssab.gov/NEW/documents/2003TechnicalPanelRept.pdf.

Social Security Trustees (2005). Annual Report, available at http://www.ssa.gov/OACT/TR/TRO5/index.html.

Fiscal and Generational Imbalances: An Update · of implicit debt under current fiscal policy that past and current gener-ations are passing to future generations, who must finance

Documents