WHO PAYS AND WHEN?

AN ASSESSMENT OF GENERATIONAL ACCOUNTING

NOVEMBER 1995

The Congress of the United States

Congressional Budget Office

T

Preface

he Congressional Budget Office (CBO) prepared this report at the request of the

Chairman of the Subcommittee on Long-Term Growth, Debt and Deficit Reduction

of the Senate Committee on Finance. The study examines the system of generational accounting, which was developed to show how fiscal policy affects people of different ages--living now or yet to be born.

John Sturrock of CBO's Macroeconomic Analysis Division wrote the study under the

supervision of Robert Dennis, Douglas Hamilton, and Kim Kowalewski. CBO analysts

Thomas Cuny, Douglas Elmendorf, Jon Hakken, Robert Hartman, Marvin Phaup, Kathy

Ruffing, Kent Smetters, and Paul Van de Water made helpful comments and suggestions.

Nicholas Dugan, John Romley, and Michael Simpson gave able research assistance.

Outside CBO, David Bradford, Christopher Barker, David Cutler, Robert Haveman,

and Michael Weiksner contributed valuable comments and insights. Alan Auerbach,

Jagadeesh Gokhale, and Laurence Kotlikoff supplied much data, explained many points,

and provided extensive and insightful comments. Marilyn Sorenson of the House Information Systems deserves special thanks for helping to prepare the numerical results.

Those outside CBO are not responsible for conclusions expressed or errors that may appear in the report.

Sherwood D. Kohn edited the manuscript. Christian Spoor provided editorial assistance. Dorothy Kornegay, Verlinda Lewis, and Linda Rae Roy typed the drafts. Kathryn

Quattrone prepared the study for publication.

June E. O'Neill

Director

November 1995

Contents

SUMMARY ix

ONE INTRODUCTION 1

The Deficit Does Not Show the

Effects of Policy by Age 1

Generational Accounts Aim to Show

the Effects of Policy by Age 2

The Role of Generational Accounts 3

TWO ELEMENTS OF GENERATIONAL ACCOUNTS 5

Forming the Basis of Generational Accounts 5

Estimating Tax and Transfer Payments by Age 6

Calculating Generational Accounts 12

Reporting and Interpreting Generational

Accounts 16

THREE FINDINGS OF GENERATIONAL ACCOUNTS 19

Assessing the Evolution and Status of

Generational Policy 19

Eliminating the Difference in Lifetime Net

Tax Rates of Future Generations and

Current Newborns 21

Assessing Past or Prospective Fiscal Policy 24

FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 29

Sensitivity of Results to Economic and

Demographic Assumptions 29

Sensitivity of Results to Other Sources

of Uncertainty 37
vi AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

FIVE AMBIGUITIES IN GENERATIONAL ACCOUNTS 41

There Is No Uniquely Right Discount Rate 41

The Accounts Assume That Prospective 

Income Is Fixed 44

Issues Common to Other Tools

of Analysis 44

SIX CONCLUSION 49

APPENDIXES

A Is the Zero-Sum Constraint Necessary? 53

B How Generational Accounts Treat Taxes

on Income from Capital 57

C The Roles of Generational Accounts and

the Standard Budget Accounts 59

D How Generational Accounts Were Developed

Under Alternative Economic and

Demographic Assumptions 65
CONTENTS vii

TABLES

S-1. Estimated Lifetime Net Tax Rates by Year of Birth xi

1. Estimated Lifetime Tax and Transfer Rates by

Year of Birth 20

2. Distribution of Costs of Hypothetical Policy Changes

Needed in 1991 to Reach a Sustainable Policy 23

3. Alternative Policies That Would Change the Timing or

Mix of Taxes and Transfers 26

4. Alternative Policies That Would Cut the Deficit by

an Equal Amount 27

5. Lifetime Net Tax Rates Under Alternative Economic

and Demographic Assumptions 30

6. Hypothetical Proportionate Cut in Government Purchases

Required in 1991 to Reach a Sustainable Policy 32

FIGURES

1. Taxes Paid by the Average Member of Each

Generation in 1991 7

2. Transfers Received by the Average Member of

Each Generation in 1991 8

3. A Policy That Raises the Deficit: Variation in

Results Under Alternative Assumptions 33

4. Policies That Do Not Affect the Deficit: Variation

in Results Under Alternative Assumptions 34

5. Policies That Cut the Deficit by an Equal Amount:

Variation in Results Under Alternative Assumptions 35

6. Productivity and Its Trends 36
viii AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

BOXES

1. How Generational Accounts Treat Taxes

and Transfers 9

2. Tangible Assets of Government 15

3. Lifetime Labor Income and Lifetime Consumption 17

4. The Case in Favor of Separate Generational Accounts 21

5. Would an Updated Version of Generational Accounts

Change the Results? 22

C-1. How Labels Can Affect Measures of Fiscal Policy 60
F

Summary

iscal policy affects future as well as current

generations; someone must pay at some time

for all that government ever spends. Economists call this condition the "zero-sum constraint"--if

one generation pays less for a given amount of

spending, another generation must pay more. If government does not retire its debt or reduce its spending, it must impose higher taxes to pay the interest.

Either way, someone pays. Thus, fiscal policy transfers resources according to age; it determines how

much and when anyone of a given generation will

ever pay to government.

But there is no general measure of how fiscal

policy affects different generations. The deficit does

not; it only records the change in legal claims on

government. For instance, if higher payroll taxes

paid for higher Social Security benefits, the deficit

would not change. But the elderly would benefit at

the expense of young and future generations. Similarly, a new policy that did not change the current

deficit, but raised prospective deficits, would impose

costs on people who had to meet those obligations.

To address such issues, economists Alan Auerbach, Jagadeesh Gokhale, and Laurence Kotlikoff

propose a system they call generational accounts.

The system can be used to estimate the net amount

that the average person of any age today would ever

pay government under a given policy. Thus, the accounts add to the box of tools for policy analysis;

they try to measure how policy directly affects people by age. They also offer insight into important

issues, including long-run solvency, the prospects of

future generations, and the cost of risk in choosing

policy.

Despite their ambitious scope, generational accounts are limited in important ways. They depend

on calculations that are not only empirically uncertain but theoretically ambiguous. Moreover, the accounts take prospective income as a given, although

the effect of policy on young and future generations

depends greatly on how it affects income. Similar

issues arise with many commonly used tools of analysis. But ambiguity and omission of the effects of

policy on income undermine the ambitious claim that

the accounts describe the generational effect of fiscal

policy, especially for future generations.

Should generational accounts supplement the

regular presentation of the budget outlook by the

Congressional Budget Office (CBO)? CBO concludes that, despite the valuable insights generational

accounts afford, they should not become part of the

regular budget outlook. They lie in the realm of analysis, not accounting. Therefore, CBO believes that

the accounts should remain as a tool to analyze policy from a conceptual perspective, rather than serve

as an official statement.

What Are Generational 

Accounts?

Generational accounts estimate who pays for all that

government ever buys. Such purchases are used to

provide defense, build roads, educate children, and so

forth. People pay for those purchases with net taxes

--that is, taxes less transfers (government payments,

such as those for Social Security or welfare). The
x WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

accounts, therefore, estimate the real (that is,

inflation-adjusted) net taxes ever to be paid by the

average member of each generation (today's newborns, one-year olds, and so on). They also estimate

the net taxes of the average member of the representative future generation (those not yet born). The

accounts do not try to estimate who benefits from

what government buys, only who pays for it with

their net taxes.

How Generational Accounts 

Are Constructed

The accounts rely on two standard ideas--"present

value" and the zero-sum constraint. Present value

expresses a stream of net payments over time by

what they would be worth if they were all paid at a

given date as one sum. To calculate present value,

the accounts must use an interest rate to discount all

net payments to the given date. Using present value

makes it possible to compare net taxes of various

generations on a common basis.

The zero-sum constraint specifies that future

generations must pay with interest for purchases that

past and current generations do not pay for. The constraint may be expressed as an equation: the present

value of net taxes of future generations must equal

the current value of government debt, plus the present value of all prospective purchases by the government, less the present value of net taxes of current

generations.

Using these ideas, generational accounts address

a hypothetical question: if policy remained as it is for

current generations for the rest of their lives, how

much would they pay in net taxes, and how much

would future generations have to pay? Thus, the accounts do not try to predict the actual course of policy; instead, they ask an "as if" question to reveal

what policy now implies. In that respect, the accounts resemble other standards. For example, the

baseline budget establishes a reference point as if

current policy were to remain in force for the next 10

years for everyone, alive now or born later.

To answer their "as if" question, the accounts

project government purchases and net taxes of current generations and calculate their present values.

Given the level of government debt in the base year,

the accounts then calculate the present value of net

taxes of future generations through the zero-sum constraint (or equation). The procedure depends on economic and demographic projections, assumes a discount rate, and requires a policy rule that determines

taxes and spending for current generations according

to age.

Projecting Net Taxes of Current Generations. In

order to project the net taxes of current generations,

the accounts start from official projections of taxes

and spending. The projections are then mechanically

extended to estimate the net taxes of the average

members of all current generations for the rest of

their lives.

The accounts break net taxes into broad components because each particular tax or transfer varies

with the age of the payer or recipient. Taxes are

grouped into those that apply to sales, payroll, labor

income, capital income, or homes. Transfers are

grouped with Social Security, Medicare, Medicaid,

Aid to Families with Dependent Children, Food

Stamps, unemployment insurance, or general welfare

payments.

The method supposes that the net taxes of current

generations will continue to depend on age as they do

now. For example, the accounts assume that the average 30-year-old man will always pay three-quarters

as much in income taxes as the average 40-year-old

man. (The extensions for Social Security benefits,

however, reflect the prospective changes provided for

by current law.)

Given such relationships and a projection of

population, the accounts can take an official projection of total net taxes in each year and convert it into

an amount for the average person of each generation.

Such annual amounts can then be extended, depending on assumptions for productivity (output per

worker) and population growth. A discount rate is

then applied to find the present value of net taxes of

all current generations and of the average members

of each current generation.

Unlike a baseline budget projection, the accounts

do not assume that the law remains unchanged when
SUMMARY xi

they extend taxes and transfers. Instead, they assume

that after the projection period, all taxes and transfers

for the average person (now alive) of a given age

would grow at the same rate as output. For example,

the accounts assume that the Congress would index

all transfers to people now living for increases in inflation and productivity, whereas only some transfers

are so indexed by current law. For that reason, CBO

refers to the policy assumptions in the accounts as

"prevailing policy" rather than current policy.

Applying the Zero-Sum Constraint and Expressing the Results. A projection of purchases is the last

element needed to apply the zero-sum constraint.

Purchases are projected in a manner similar to that

for net taxes of current generations. That is, total

purchases are first taken from an official projection,

then extended on the basis of population and productivity. Unlike the rules for net taxes of current generations, the rules for purchases apply to future generations as well (because the accounts ask who pays for

all purchases that policy determines). Given projected purchases, the accounts apply a discount rate

to find the present value of the purchases.

The net taxes of future generations can then be

found through the zero-sum constraint, given net

government debt and the present values of purchases

and net taxes of current generations. By assuming

that all future generations pay net taxes at the same

rate, the accounts can speak of a representative future

generation.

The results of the accounts may be stated in

terms of the "lifetime net tax rate" of a given generation. That rate is the present value at birth of net

taxes paid over a lifetime as a percentage of the present value at birth of labor income earned over a lifetime. (Lifetime labor income is used as the base because it is closely related to lifetime consumption.)

That concept requires estimates of both past and prospective net taxes in order to compare members of all

generations on the same basis. Historical totals for

net taxes are converted into net taxes of each generation in the same manner that projected totals are converted.

Results of Generational Accounts

Given past and prevailing policy, lifetime net tax

rates have risen during the century and would rise

much further for future generations (see Summary

Table 1). Under the assumptions used in the accounts, the estimated rates have risen from 24 percent for those born in 1900 to 37 percent for those

born in 1990. (Those figures include net taxes at all

levels of government--federal, state, and local--but

do not include the effects of any policy change under

Summary Table 1.

Estimated Lifetime Net Tax Rates by Year

of Birth (Average for males and females,

in percent)

Year of Birth Net Tax Ratea

1900 24

1910 28

1920 29

1930 31

1940 32

1950 34

1960 35

1970 36

1980 37

1990 37

Future Generations 78

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described

in Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff, "Generational Accounts: A

Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5

(Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The rates shown are for net taxes at all levels of government combined--federal, state, and local.

The estimates assume a real discount rate of 6 percent, a prospective annual rate of growth in productivity

of 0.75 percent, and the midgrowth path of population

used by the Social Security Administration in its 1993

annual report.

The values in the table reflect the implication of generational accounts as constructed, not necessarily the

views of the Congressional Budget Office.

a. A lifetime net tax rate is the present value at birth of lifetime

net taxes as a percentage of the present value at birth of lifetime labor income. Net taxes are taxes less transfers.
xii WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

consideration.) Most of that increase has paid for a

similar rise in the rate of government purchases from

1900 to about 1950. But to enjoy the now-prevailing

rate of purchases in relation to income, future generations would have to pay lifetime net taxes at a rate of

78 percent. That is more than twice the rate for today's newborns.

That outcome agrees with results from traditional

analysis, which also show that tax and spending policy cannot remain as they are. For example, the General Accounting Office estimates that with no change

in policy, the federal deficit would exceed 20 percent

of gross domestic output in 2025, and the federal

debt would exceed 200 percent. (The corresponding

figures in 1994 were 2 percent and 53 percent.) Similarly, the Social Security and Health Care Financing

Administrations project that current policy would

exhaust the trust funds for Social Security and Medicare.

Those projections and generational accounts

represent different ways of showing that current policy is not "sustainable." That is, tax or spending

rates must change for someone at some time; they

cannot remain as they are. The budget projections

show that federal debt would get out of hand if policy continued as is for everyone, alive or yet to be

born. The accounts show that future generations

would have to pay net taxes at higher rates than current newborns in order to redress fiscal imbalance if

policy stayed as it is for those alive now.

Of course, neither lifetime net tax rates of nearly

80 percent nor a debt more than twice as large as domestic output is at all likely. Most people expect

policymakers to make the tough choices needed to

put the nation's fiscal house in order. Generational

accounts and long-term budget projections are two

ways of showing numerically the implications of inaction.

Generational accounts, however, may not always

tell the same story that the deficit would seem to tell.

Furthermore, they can address questions beyond

sustainability. For example, most analysts agree that

since World War II, fiscal policy has transferred resources from young and future to old generations.

Surprisingly, the accounts indicate that most of that

transfer occurred from the 1950s through the 1970s

when deficits were low, rather than since that time

when deficits have been high. The main reason for

the transfer is that the Congress raised payroll taxes

to pay for higher benefits for Social Security and

Medicare, thus increasing the obligations of young

and future generations.

In the years ahead, the Congress could reduce the

net taxes of future generations in ways that could

have very different effects on living generations. For

example, prospective Medicare benefits could be reduced by cutting benefits now or by raising the age

of eligibility. Cutting benefits would fall harder on

those who are now 65 or older; raising the age of eligibility would fall harder on those who are under 65.

Or raising payroll taxes would harm workers (mostly

young); raising taxes on capital income would harm

owners (mostly old). Generational accounts estimate

the amounts by which any change in policy would

help or hurt the average members of each generation.

Interpreting Generational Accounts

Generational accounts act as a gauge, not a predictor

or goal. They do not try to say how policy will actually evolve. And they cannot say what distributions

are fair; that is a matter for policy, not analysis. The

accounts serve only as a norm by which to evaluate

prevailing policy and compare alternative policies.

In order to use them as a norm, lifetime net tax

rates must be kept in perspective. Such rates seem

high when compared with "current net tax rates"

(current net taxes as a percentage of current market

income). For example, the current net tax rate for the

nation is 24 percent, whereas the lifetime net tax rate

of today's newborns is 37 percent under prevailing

policy.

But current net tax rates do not compare people

of different generations on the same basis. People

typically pay most of their taxes and receive little in

transfers when they are young or middle-aged, so

their current net taxes are high. The old typically

receive more in transfers than they pay in taxes, so

their current net taxes are not merely low but negative. Current net tax rates do not reflect net taxes that

the young will pay or the old have paid, and the cur-
SUMMARY xiii

rent net tax rate for the nation combines net taxes of

the young and old.

Lifetime net tax rates do compare people of different ages on the same basis because such rates are

computed from birth. They are high compared with

current net tax rates for a number of reasons. First,

present value at birth gives more weight to a dollar of

tax paid early in life than to a dollar of transfer received late in life. Second, some people born in a

given year will live long enough to pay taxes, but not

to receive transfers, thus raising the lifetime net tax

rate of the average person born in that year. Finally,

lifetime net tax rates are based on labor income

rather than total income, as are current net tax rates.

Using the smaller measure as a base makes lifetime

net tax rates higher.

In any case, lifetime net tax rates are estimates

that depend on uncertain and debatable assumptions.

Furthermore, such rates do not include many other

factors that are relevant to a consideration of distribution by age. Hence, generational accounts can serve

only as rough guides for comparison, not as hard and

fast standards.

Contributions of Generational

Accounts

Generational accounts represent a significant effort to

fashion a new tool of analysis. How fiscal policy

distributes resources among generations is interesting

in itself. It is also important because the way that

people respond to policy depends on their age,

among other factors. The accounts highlight what is

known about how policy distributes resources by age

and what is left to learn.

The accounts also command attention for other

important issues that they raise. By incorporating the

zero-sum constraint, they frame issues in terms of

ultimate limits on the government budget. The approach focuses on policy that can be sustained and

enables the accounts to represent current and future

generations on a comparable basis. Unless policymakers explicitly consider the interest of future generations, there is no reason those generations are sure

to be suitably represented.

Moreover, the accounts underscore the cost of

risk in undertaking government programs--a cost that

the interest rate on government debt fails to incorporate. Ignoring such risk could bias policy choices by

lending too much weight to estimates of prospective

costs and benefits. For instance, the Congresses that

raised benefits for Social Security and Medicare believed that revenues would match the higher obligations, although they have not. The belief that they

would was based in part on analysis that effectively

used the interest rate on government debt as a discount rate, thereby ignoring some of the risk in undertaking the higher obligations.

Limitations of Generational

Accounts

Many factors render the accounts uncertain or debatable. Most of those problems are common to other

means of analysis. But some represent limits of economic analysis that will remain intractable and require compromises. For those reasons, the accounts

can yield only broadly defined results and in some

cases may even mislead.

Problems Typical of Most 

Economic Measures

Problems that are common to economic analysis

arise from uncertainty about economic and demographic projections or about estimates of who effectively pays taxes and receives transfers. Furthermore, as with most economic measures, the accounts

do not address some issues that are relevant to distribution by age.

Uncertainty About the Economy and Population.

In one sense, the accounts can deliver only qualitative results, even though they are expressed in quantitative terms. The results can vary widely with different assumptions about population, productivity, and

the discount rate. For example, given the base as-
xiv WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

sumptions of the accounts, prevailing policy implies

that future generations would pay lifetime net taxes

at a rate 41 percentage points higher than that of today's newborns. Under a reasonable range of assumptions, however, that figure could vary from 12

percentage points to 116 percentage points. Such

variation implies that future generations would pay

net taxes at a lifetime rate between 44 percent and

242 percent higher than that of current newborns.

Such variations are typical of the uncertainty that

plagues any long-term projection. To deal with that

kind of uncertainty, the Social Security and Health

Care Financing Administrations present projections

for their trust funds as probable ranges that exhibit

substantial variation. For instance, under the assumptions that it considers most probable, the Social

Security Administration projects that its trust fund

would be exhausted in 2030. But under plausibly

optimistic assumptions, trust fund balances would

grow indefinitely.

Those sources of uncertainty do not undermine

the main implication of generational accounts: that

prevailing policy is biased against the future. Moreover, the results display much less dispersion for living generations, suggesting a rough magnitude and

general pattern.

But the uncertainty leaves a wide quantitative

margin for policymakers to consider. And many

other sources of uncertainty contribute further to that

margin--for instance, rates of participation in the labor force, distributions of earnings by age and sex,

differences in medical requirements by age, requirements for defense, and so forth.

Uncertainty About Who Pays or Benefits. The

accounts depend on uncertain estimates of how policy affects people by age. Deciding who effectively

pays a given tax or receives a given transfer rests on

imprecise empirical estimates.

Who effectively pays taxes on capital income is

especially uncertain. The accounts assume that owners of capital pay the tax, but part of it may be passed

on to workers as lower wages. Moreover, it is not

clear how changes in investment incentives, such as

accelerated depreciation or tax credits, affect the

value of assets. According to the theory on which the

accounts rest, raising such incentives would transfer

resources from the old to the young because they effectively make new capital cheaper than old. But if it

is costly to adjust to new desired levels of capital,

more generous incentives could benefit owners of

existing firms, which are better prepared to undertake

investment. Indeed, some evidence suggests that an

increase in investment incentives would transfer resources from prospective owners (mostly young) to

current owners (mostly old)--just the opposite of

what the accounts assume.

Even less is known about who effectively receives transfers. The scant evidence that exists for

Social Security suggests that direct beneficiaries may

enjoy nearly all the benefits of an extra dollar. But

little work has been done on the subject. Furthermore, much of an extra dollar for health care may

benefit third parties--often relatives or those with

private insurance--to whom the cost would have

passed otherwise.

Relevant Issues That Are Not Addressed. The accounts do not consider many ways in which policy

can distribute resources among generations. Most

important, the accounts estimate who pays for what

government buys, but do not estimate who benefits.

Nor do they consider how inflation and regulation

can benefit some generations at the expense of

others. In particular, unexpected inflation reduces

the real value of government debt and shifts costs

from future generations to current holders of the

debt. Furthermore, the accounts do not consider how

policy distributes resources among income groups,

either within or between generations. (It would be

possible, however, to adapt the accounts to reflect

distribution by income.) 

Such omissions are common to most economic

measures or tools of analysis. For instance, the national income and product accounts neither estimate

the real value of services that government buys nor

address any of the other issues raised above. Indeed,

there is no general estimate of the economic value of

services provided by what government buys, in part

because they serve functions that private markets do

not. Although knowing who pays for purchases answers half of the questions about their distribution by

age, such omissions make it necessary to interpret the

results with care.
SUMMARY xv

Special Problems of Generational 

Accounts

Generational accounts have two particularly serious

problems. First, the role of the discount rate raises

unresolved questions. That issue is especially important because different choices of discount rate lead to

most of the variation in results. Second, the accounts

assume that fiscal policy has no effect on potential

income. Although that assumption is reasonable in

the short run, it becomes less so in the long term.

Moreover, the accounts have a horizon that is very

distant--indeed, it is infinite.

Neither of those problems weakens the qualitative conclusion that prevailing policy is not sustainable. But they leave any quantitative results open to

question, especially for future generations.

Ambiguity About the Discount Rate. Questions

about which discount rate to use are basic because

such a rate is needed to calculate the present values

of lifetime net taxes. In simple terms, a discount rate

is often thought to represent the cost of waiting--that

is, postponing income or consumption. In generational accounts, however, the discount rate also reflects the cost of uncertainty--the risk that income

may be lost rather than merely postponed. But

choosing a discount rate to reflect the additional cost

requires many compromises between the real and

ideal.

To begin with, the accounts assume that the same

discount rate applies to all net taxes of all generations, although that assumption is not likely to be

strictly warranted. For instance, the old may view

their prospective Social Security benefits as more

secure than do the young; but the young may feel

better able to undertake risk. And because any generation will be richer than its predecessors, it would

assign less cost than they do to the same probability

of losing a given amount of net income. Thus, there

is no reason to expect all generations to attach the

same premium for risk to prospective payments or

receipts of each tax or transfer.

Furthermore, analysts could not estimate the

right discount rate very well, even if a single rate

were right in all cases. People cannot trade claims on

prospective taxes and transfers in markets the way

they can trade claims on prospective income from

stocks or bonds. Therefore, it is not possible to use

market information to infer the premium for risk that

people attach to prospective net taxes.

It might be difficult to infer a risk premium even

if there were markets in prospective taxes and transfers. For example, the discount rate of 6 percent that

is used as a base case in the accounts is equal to the

average rate of return on equity. But that rate is

much higher than economists can explain on the basis of equity risk. Moreover, some people--especially among the young--would not be able to express

their preferences in the market if they could not borrow against their prospective income from labor or

transfers.

The Assumption That Prospective Income Is

Given. Fiscal policy can affect prospective pretax

income in two ways that the accounts do not reflect.

Government borrowing displaces private assets that

produce income, and net taxes affect people's decisions to work, save, hire, and invest. Therefore, for

example, cutting current and prospective deficits

would raise prospective income, especially for young

and future generations. Similarly, replacing an income tax with a consumption tax would lead to more

investment and higher prospective income. By taking pretax income as given, the accounts overstate

the cost to young generations of cutting the deficit or

switching the tax base and conversely understate the

gain to future generations.

The assumption of fixed income is common, but

the ambitious scope of generational accounts makes

the premise more important. For instance, government agencies regularly estimate the 10-year budgetary effects of proposed changes in fiscal policy as if

they would have no effect on pretax income. That

procedure greatly simplifies comparisons of alternative policies and does not introduce large errors because the time horizon is short. Long-term projections by the Social Security Administration also assume no feedback from policy to national income,

but they only refer to one element of the budget. By

contrast, generational accounts try to present a comprehensive view of fiscal policy indefinitely. 
xvi WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Taking income as given introduces little error for

most generations but sizable error for young and future generations. For example, the accounts might

overstate the effect of deficit reduction by about 25

percent for current newborns and understate it by

about 65 percent for generations far in the future. Put

another way, the accounts would overstate by a multiple of three the costs that current adults would have

to undergo to equalize the treatment of future generations and current newborns. That is a serious problem for a system that attempts to represent current

and future generations on the same basis.
A

Chapter One

Introduction

mong its other effects, fiscal policy distributes resources among generations. That is,

it determines how much a person of any age

today will ever pay for what government spends.

What policy implies for people of different ages is

intrinsically interesting. Moreover, it is important to

know because the way that people respond to policy

depends on their age, among other factors. Finally,

current policy affects the well-being of both current

and future generations (those yet unborn). But the

unborn cannot bargain with the living. Unless policymakers explicitly consider the interests of future

generations, there is no reason to assume that those

generations will be suitably represented.

Nevertheless, no general tool of analysis estimates the amounts of resources that fiscal policy

transfers among generations. In particular, the deficit

does not, although it may seem to do so.

The Deficit Does Not Show the

Effects of Policy by Age

The deficit records the increase in government debt

held by the public--that is, legal obligations that people buy with cash and will present for payment later.

The cash from issuing debt pays for current government spending in excess of revenue. As a measure of

that excess, the deficit shows how much government

reduces current national saving, other things being

equal. (A higher deficit would not reduce national

saving if the extra cash was used to add to national

assets, such as knowledge, public health, or useful

government capital. High deficits of the past 20

years have not been used to do so, however.)

The reported deficit may seem to suggest what

policy implies for the future. A deficit can transfer

resources by age if it is used to consume more now

and let later generations pay. Moreover, the higher

public debt that is recorded by the deficit crowds out

private assets because both compete for the same

supply of funds. The private assets that are displaced

would have produced income later. With more debt

and fewer assets, future generations could inherit the

mortgage instead of the house.

But the deficit need not show what implications

policy has for any generation because tax and spending programs affect people of different ages differently, and the current deficit does not record implicit

obligations.

Tax and Spending Programs Affect

People of Different Ages Differently

Tax and spending programs do not affect people of

all ages uniformly. For instance, Aid to Families with

Dependent Children directly helps the young,

whereas Social Security directly aids the old. Similarly, payroll taxes fall harder on the middle-aged

because they earn more labor income, whereas
2 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

corporate taxes fall harder on the old because they

own more assets.

Therefore, fiscal policy could transfer resources

among generations whether the deficit rose or fell.

For example, an increase in Social Security benefits

paid for by a payroll tax would not change the deficit.

But the policy would aid those who are in or near

retirement at a cost to all others, alive or yet to be

born.

The Current Deficit Does Not Record

Implicit Obligations

Government has implicit obligations that do not show

up in the current debt or deficit. For example, today's

debt does not reflect how much it will cost to pay

Social Security benefits under current law when the

baby boomers retire. Deficits of the past 30 years

would have been much higher than those reported if

they had included increases in such implicit liabilities. By contrast, a cut in Medicare benefits that is

scheduled for the future would not change the deficit

now but would reduce it later. And a scheduled cut

in tax rates would raise prospective deficits. Thus,

policy choices made at one time may not show up in

the deficit until later.

In a sense, all of the government's prospective

spending is an implicit liability. That is, people expect government to provide a legal system, national

defense, public works, education for the young, a

safety net for the poor, an income floor for the old,

and so on. Similarly, prospective revenue is an implicit asset of government because people expect to

pay taxes to finance such spending.

The deficit does not record such implicit obligations because they do not represent binding claims.

For example, retirees have no legal claim to the

Medicare benefits they expected when they retired.

Technically, the Congress could reduce the benefits

at any time, even though people had planned on receiving higher benefits.

Nevertheless, government has a duty to try to

meet its implicit commitments. It could not capriciously change taxes or benefits without losing its

reputation for keeping its implicit word and treating

people fairly. The ability to govern ultimately rests

on such a reputation.

Even if the deficit did record changes in such

implicit liabilities and assets, it would not reveal distribution by age. It would only show a total for government; it would not show what that implied for the

average person of a given age today.

Generational Accounts Aim 

to Show the Effects of 

Policy by Age

To gauge the effects of policy by age, economists

Alan Auerbach, Jagadeesh Gokhale, and Laurence

Kotlikoff propose a system they call generational accounts. That system estimates, under a given policy, 1

how much and when the average person of any age

today would ever pay in taxes or receive in benefits.

The system also estimates the implications of that

policy for the net payments of people born in the future.

Generational accounts go beyond proposals to

adjust the unified budget deficit at the federal level to

account for various factors. Those factors include

inflation, economic growth, interest costs, the value

of government assets, or the phase of the business

cycle. Such adjustments are intended to help show

the amount of fiscal stimulus or put the debt in perspective. But the adjustments would not reveal how

fiscal policy distributes resources by age.

By contrast, generational accounts aim to record

all obligations that a policy undertakes and to estimate how it directly transfers resources among people of all ages, including future generations. Thus,

1. See Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J.

Kotlikoff, "Generational Accounts: A Meaningful Alternative to

Deficit Accounting," in David Bradford, ed., Tax Policy and the

Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-

110; and Laurence J. Kotlikoff, Generational Accounting: Knowing Who Pays, and When, for What We Spend (New York: The

Free Press, 1992).
CHAPTER ONE INTRODUCTION 3

the accounts address issues that the deficit does not

and add to the box of tools for policy analysis.

The Role of Generational 

Accounts

Should generational accounts supplement the regular

presentation of the budget outlook by the Congressional Budget Office (CBO)? To consider that question, CBO examined how the accounts are constructed; how they are to be interpreted; what questions they can address; and how quickly, completely,

and accurately they can do so.

CBO concludes that the generational accounts

should not be a regular part of its presentation of the

budget outlook. By addressing distribution by age,

the accounts contribute valuable insights to the analysis of fiscal policy. They also provide a new focus

on important issues, including those of long-run solvency, the cost of risk in choosing policy, and prospects for the future. Despite their name, however,

the accounts are best seen as an exercise in analysis,

rather than as an accounting report. CBO believes,

therefore, that generational accounts should remain a

tool for analyzing policy rather than serving as an

official statement.

G

Chapter Two

Elements of Generational Accounts

enerational accounts estimate who will pay

for all that federal, state, and local governments will ever buy under a given policy.

Such purchases are used to provide defense, build

roads, educate children, and so forth. People pay for

those purchases with net taxes--that is, taxes less

transfers (government payments, such as those for

Social Security or welfare). The accounts estimate

the real net taxes ever to be paid by the average

member of each current generation (today's newborns, one-year olds, and so on). They also summarize the real net taxes of the average members of future generations (those born next year, the year after

that, and so on). The accounts do not try to estimate

who benefits from what government buys, only who

pays for it with their net taxes.

To do so, the accounts start from the premise that

all government purchases must be paid for--either at

the time with taxes, or later by retiring debt or paying

interest. Therefore, the net taxes that current generations pay under a given tax and spending policy will

determine the net taxes of future generations.

Finding the implications of a policy for people of

different ages requires first estimating how that policy relates their taxes and transfers to their age.

Given such relationships, the accounts extend official

economic, budget, and population projections to estimate the net taxes of all current generations for the

rest of their lives. Those net taxes will determine the

bill that future generations will have to pay, given

what government will ever buy under that policy.

Thus, the accounts pose a hypothetical question:

if a given policy applies to all current generations for

the rest of their lives, what would that imply for the

net taxes of current and future generations? The answer to that question does not predict actual policy,

but is an abstract indicator of how today’s policy

would distribute resources among generations.

Forming the Basis of 

Generational Accounts

Two standard ideas form the foundation of generational accounts: "present value" compares payments

at different times on the same economic basis, and

the "zero-sum constraint" enforces government solvency in the long run.

Present Value

Present value puts the prospective net taxes of the

average person of every age on the same basis--one

payment at one time. It is the net amount that an individual is willing to pay at that time, then never

again pay taxes or receive transfers.

A discount (interest) rate is used to calculate

present value. For instance, if the interest rate is 5

percent, this year's $100 will grow to $105 next year.

Hence, $100 is this year's present value of $105 next
6 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

year; alternatively, $105 is next year's present value

of $100 this year. Other things being equal, present

value gives less absolute weight to a prospective dollar if:

o The discount rate is higher (because a smaller

amount can grow to a dollar in a given time when

it compounds at a higher rate), or

o The payment is later (because a smaller amount

can grow to a dollar at a given rate when it compounds for a longer time).

The Zero-Sum Constraint

The zero-sum constraint says there is no free lunch;

someone, sometime, must pay for all that government ever spends. That is, the present value of prospective net taxes of all current and future generations must match today's net government debt (liabilities less assets), plus the present value of all prospective government purchases. Purchases that past

and current generations do not pay for, future generations must, and with interest.

The zero-sum constraint ensures that government

debt cannot forever grow faster than output. Without

the constraint, mounting interest costs could swell the

debt beyond control and bring on default, either direct or by inflation. (Of course, the constraint is satisfied even if government defaults--then the bondholders pay.)

The zero-sum constraint does not specify that

government must ever retire any of its debt or can

borrow no more; only that it cannot borrow forever to

pay interest. If it could, the bill for a deficit would

never come due; each generation could pass the bill

to its children, who could pass it to its children, and

so on. If government cannot borrow forever to pay

interest, it must raise taxes or reduce spending at

some time, either to retire debt or pay interest

forever--choices that are equivalent in present value.

Some conditions may allow the bill to be passed

on forever, but they do not prevail now. It may be

feasible to pass the bill if the rate at which output

grows is forever greater than the rate at which government pays interest on debt. (Even then, the noninterest part of the deficit must stay within a limit in

relation to output.) But current and prospective interest rates are too high for that policy to work; and

even if they were not too high now, they may become

so later. Therefore, trying to evade the constraint and

pass the bill is at best a gamble that exposes current

or future citizens to the risk of higher net taxes than

expected (see Appendix A). Of course, the borrowing crowds out private assets even when the gamble

succeeds.

Estimating Tax and Transfer

Payments by Age

The first step in carrying out the ideas behind the accounts is to find how taxes and transfers are now related to age. The average amount of any tax or transfer can vary greatly by age and sex (see Figures 1 and

2 and Box 1). By the estimates in the accounts, those

who pay the highest taxes on income from labor are a

bit over the age of 40; those who pay the highest

taxes on income from capital are about 60 years old.

Excise and property taxes fall more evenly on all age

groups. Most Social Security and Medicare benefits

go to those who are 65 or older, and benefits from

Medicaid and other transfers appear more evenly distributed.

The profiles of taxes and transfers by age that are

shown in Figures 1 and 2 reflect the judgments used

in making them, not necessarily judgments that the

Congressional Budget Office would make. Moreover, the profiles shown reflect an outdated version

of the accounts, which contains errors that have since

been corrected. The profiles shown for Medicare and

Medicaid wrongly exclude disabled people who are

younger than 65 or in nursing homes. Such people

now receive about 16 percent of all Medicare benefits and 28 percent of all Medicaid benefits. For

Medicare, the exclusions make the profile of those

older than 65 too high in relation to that of younger

people; for Medicaid, the profile is too low. As a

practical matter, the exclusions have little effect on

the main results considered later.
90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $75 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $523 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $457 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $234 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $414 billion

Thousands of Dollars

CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 7

Property

Payroll Labor Income

Capital Income

Figure 1.

Taxes Paid by the Average Member of Each Generation in 1991

Excise

SOURCE: Congressional Budget Office, using data provided by the authors as described in Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff, $Generational Accounts: A Meaningful Alternative to Deficit Accounting,# in David Bradford, ed., Tax Policy

and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTE: N = newborns.
90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $118 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $100 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $111 billion

Thousands of Dollars

90 80 70 60 50 40 30 20 10 N

0

2

4

6

8

10

Age in 1991

Male

Female

National Total: $286 billion

Thousands of Dollars

8 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Medicare

Medicaid Other Transfers

The accounts do not use the profiles in absolute

terms, but as "relative-age profiles." For example,

compared with the average 40-year-old man, the average 60-year-old man pays 66 percent as much in

payroll taxes; the average 40-year-old woman, 46

percent as much; and so on. Such relationships are

assumed to remain fixed. Given the relative-age profiles and population by age, the national total for any

tax or transfer can be converted into an amount for

the average person of any age and sex. The reverse is

also true--that is, amounts per person can be converted to a total. Consequently, for example, total

payroll taxes would fall if there were fewer 40-yearold men and as many more 60-year-old men, other

things being equal.

Figure 2.

Transfers Received by the Average Member of Each Generation in 1991

Social Security

SOURCE: Congressional Budget Office, using data provided by the authors as described in Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff, $Generational Accounts: A Meaningful Alternative to Deficit Accounting,# in David Bradford, ed., Tax Policy

and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The profiles shown reflect judgments made in constructing generational accounts, not necessarily judgments the Congressional

Budget Office would make. The profiles have been updated in the latest version of generational accounts using more recent data or

new data sources.

N = newborns.
CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 9

Box 1.

How Generational Accounts Treat Taxes and Transfers

Generational accounts broadly consider five groups of

taxes and three groups of transfers to persons. Taxes

comprise:

o Excise taxes, which consist of sales taxes, tariffs,

and property taxes paid by all businesses, including farms;

o Property taxes on owner-occupied homes;

o Payroll taxes, which consist of both employees'

and employers' shares for social insurance and

include the contributions of government workers

to their pension funds;

o Taxes on labor income, which consist of income

taxes paid on the income from labor of workers

and proprietors; and 

o Taxes on capital income, which consist of corporate income taxes (excluding taxes paid by the

Federal Reserve System), estate taxes, and income taxes paid on the capital income of proprietors, investors, and lenders. The category also

includes seignorage--a minor item that represents

the revenue obtained from issuing money.

Transfers to persons comprise:

o Social Security, which consists of Old-Age and

Survivors Insurance and Disability Insurance

(less federal income tax paid on such benefits),

Railroad Retirement, and Supplemental Security

Income;

o Health, which separately treats Medicaid and

Medicare (less premiums for Part B); and 

o Other transfers, which treats separately Aid to

Families with Dependent Children, Food Stamps,

unemployment insurance, and general welfare.

The earned income tax credit is included with

Food Stamps.

Traditionally, transfers are defined as payments

for which the government does not receive a current

good or service in return. People may receive them

under entitlement programs, such as Medicare, or under discretionary programs, such as the Special Supplemental Food Program for Women, Infants, and

Children. 

In some cases, however, the accounts do not define taxes or transfers to persons in the usual way.

For example, they treat personal nontax receipts--such

as licenses and user fees or tuition and hospital

charges--as returns on government assets rather than

taxes. As a result, such fees are netted from both

taxes and government purchases in the accounts.

Similarly, medical, disability, and retirement benefits for civil service and military personnel and veterans are treated in the accounts as purchases (compensation of employees) rather than transfers. That treatment supposes that the government makes such payments as deferred compensation for past service under

previously agreed terms.

Finally, payments that are not conventionally

considered either purchases or transfers to persons

must be dealt with. The accounts treat as purchases

both government transfers to foreigners (mostly foreign aid) and subsidies less current surpluses of government enterprises. Payments of net interest on public debt need not be treated explicitly because they are

implied in the process of discounting.

In order to construct the relative-age profiles, the

accounts start from official survey data. They also

need to decide what to assume about the "incidence"

of each tax and transfer; that is, who effectively pays

or receives the cash value of a given tax or transfer?

For economic or social reasons, that may not be the

legal payer or recipient. Special assumptions are also

needed to assign taxes on capital income and taxes

and transfers within families.

Using Survey Data

The Current Population Survey, conducted by the

Bureau of the Census, was used to estimate average

labor earnings at any age in 1988. The accounts assume that people pay payroll and labor income taxes

in proportion to their income from labor. Labor income includes the implicit labor income of proprietors, as well as the compensation of employees.
10 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

The accounts assume that labor's share of proprietors'

income is about 80 percent--the same as its share of

the rest of national income.

Other taxes and transfers are assigned in a similar

way:

o Property taxes are assigned according to home

values reported in the Survey of Income and Program Participation (SIPP) conducted by the Census Bureau;

o Capital income taxes (with special adjustments

described below) according to assets reported in

the Survey of Consumer Finances conducted by

the Federal Reserve Board;

o Excise taxes according to household consumption reported in the Consumer Expenditure Survey presented by the Bureau of Labor Statistics;

o Social Security benefits according to payments

reported in the Social Security Bulletin published

by the Social Security Administration (SSA);

o Medicare and Medicaid according to health benefits reported in the National Medical Care Expenditure Survey conducted by the National Center for Health Services Research; and

o All other transfers according to benefits reported

in the SIPP.

The accounts do not reflect the nature of the federal tax on personal income. They assume that the

tax is paid in proportion to income from capital or

labor. But the federal income tax is progressive--that

is, people with higher incomes pay tax at higher

rates. And incomes are related to age and sex; on

average, people who are young or female have lower

incomes than those who are middle-aged or male.

The relative-age profiles will change somewhat

each time they are updated from the most recent survey or from a new data source. The change may reflect real trends or misleading results of sampling. In

particular, the business cycle will affect relative-age

profiles. For example, a young worker is more likely

to lose a job during a recession; an old stockholder is

more likely to suffer a drop in asset value and dividend income. Year-to-year changes in the accounts

must be interpreted with those possibilities in mind.

Deciding on the Incidence 

of Taxes and Transfers

The way that the relative-age profiles are constructed

depends on assumptions about the incidence of each

type of tax and transfer. The assumptions made in

the accounts imply that the supplies of saving and

labor do not respond to changes in incentives that

taxes and transfers provide.

Incidence is not obvious for two reasons. First,

market forces may "shift" a tax or transfer from the

legal payer or recipient to others. For example, if

workers supply the same amount of labor regardless

of pay, employers can shift their share of the payroll

tax to workers by reducing wages. That example 1

illustrates a general rule: the less elastically supply

responds to price, wage, or interest rate, the more the

supplier bears the tax on the good, labor, or capital.

By contrast, higher retirement benefits might induce old workers to leave their jobs. Owners would

have to raise the pay of remaining workers and suffer

lower profits or pass the cost to consumers (including

owners, workers, and retirees) as higher prices. None

of that would happen, however, if old workers stayed

at their jobs despite the higher retirement benefits

(that is, if they supplied labor inelastically). Those

who are retired now--or who will retire later--would

get higher benefits, and that would be that.

Second, for familial or social reasons, transfers

may "slide" from the direct recipient to others. For

example, Social Security recipients might need less

support from or give larger bequests to their children

because of the benefits. If so, at least some of the

benefits slide to the children. Any benefits that slide

make the children better off and leave the parents as

well off as they would have been otherwise. Benefits

can slide even when the parties do not know each

other. For instance, hospitals may treat uninsured

patients and recoup their costs by charging higher

1. Congressional Budget Office, An Analysis of the Administration's

Health Proposal (February 1994), Chapter 4.
CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 11

prices to other patients. Those patients would therefore benefit if government provided aid to the uninsured.

The accounts assume that some taxes shift fully,

some partially, and some not at all, and that no transfers shift or slide. Business excise taxes and the employer's share of the payroll tax are assumed to shift

completely. Consumers and workers are assumed to

pay those taxes rather than merchants and employers.

Taxes on capital income are assumed to shift partially--that is, owners of capital, financial assets, and

homes bear the total tax in the same proportion that

they own the total net assets. By contrast, the accounts assume that people pay all of the property

taxes on their homes, and workers pay all of the income and payroll taxes on their earnings from labor.

And recipients of transfers are assumed to enjoy the

full benefits without any effect on anyone else.

The assumptions for shifting and sliding imply

that both labor and saving are supplied inelastically.

Competition in financial markets ensures that capital,

financial assets, and homes earn comparable riskadjusted rates of return after tax (which is why, in the

accounts, their owners bear the tax on income from

capital according to their share of total net assets).

Assigning Taxes on Capital Income

The accounts treat taxes on capital income in a complex way because of investment incentives (accelerated depreciation or investment tax credits). The incentives make it necessary to adjust the data from the

Current Population Survey in order to assign taxes to

the right generations. Those adjustments are required, given the incentives under either current law

or a change in law.

Investment Incentives Under Current Law. Investment incentives make owners of existing capital

pay higher taxes on their prospective income than

owners of new capital--that is, investment (see Appendix B). Hence, existing capital commands a

lower price than otherwise-equivalent new capital;

the difference in price is the present value of the excess taxes--in other words, the difference in taxes on

income from existing and new capital. ("Excess" is

used to describe the effect of tax law, not to suggest

that taxes are too high.) Given its discounted price,

buyers of existing capital will earn the same income

after taxes as if they had bought new capital. Current

owners pay the excess taxes whether they hold or sell

their capital; they pay in fact if they hold and in effect if they sell. (For that purpose, owners include

those who hold financial assets or homes because in

the long run competition makes them bear their proportional share of the tax.)

Therefore, some taxes in a later year will in effect be paid by this year's owners who have sold in

the meantime, rather than by that later year's owners.

The accounts must allow for that event in order to

assign prospective taxes to people in the right generations. To do so, they prorate the present value of the

excess taxes to this year's owners.

Without the adjustments, the accounts would understate prospective taxes of the middle-aged and old

and overstate those of the young. For example, the

adjustments add about $6,000 to the present value of

taxes of the average 60-year-old. That amount is

about 15 percent of the value of his or her capital.

Investment Incentives Under a Change in Law. If

investment incentives are raised, resources are transferred from old to young, according to the accounts.

The higher incentives effectively reduce taxes on

new capital. But taxes on existing capital remain as

they were, so excess taxes are even higher than before. The accounts prorate the present value of the

increase in excess taxes to current owners. At the

same time, the lower effective tax rate on new capital

reduces the taxes that prospective owners will pay.

Thus, according to the accounts, an increase in incentives raises taxes of current owners (mostly old) and

reduces those of prospective owners (mostly young).

In principle, the effect on a current owner when

an investment incentive rises is the same as that on a

bondholder when the interest rate rises. If both hold

their assets until the assets expire, they will pay as

much tax or earn as much interest as they would have

in the absence of the rise. But their assets will fall in

value because new capital would pay less tax, or a

new bond would earn more interest. If they sell, they

have to absorb the difference in higher taxes or lower

interest.
12 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Assigning Taxes and Transfers 

Within Families

Arbitrary judgments must be made in order to assign

taxes and transfers within families. There is no

clearly right way to split net taxes between husbands

and wives, or between parents and children. Should

a payroll tax be assigned to the earner, to husband

and wife jointly, or to all family members according

to their share of consumption?

The accounts use a variety of methods to assign

taxes within families. They assign payroll and income taxes to husbands and wives according to

which earns the pay or owns the asset. By contrast,

property taxes are split 50-50. And excise taxes are

assigned to all family members according to their

share of consumption. So, for example, the accounts

estimate that a current newborn pays about one-fifth

as much in excise taxes as a 40-year-old.

Transfers are assigned to the person who directly

receives a payment or service. Therefore, the accounts assign to the head of a family the benefits

from Aid to Families with Dependent Children

(AFDC), Food Stamps, and general welfare. And the

direct recipient is assigned the benefits from Social

Security, Medicare, Medicaid, and unemployment

insurance.

Those treatments can lead to anomalies, although

the most severe problem can easily be avoided. Any

method of splitting net taxes between husbands and

wives must be arbitrary and can produce misleading

results. It is possible to avoid such problems by presenting the results as weighted averages for males

and females together rather than separately. This

study does so.

Problems remain in treating dependent children,

however. For instance, according to the version of

the accounts used for this study, children would benefit from an increase in their Medicaid or Survivors'

Insurance benefits, but not from an increase in AFDC

benefits. But they should benefit from AFDC; that is

its purpose. Similarly, the accounts indicate that

children would lose if an increase in excise taxes paid

for higher income tax exemptions for dependents.

The net income of their family, however, would rise.

It would seem preferable to choose one consistent method to treat dependent children--that is, to

assign the cash value of net taxes either to adults or

to all family members according to their share of

consumption. Either choice involves arbitrary elements, but consistency would help clarify matters.

Calculating Generational 

Accounts

In order to estimate the net taxes of future generations, the zero-sum constraint is rearranged. In other

words, the present value (PV) of net taxes of future

generations must equal the current net debt of government, plus the present value of all prospective

government purchases, minus the present value of

prospective net taxes of current generations:

PV(Net Taxes of All Future Generations) =

Net Government Debt

+PV(All Prospective Government Purchases)

-PV(Prospective Net Taxes of All Current Generations).

Thus, calculating the present value of net taxes of

future generations involves estimating the three parts

of the right side of the equation. Essentially, the

present value of net taxes of future generations defines the "bill" that they would inherit if prevailing

policy remained unchanged. Because it is calculated

as a residual, that bill will accumulate any errors on

the right side of the equation.

Two elements are required to project net taxes of

current generations and government purchases: a definition of "prevailing policy," which relates taxes and

spending to population and income, and projections

of population and income.
CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 13

Defining Prevailing Policy

The relative-age profiles serve as a key to defining

prevailing policy. The assumption that the profiles

remain fixed under prevailing policy relates people's

prospective taxes and transfers with their age. It then

remains to relate taxes and spending with their income.

Net Taxes of Current Generations. Prevailing policy is defined in two parts: first by current policy,

then by a mechanical rule. That is, current policy

determines the total of each tax and transfer in an

official projection of the economy and budget. Given

the relative-age profiles and a projection of population, the taxes and transfers of the average member of

each current generation are calculated through the

end of the projection period.

Beyond the official projection, prevailing policy

applies a rule: each year, the real taxes and transfers

of the average person of a given age grow at the same

rate as productivity (loosely, real output per worker).

For instance, suppose a 30-year-old man paid $4,000

in payroll taxes in a given year and productivity grew

at 1 percent a year. The next year, a 30-year-old man

(the previous year's 29-year-old) would pay $4,040 in

payroll taxes. That rule keeps relative-age profiles

fixed, but allows absolute profiles to grow in line

with productivity.

This method enables the accounts to project the

net taxes of the average members of all current generations through the rest of their lives. A projection

of population determines the number of people of a

given generation who will survive in each succeeding

year. Therefore, the extensions reflect growth in the

economy, and mortality and migration in the population. The entire procedure applies only to current

generations because the net taxes of future generations are determined from the zero-sum constraint.

Government Purchases. Government purchases are

also determined by an official projection, then by a

rule that relates them to the growth of productivity

and population. The rule for purchases, however,

applies to both current and future generations. In

other words, the accounts take all purchases as given

by prevailing policy, then ask which generations pay

for them with their net taxes.

Implications of Prevailing Policy. The mechanical

rules used to define prevailing policy imply that current law would not remain as it is for current generations. For example, the rules would require that the

Congress adjust tax schedules so that overall growth

in real incomes did not push people now living into

higher income tax brackets. Similarly, the Congress

would have to adjust welfare benefits so that the payment for the average person (now alive) at each age

grew at the same rate as wages (which grow at the

same rate as productivity).

Such rules are commonly used for long-run projections because they make all sectors of the economy grow at the same rate as income and output. For

instance, the taxes and transfers of current generations would remain constant as shares of their incomes. And government purchases would remain

constant as a share of output (when the age of the

population remains stable). If sectors did not grow at

the same rate in the long run, the fastest-growing sector would grow to the size of the whole. Therefore,

mechanical rules are typically used in the absence of

better information.

Nevertheless, sectors can grow faster or slower

than output for long periods. For instance, over the

past century consumer services have grown from 23

percent of output to 39 percent, and farm products

have shrunk from 23 percent of output to 1 percent.

Thus, the definition of prevailing policy contains a

subjective element.

Choosing Projections of Population 

and Income

Given the rules of prevailing policy, the accounts

need economic and demographic assumptions in order to extend and discount the components of the

zero-sum equation. For their base case, the accounts

assume:

o Productivity, as the accounts define it, grows at

the rate that the Office of Management and Budget (OMB) projects through 2004, and thereafter
14 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

at 0.75 percent a year (roughly its rate since the

mid-1970s);

o Population follows the Social Security Administration's midgrowth projection through 2080 and

a mechanical extension thereafter;

o The structure of the economy remains as it is today; and

o A real discount rate of 6 percent applies to all

streams of taxes and transfers for all generations.

Productivity. In accord with fixed relative-age profiles, productivity is defined as real output per "effective worker" rather than per actual worker. The definition notes that, say, the average 40-year-old is more

productive than the average 60-year-old. Thus, output per actual worker will grow faster than output per

effective worker if the number of 40-year-olds grows

faster than the number of 60-year-olds, other things

being equal. That assumption implies that all income

from labor will fall as a share of total income as the

population ages.

Population. Population is extrapolated from 2080 to

2200 by assuming that the rates of fertility, death,

and immigration remain at the levels the SSA projects for 2080. After 2200, the size and composition

of the population are assumed to remain constant.

(By about 2040, the SSA projections already put

growth of the population near zero.)

Structure of the Economy. Fixed relative-age profiles define the structure of the economy. For instance, they imply that, by age and sex, there is never

any change in rates of participation in the labor force,

relative earnings, the average work week, the ratios

of assets to income, health needs, and so forth.

Discount Rate. The authors of the accounts reason

that the real rate of discount should be higher than

the real rate of interest on long-term government debt

(which is about 2 percent or 3 percent). They maintain that payment of prospective taxes and transfers is

less certain than payment of interest and repayment

of debt. If so, people should use a discount rate that

includes a premium to account for the risk that their

net taxes may vary from those scheduled. A real rate

of 6 percent equals the average historical rate of return on equity before tax. A before-tax rate is used

because net taxes are drawn from the before-tax income of the nation.

Calculating the Components 

of the Zero-Sum Constraint

Given specific projections of the economy, it is now

possible to calculate the components of the zero-sum

constraint, namely:

o Net government debt,

o Present value of all prospective government purchases,

o Present value of prospective net taxes of current

generations, and

o Present value of net taxes of future generations.

Net Government Debt. As an estimate of net government debt, the accounts use the sum of all deficits

since 1900 at the federal, state, and local levels. The

deficits are those defined by the national income and

product accounts (NIPAs). Unlike the unified deficit,

the NIPA deficit excludes financial transactions of

government, such as loans to the public. Therefore,

the sum approximates what government owes to the

public, less what the public owes to government.

The sum excludes government debt held by government entities, such as the Social Security trust

fund, because issue of that debt does not show up in

the unified deficit. Such issue is merely a bookkeeping entry that authorizes the agency to spend money.

Moreover, generational accounts omit tangible assets

of government--such as land, schools, or highways--

that reduce net debt. Omitting such assets is not serious, however, because including them would also

require including an offsetting item (see Box 2).

Present Value of All Prospective Government

Purchases. Purchases are projected under current

policy for 10 years, through 2004 in the version of

the accounts that the Congressional Budget Office

used. Federal purchases are projected by OMB, and

state and local purchases are assumed to grow at the
CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 15

Box 2.

Tangible Assets of Government

A tangible asset produces services that people consume during its lifetime. For instance, people use the

services of public highways when they travel by car,

just as they use the services of private rail tracks when

they travel by train. In other words, people consume

the services of an asset when they use it, not when

they buy it. Moreover, the present value of those services (less associated costs) is simply the value of the

asset (otherwise it would not be worth its cost).

Ideally, a record of government activity would

include consumption of the services of tangible public

assets, not just their purchase. But generational accounts treat such assets as if they were consumed the

year they were bought. That is, government purchases for any year include the purchase of new public capital, but exclude the services of existing public

capital. (The accounts follow the Department of

Commerce in this regard.) 

That treatment makes little practical difference

for the accounts. It would make no difference

whether the accounts included the prospective purchase of public assets when they are bought or the

consumption of their services when they are used.

The present value of prospective government purchases would be the same in either case (because the

value of the asset is the present value of its services).

Similarly, if the accounts included tangible government assets as an offset to government debt, they

would have to include the services of those assets in

prospective purchases. For instance, if government

sold an asset to reduce its debt, it would no longer be

able to provide the public services that the asset would

produce. Government would have to buy such services in order to provide for the public consumption

that is scheduled under prevailing policy. Again, the

result would be a wash in terms of present value.

An asset sale by itself would have no effect on the

net taxes of any generation because government

would simply exchange one asset for another (cash).

By contrast, a sale would reduce the unified deficit in

that year by the sale price (but would not affect spending caps under the Budget Enforcement Act of 1990).

The discussion above supposes some conditions

that may not always be true. The sale or lease of a

government asset may not correctly reflect its social

value. For example, government receives fees that are

generally lower than market values for rights to mine,

graze, or cut timber on public lands. Moreover, it is

often difficult to assess the social value of public assets, primarily because they serve functions that the

private sector does not. (What is the social value of

the Liberty Bell or an aircraft carrier?) Moreover,

generational accounts would not record unexpected

changes in the value of government assets, such as the

discovery of oil on public land. Stating those problems, however, does not do much to advance their

solutions.

rate OMB projects for gross domestic product. (The

latest presentation of the accounts has OMB's numbers for federal taxes and spending through 2030.2

The difference does not affect the main results presented later.)

To extend purchases by a mechanical rule, it is

assumed that some are related to the age of the population, whereas others are not. More specifically,

about 40 cents of each dollar of purchases depend on

the number of people in given age groups (for instance, for education of the young), and about 60

cents depend on total population without regard to

age (for instance, for defense). The accounts assume

that those fractions apply at the end of the official

projection and will remain fixed.

Total purchases are then extended by assuming

that real purchases per person in each subpopulation

group and in the total population grow at the rate of

productivity. The present value of prospective purchases through 2200 can be calculated by applying a

discount rate. It possible to calculate the present

value of purchases beyond that date by a simple

2. Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J. Kotlikoff,

"Restoring Generational Balance in U.S. Fiscal Policy: What Will

It Take?" Economic Review, Federal Reserve Bank of Cleveland,

vol. 31, no. 1 (First Quarter 1995), pp. 2-12.
16 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

equation because the size and composition of the

population are assumed to remain stable after 2200.

Over the past 30 years, this method of projecting

government purchases would have overstated their

growth. During that period, state and local purchases

rose as a share of gross domestic product (GDP) from

9 percent to 11 percent, but federal purchases fell

from 11 percent to 7 percent, mostly because of slow

growth in defense spending. All government purchases fell from 20 percent of GDP to 18 percent.

Present Value of Prospective Net Taxes of Current

Generations. Generational accounts combine official projections under current policy from a number

of sources. OMB's projection of taxes and spending

through 2004 serves as a base in the version of the

accounts that CBO used. Current policy can be de- 3

fined in two ways, however: after 1998, it might hold

discretionary federal spending constant in either real

or nominal terms. The definition OMB used implies

more spending through 2004 and, hence, higher net

taxes for future generations.

Other official sources are used to extend the totals of some taxes and transfers beyond 2004.

Through 2030, the accounts use projections by the

Health Care Financing Administration (HCFA) for

Medicare and Medicaid; through 2070, the accounts

use projections by the SSA for payroll taxes and Social Security benefits. Those agencies provide modifications of their official projections that are consistent with the economic assumptions of the accounts.

The accounts then make the yearly total for each tax

or transfer grow from 2004 to the end of its official

horizon at the same rate as it does in its modified

projection.

Beyond the official horizons, prevailing policy

assumes that the real taxes and transfers of the average person of a given age grow at the rate of productivity. Thus, projections of most taxes and transfers reflect rules that keep their growth in line with

incomes after 2004.

But the largest and fastest-growing transfers reflect current law and official projections through

2030 or 2070. For instance, prevailing policy includes the assumption by HCFA that real medical

costs per recipient will grow faster than productivity

through 2020 and the phase-in of the earliest age--

from 65 to 67--at which Social Security recipients

may draw full benefits.

This method yields the prospective net taxes of

the average members of each current generation for

the rest of their lives. The accounts apply a discount

rate to those net tax streams to calculate their present

values. Adding those present values for all the people of every age now alive gives the present value of

net taxes of all current generations.

Present Value of Net Taxes of Future Generations.

The present value of net taxes of all future generations is now given from the right-side components of

the zero-sum equation. To find the payments of each

future generation, it is assumed that they all pay net

taxes at the same rate. Then it is possible to calculate

their payments knowing the number of people in

each generation and their income. The number of

people is given by the population projection, and

their income by the growth of productivity. For example, the real income of next year's average newborn will be higher than that of this year's by the

growth of productivity, and so on. Arithmetic then

gives the present value of net taxes of each future

generation. That calculation is not intended to be

realistic, but to make it possible to speak of a representative future generation.

Reporting and Interpreting

Generational Accounts

Generational accounts must report the results in a

way that provides a basis of comparison among generations. Simply reporting the results as the present

values of prospective net taxes under a given policy

would not do so. For example, under prevailing policy, the present value of prospective net taxes of a

40-year-old is higher than that of a 50-year-old. The

3. Budget of the United States Government, Fiscal Year 1995 (January 1994).
CHAPTER TWO ELEMENTS OF GENERATIONAL ACCOUNTS 17

Box 3.

Lifetime Labor Income and Lifetime Consumption

If it was not for gifts and bequests, generational accounts would accurately represent the present value at

birth of lifetime consumption. With no gifts or bequests, people would consume all of their lifetime income, and all income from capital would be the return

from previously saved income from labor. But the

present value of the return from capital is simply the

original amount saved (not consumed). Thus, the

present value at birth of lifetime consumption would

equal the present value at birth of lifetime income

from labor--the measure that the accounts use.

But gifts and bequests upset the equality. Income

from inherited capital does not represent a return on

saving from an heir's past income from labor. And

gifts and bequests are important to the distribution of

wealth. One study estimates that about 80 percent of

existing capital has been received as a gift or bequest

and only 20 percent saved from the owner's income

from labor. Estimates from another study, however,

reverse those figures. The most recent study estimates

that at least 20 percent of wealth represents past

gifts and that at least 50 percent represents either gifts

or bequests.1

The approximation in the accounts, however, remains fair. Income from labor amounts to about fourfifths of total net income. Moreover, inheritances

usually occur so late in life that their present value at

birth remains small in relation to that of income from

labor. The error in the approximation would differ

among generations if they received bequests of different amounts (in relation to their income from labor) or

at different ages.

1. See Laurence J. Kotlikoff and Lawrence H. Summers, "The

Role of Intergenerational Transfers in Aggregate Capital Accumulation," Journal of Political Economy, vol. 89, no. 4

(August 1981), pp. 706-732; Franco Modigliani, "The Role

of Intergenerational Transfers and Life Cycle Saving in the

Accumulation of Wealth," Journal of Economic Perspectives,

vol. 2, no. 2 (Spring 1988), pp. 15-40; and William G. Gale

and John Karl Scholz, "Intergenerational Transfers and the

Accumulation of Wealth," Journal of Economic Perspectives,

vol. 8, no. 4 (Fall 1994), pp. 145-160.

40-year-old has 10 more years of taxes to pay and is

10 years further from receiving Social Security and

Medicare.

It is not possible to know from that comparison,

however, whether past and prospective policy treat

the two in the same way. For example, the 40-yearold has earned higher real income than the 50-yearold did at comparable ages. Furthermore, has the 40-

year-old paid net taxes in the past at the same rates

that the 50-year-old had at the age of 40? Will the

40-year-old pay net taxes for the next 10 years at the

same rates that the 50-year-old did for the past 10

years?

Reporting the Results

Generational accounts can be reported in at least two

ways that provide a basis of comparison among all

generations: as a net tax rate paid over a lifetime or

as a change in the present value of prospective net

taxes under a change in policy.

Lifetime Net Tax Rate. A generation's lifetime net

tax rate is its lifetime net taxes as a percentage of its

lifetime labor income. Specifically, a lifetime net

taxrate is the present value at birth of net taxes over a

lifetime as a percentage of the present value at birth

of labor income over a lifetime. (Lifetime labor income is used as a base because it is closely related to

lifetime consumption--a basic measure of well-being.

See Box 3.) This calculation compares all generations on the same basis because it includes the effects

of all policy, past and prospective, from birth.

To calculate lifetime net tax rates, the accounts

must first estimate net taxes already paid by the average member of each current generation. To do so,

the accounts use survey data to estimate the relativeage profiles for labor income, taxes, and transfers

that prevailed in the past.

The survey data go back only as far as 1964, so

the accounts assume that the relative-age profiles for

1964 were valid from 1900 to 1964. (That assumption is clearly heroic. For instance, females were
18 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

about twice as likely to work for pay in 1964 as they

were at the turn of the century.) The accounts then

use historical data to estimate how much the average

member of each generation earned in income from

labor, paid in taxes, and received in transfers each

year in the past. Past net taxes and income from labor, together with prospective net taxes and income

from labor, yield lifetime net taxes and income from

labor. Those lifetime streams for each generation are

discounted to find their present value, then divided to

find their lifetime net tax rate.

Dollar Change in Present Value of Net Taxes. The

results may also be presented as the change in the

present value of net taxes for any given change in

policy. For instance, a new policy might reduce the

present value of net taxes of the average 20-year-old

by $200 and raise that of the average 50-year-old by

$100. This presentation also compares people of all

ages on the same basis because the entire effect of

the change in policy is prospective. But the results

must be interpreted with care because they do not

reflect the net taxes that people of different ages have

paid or will pay.

Interpreting the Results

Generational accounts serve only as an abstract indicator, not a predictor or goal. They do not say how

policy will or should evolve; such questions remain

beyond analysis.

The accounts set a standard by which prevailing

policy may be judged and other policies compared.

In that respect, they resemble other conceptual standards that answer "as if" questions, rather than making realistic predictions. For example, the baseline

budget establishes a reference point as if current policy were to remain in force for everyone, alive or yet

to be born; or the full-employment budget separates

the effects of policy on the budget from the effects of

the economy on the budget as if the economy were at

full employment. Generational accounts indicate

how policy would distribute resources among generations as if prevailing policy were to continue without

change for those now living.

As one point of reference, the accounts indicate

whether a policy is "sustainable." It is if scheduled

rates of taxes and spending according to age need not

change to satisfy the zero-sum constraint. Thus, a

policy is sustainable if it implies no difference in the

lifetime net tax rates of future generations and current newborns. In that case, each generation could

pay net taxes at every age at the rates that are scheduled now and satisfy the zero-sum constraint. Of

course, those rates must also be feasible; for instance,

people cannot pay more in net taxes than they earn in

a lifetime.

A policy is not sustainable if there is a difference

in the lifetime net tax rates of future generations and

current newborns. In that case, scheduled rates of

taxes or spending according to age would have to

change--for either current or future generations--in

order to satisfy the zero-sum constraint. The accounts do not predict how taxes or spending would

change.

Sustainability need not imply desirability. For

example, future generations will typically be much

richer than current generations, so it may be fair for

them to pay net taxes at higher rates. The accounts

can address only sustainability, not fairness.

Generational accounts and long-term deficit projections both address sustainability, but present the

information in different ways. Strictly, the accounts

and an infinite projection of the deficit would require

the same data and assumptions. (The information

they convey would be equivalent if the accounts used

a discount rate equal to the interest rate on government debt.) Given an infinite horizon, implicit obligations must show up in the deficit at some time. In

that case, it is not possible to obscure the direction of

policy by undertaking implicit obligations that do not

raise the deficit now, but would raise it later. Thus, a

deficit projection would show that policy is not sustainable if government debt would continually rise in

relation to output.

A deficit projection would not, however, address

distribution by age. Therefore, some advocates of

generational accounts maintain that debate about fiscal policy should focus on how it affects those accounts, rather than the deficit (see Appendix C).
G

Chapter Three

Findings of Generational Accounts

iven the base assumptions of generational

accounts, three findings stand out. First, prevailing policy is not sustainable. It implies

that future generations would have to pay lifetime net

taxes at about twice the rate of current newborns (assuming that all current generations pay net taxes at

prevailing rates for the rest of their lives). Second,

reaching a sustainable policy would require a change

in policy equivalent in present value to spending cuts

and tax increases of about 8 percent across the board.

Third, the deficit does not necessarily indicate the

way in which fiscal policy is distributing resources

among generations. The accounts indicate that fiscal

policy since World War II had different generational

effects than the deficit would seem to suggest. The

accounts and the deficit may also give different signals about prospective policies.

In analyzing these findings, the Congressional

Budget Office used a computer program and data

provided by the authors of the accounts. CBO cannot

vouch for the data or program. There is no reason to

believe that they contain errors, although errors have

appeared in past versions (a common occurrence

when developing a complex system).

Assessing the Evolution and

Status of Generational Policy

According to the accounts, lifetime net tax rates of

succeeding generations have risen steadily over this

century. The rates rose from 24 percent for people

born in 1900 to 37 percent for those born in 1990

(see Table 1). Those figures combine net taxes at all

levels of government--federal, state, and local (see

Box 4 on page 21).

The lifetime net tax rate of future generations

would have to rise to nearly 80 percent to settle the

bill. That represents about twice the lifetime net tax

rate of current newborns, or a difference in lifetime

net tax rates of future generations and current newborns of more than 40 percentage points.

The bill for the future would be even higher if

not for the Omnibus Budget Reconciliation Act of

1993 (OBRA-93). The version of the accounts that

this study used predates OBRA-93. But an updated

version that includes the provisions of OBRA-93 also

includes new economic and technical assumptions

that offset the effects of those provisions. As a result, using the updated version would not appreciably

change any numbers reported here (see Box 5 on

page 22).

Rapidly rising medical costs and aging of the

population account for most of the difference in lifetime net tax rates of future generations and current

newborns. Rising costs of medical services per recipient account for most of the rise in health spending; a rising number of Medicare recipients accounts

for a much smaller part. The aging of the population

means that baby boomers are scheduled to receive

more in Social Security benefits when they retire

than prevailing tax rates will provide.
20 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Why Do Lifetime Net Tax Rates 

Seem So High?

The lifetime net tax rates shown in Table 1 may seem

high when compared with the more familiar "current

net tax rates" (current net taxes as a percentage of

Table 1.

Estimated Lifetime Tax and Transfer Rates 

by Year of Birth (Average for males and females,

in percent)

Net Gross Transfer

Year of Birth Tax Rate Tax Rate Rate a

1900 24 28 3

1910 28 33 6

1920 29 36 7

1930 31 39 8

1940 32 41 9

1950 34 44 10

1960 35 46 11

1970 36 50 12

1980 37 51 13

1990 37 51 13

Future Generations 78 b b

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described

in Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff, "Generational Accounts: A

Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5

(Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The rates shown are for taxes and transfers at all levels of government combined--federal, state, and local.

The estimates assume a real discount rate of 6 percent, a prospective annual rate of growth in productivity

of 0.75 percent, and the midgrowth path of population

used by the Social Security Administration in its 1993

annual report.

The values in the table reflect the implication of generational accounts as constructed, not necessarily the

views of the Congressional Budget Office.

a. A lifetime net tax rate is the present value at birth of lifetime

net taxes as a percentage of the present value at birth of lifetime labor income. The net tax rate equals the gross tax rate

less the transfer rate (except for possible differences because

of rounding).

b. There are no unique values of gross tax and transfer rates for

future generations. For the base case shown, any combination

of lifetime tax and transfer rates that nets to 78 percent is feasible, at least arithmetically.

current market income). For example, the lifetime

net tax rate of current newborns is 37 percent,

whereas net taxes of the nation now stand at only 24

percent of national income.

But current net tax rates do not directly compare

all generations on the same basis because such rates

vary widely with age. The young and middle-aged

typically earn most of market income and pay most

of total taxes. And the old typically receive more in

transfers than they pay in taxes.

Given that pattern, three factors explain why estimated lifetime net tax rates are as high as they are.

First, present value gives more weight to taxes paid

earlier than to transfers received later. Second, people do not all live to old age. Therefore, the accounts

give more weight to prospective taxes than to prospective transfers because people are more likely to

pay the taxes than receive the transfers. Finally, lifetime net tax rates are based on labor income rather

than total income, which current net tax rates are

based on. Using the smaller measure as a base leads

to a higher lifetime net tax rate. For comparison, current net taxes are 30 percent of labor income,

whereas they are only 24 percent of total income.

What Do the Lifetime Net Tax Rates

of Various Generations Imply?

Rising lifetime net tax rates did not necessarily make

successive generations worse off than their predecessors. First, most of the increase has paid for a similar

rise in the rate of government purchases during the

period from 1900 to about 1950. But the accounts do

not assign the benefits of purchases to specific generations. Second, estimated lifetime incomes rose significantly during this century (aside from any benefits from government purchases). The accounts estimate that the lifetime income, after taxes and inflation, of the average person born in 1990 is about

three times that of the average person born in 1900.

Prevailing policy, however, implies that the lifetime after-tax income of at least some future generations would fall below that of current newborns

(given the base assumptions of the accounts). That

would happen if, as the accounts assume, all future
CHAPTER THREE FINDINGS OF GENERATIONAL ACCOUNTS 21

Box 4.

The Case in Favor of Separate Generational Accounts

It would be useful to present generational accounts for

the federal sector separately because combined accounts for all levels of government mask the source of

generational policy. (The combined accounts, however, can isolate the effects of changes in, rather than

levels of, federal activity.)

For example, suppose that projected purchases

by local governments reflect the need for relatively

less spending on education. Thus, if local governments maintain budgets in approximate balance, they

could reduce the rate of property taxes, which largely

finance education. Even if local authorities kept the

same property tax rate, as the accounts assume, it

would not correct fiscal imbalance at the federal level.

Instead, it would maintain the amount of property

taxes deducted from the federal tax base.

Combining the accounts also mixes apples and

oranges. Typical federal activities usually have different implications for given age groups than typical

nonfederal activities. For example, about half of federal excise taxes come from gasoline, tobacco, and

alcohol. Taxes on those items tend to apply more narrowly to specific age groups than the more broadly

based excise taxes of states and localities. And most

of the purchases that state and local governments

make are related to the age of the people, such as

those for education, whereas most of the federal government's are unrelated to age, such as those for defense. Finally, particular taxes of state and local governments are more often tied to particular purchases--

for example, property taxes and purchases to provide

municipal services. Separating the accounts, therefore, would alleviate some problems of interpretation.

generations pay lifetime net taxes at twice the rate of

current newborns. But it would also happen no matter how future generations might settle the bill.

For example, it may seem arithmetically feasible

for future generations to settle the bill by having incredibly rich generations far in the future pay net

taxes at a lifetime rate of nearly 100 percent. If their

before-tax incomes were high enough, they would be

left with at least as much after-tax income as current

newborns. (Of course, this hypothetical scheme ignores the adverse effects of high taxes on economic

activity.) But prevailing policy would leave too large

a bill for future generations to make the scheme feasible, even arithmetically. Therefore, under the base 1

assumptions of the accounts, prevailing policy would

make at least some future generations worse off than

current newborns.

Eliminating the Difference in

Lifetime Net Tax Rates of 

Future Generations and 

Current Newborns

What policy would equalize the lifetime net tax rates

of current newborns and future generations? An infinite number of policies could do so. One way to pose

the problem in an easily handled form is to ask the

hypothetical question: how much would a tax have to

be raised or a transfer reduced now if its total grew

thereafter at its previously projected rate?

Such an abstract approach does not consider realistic options; it merely defines the size of the problem for further analysis and debate. The approach

does not address many issues that the Congress

would have to consider: the short- and long-term effect on the economy, distribution by income, and so

forth. In fact, the Congress may decide to reduce

lifetime net tax rates of future generations, but not to

the same rate as that of current newborns. In any

1. According to the accounts, the scheme would be arithmetically

feasible in some instances with a low rate of discount and high

rates of growth of productivity and population. 
22 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Box 5.

Would an Updated Version of Generational Accounts Change the Results?

The results reported in this study would not change significantly if the Congressional Budget Office had used an updated version of generational accounts. The version used

reflects the 10-year economic and budget projections of the

Office of Management and Budget's (OMB's) 1992 midyear

update, which do not include the provisions of the Omnibus

Budget Reconciliation Act of 1993 (OBRA-93). The latest

official version reflects the 10-year projections of OMB's

1993 midyear update, which include the provisions of

OBRA-93, plus a new method of projecting the Medicaid

expenditures of state and local governments, and updated

relative-age profiles for taxes and transfers.

The results of those changes nearly cancel each other.

Without OBRA-93, the changes would have raised the lifetime net tax rates of future generations from 78 percent to

94 percent, while barely changing those of current generations (see table below). About half of this difference arises

because the new version of the accounts assumes that Medicaid spending by state and local governments will grow

through 2004 at the same rate that the Health Care Financing Administration projects total Medicaid expenditures to

grow rather than at the same rate as gross domestic product.

The rest of the difference comes from updated economic

projections and relative-age profiles for taxes and transfers--

and, to a small extent, because the new generation of current

newborns has moved from being part of future generations

to being part of current generations.

Alternatively, OMB estimated that OBRA-93 would

directly reduce the deficit from 1994 through 1998 by $429

billion by means of a combination of higher taxes, lower

spending for mandatory programs, and new caps on discretionary spending from 1996 through 1998. Given the 1993

economic projections, those provisions lowered the lifetime

net tax rates of future generations to 82 percent, but again

barely changed those of current generations. The net result

of the two effects is essentially a wash, and there is no reason to believe that using the latest version would significantly change any results reported in this study, either qualitatively or quantitatively.

The budget resolution of 1995 would substantially

change the results that are shown in the table. But the decisions necessary to carry out the resolution have not been

made. Therefore, it would be premature to speculate about

how the generational accounts for people of different ages

would change.

Estimated Lifetime Net Tax Rates Before and After the Omnibus Budget Reconciliation Act of 1993

(Average for males and females, in percent)

Before OBRA-93 Before OBRA-93 After OBRA-93

Year of Birth (1992 Version) (1993 Version) (1994 Version)

1900 24 24 24

1910 27 27 27

1920 29 29 29

1930 31 31 31

1940 32 32 32

1950 34 33 33

1960 35 34 35

1970 36 36 37

1980 37 36 37

1990 37 36 37

Future Generations 78 94 82

SOURCE: Congressional Budget Office, using data and a computer program provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, $Generational Accounts: A Meaningful Alternative to Deficit Accounting,# in

David Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110; and Office of Management and Budget, Budget of the United States Government, Fiscal Year 1995: Analytical Perspectives (January 1994), p. 25.

NOTES: A lifetime net tax rate is the present value at birth of lifetime net taxes as a percentage of the present value at birth of lifetime labor

income. The rates shown are for net taxes at all levels of government combined--federal, state, and local. The estimates assume a real

discount rate of 6 percent, a prospective annual rate of growth in productivity of 0.75 percent, and the mid-growth path of population

used by the Social Security Administration in its 1993 annual report. Compared with the 1992 version of generational accounts, the

1993 version projects Medicaid spending by state and local governments differently and contains updated profiles of taxes and

transfers by age. The values in the table reflect the implication of generational accounts as constructed, not necessarily the views of

the Congressional Budget Office.
CHAPTER THREE FINDINGS OF GENERATIONAL ACCOUNTS 23

case, the Congress would not cut only one type of

spending or raise only one tax, and would almost certainly make spending or taxes grow at different rates

than would prevailing policy. But the approach is

realistic in one sense: it identifies sustainable policies

in common terms.

The budget item that is changed determines both

the size of the change that is needed and the way its

costs are spread by age (see Table 2). The size of the

hypothetical deficit reduction could vary from $109

billion for cuts in Social Security benefits to $227

billion for cuts in government purchases. Those figTable 2.

Distribution of Costs of Hypothetical Policy Changes Needed in 1991 to Reach a Sustainable Policy

Alternative Alternative

Proportionate Tax Increases Proportionate Spending Cuts

Payroll Medicare

or Labor Capital and Social Other Government

Age in 1991 Income Excise Income Medicaid Security Transfers Purchases a b

Change in Present Value of Net Taxes (In thousands of 1991 dollars)c

90 0 1 0 3 3 n.a. 0

80 0 4 6 24 30 n.a. 0

70 0 7 13 33 45 n.a. 0

60 4 11 21 33 44 n.a. 0

50 13 14 26 18 17 n.a. 0

40 21 18 26 18 17 n.a. 0

30 25 19 21 13 11 n.a. 0

20 24 20 15 11 7 n.a. 0

10 15 17 9 8 6 n.a. 0

Newborns 9 12 6 6 4 n.a. 0

Future Generations -55 -52 -59 -59 -61 n.a. -64 d

Corresponding Budget Change in 1991 (In billions of 1991 dollars)

n.a. 197 210 182 -112 -109 n.a. -227

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The estimates assume a real discount rate of 6 percent, a prospective annual rate of growth in productivity of 0.75 percent, and the

midgrowth path of population used by the Social Security Administration in its 1993 annual report.

The values in the table reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional

Budget Office.

A feasible policy is sustainable if lifetime net tax rates of future generations and current newborns are equal.

n.a. = not applicable.

a. There are no entries for a cut in other transfers because the required cut would be about twice their total.

b. A proportionate cut in prospective government purchases affects the net taxes of future, but not current, generations. Both receive fewer

services from government purchases. Current generations continue to pay as much as if there had been no cut, so future generations can

pay less than they would otherwise.

c. Average for males and females.

d. The figures for future generations apply to those born next year. The respective figures for successive future generations would grow at the

rate of productivity.
24 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

ures represent 38 percent and 18 percent of the respective totals. For perspective, the results shown in

Table 2 imply that federal spending cuts and tax increases of about 8 percent across the board would

achieve a sustainable policy. That translates to about

$175 billion in 1991. By coincidence, that hypothetical figure is about the size of the federal deficit in

that year. But simply eliminating the deficit would

not do the job if it did not deal with the long-run

problems of an aging population and rapidly growing

medical costs.

Two main factors account for the wide variation

in the size of the hypothetical deficit cut that is

needed: the rate at which the budget item grows and

the number of people that the deficit cut affects.

How Fast Does the Budget Item Grow?

A smaller deficit cut is needed when the tax or

spending is projected to grow faster. To see why,

consider what happens when a shrinking item in the

budget gets cut by the same proportion every year.

Suppose spending is going to be $100 this year and

$90 next year. It would take a proportionate cut of

10 percent--$10 this year and $9 next year--to save a

total of $19. By contrast, consider a growing program. Suppose spending is going to be $100 this

year and $110 next year. Then a proportionate cut of

only 9 percent would be necessary--$9 this year and

$10 next year--to save a total of $19. Cutting a

growing spending program gives a bigger bang for

the buck. The faster the item grows, the smaller the

proportionate change needed to save a given total.

The effect is most pronounced in cuts to health

benefits and Social Security. Those programs are

projected to grow much faster than other federal

spending. Medical costs per recipient are assumed to

grow faster than output per capita through 2030 in

the version of the accounts that CBO used. Hence, a

relatively small proportionate cut in health spending

is required to reach a sustainable path. Similarly,

retirees are expected to grow as a share of the population; thus, a relatively small proportionate cut in

Social Security benefits is necessary to reach a sustainable path. By contrast, a big cut in purchases is

necessary to achieve sustainability, mostly because

defense purchases are assumed to grow slowly.

How Many People Does 

the Deficit Cut Affect?

The size of the deficit cut that is needed also depends

on the number of people now alive who will pay for

the cut with higher net taxes. For instance, the old

contribute little to taxes on labor income, but a lot to

taxes on capital income. As a result, taxes on labor

income would have to rise more than taxes on capital

income to achieve sustainability. Similarly, everyone

now alive would contribute at some time if benefits

for Social Security or Medicare fell. Thus, those actions need a relatively small proportionate deficit cut.

Excise taxes may have to rise by so much, according to the accounts, simply because the accounts

assign excise taxes to children. But a newborn next

year belongs to a future generation and will not contribute to net taxes of current generations. By contrast, the average 15-year-old does not contribute to

payroll taxes this year, but will next year. Thus,

there are more current generations in the pipeline to

pay tax at higher rates on payroll than on sales.

To some extent, the size of the deficit cut that is

needed also depends on how it affects the lifetime net

tax rate of current newborns. The more the cut raises

their lifetime net tax rate, the less that of future generations has to fall to become equal. That effect is

most pronounced in the case of a cut in government

purchases because such a cut does not raise the net

taxes of current newborns at all.

Assessing Past or Prospective

Fiscal Policy

Both retrospective and prospective analyses show

that fiscal policy can head in a different direction

than the deficit seems to indicate. Looking back,

most analysts agree that policies since World War II

shifted resources from the young to the old. The accounts, however, put most of the blame on the policies of the 1950s, 1960s, and 1970s rather than the

high-deficit years of the 1980s. Looking ahead, the

accounts show that the way that fiscal policy shifts
CHAPTER THREE FINDINGS OF GENERATIONAL ACCOUNTS 25

resources among generations can be unrelated to the

deficit.

Assessing Fiscal Policy 

Since World War II

Generational accounts suggest that the direction of

postwar fiscal policy was quite different from what is

commonly supposed. According to an early version

of the accounts, policy through the 1970s made the

old better off at the expense of then-young-and-future

generations, although deficits were low and debt was

falling in relation to output. Perhaps more surpris- 2

ing, policy in the 1980s had little effect on the net

taxes of future generations, although deficits were

high and debt was rising in relation to output.

Two main factors account for the gains of the

elderly from the 1950s through the 1970s. First, benefits for Social Security and Medicare were increased

in each of those decades. Second, payroll taxes rose

to help pay for the higher benefits, while taxes on

capital income fell as a share of all taxes. The benefit increases helped the old more than the young; the

switch in tax bases helped the old and hurt the young;

and the mounting bill hurt future generations.

That pattern changed in the 1980s. The Social

Security Amendments of 1983 raised payroll taxes

and reduced prospective benefits. The law phased in

an increase in the earliest age (from 65 to 67) at

which retirees could draw full benefits. The law also

set a cap on the benefits that people could receive in

any year before they were subject to income tax. Because the cap is set in nominal terms, inflation will

expose a growing portion of benefits to tax.

The amendments had different effects on different generations. Net taxes changed little for those

who were retired or about to retire, but increased for

the young and middle-aged. Moreover, the amendments lowered the net taxes required of future generations by raising those of current generations. According to the accounts, that change approximately

offset the effects of higher deficits in the 1980s on

the net taxes of future generations.

Those results, however, do not establish that

policymakers would have made different choices if

they had used generational accounts at the time.

First, the accounts assign only the cash cost of net

taxes, not the benefits of government purchases. If

the accounts could assign those benefits, the pattern

of distribution might look different. Purchases, especially for defense, were raised in the 1950s. The benefits to the young of more national security could

have been enough to offset the prospect of higher

payroll taxes.

Second, the exercise used 20/20 hindsight about

the growth of output and population. But analysts in

the 1950s and 1960s did not have 20/20 foresight and

made inaccurate economic and demographic projections. Analysts at the time assumed that medical

costs would rise more slowly than they actually did,

that the death rate would fall more slowly, and that

productivity would grow more rapidly. Those errors

would also have appeared in generational accounts if

they had been prepared then.

In a sense, from the 1950s through the 1970s, the

nation won one gamble but lost another. During that

period, the interest rate on government debt was

lower than the growth rate of the economy. That

made it possible to win a gamble that the ratio of

debt to output would fall without having to raise

taxes to pay interest on the debt. But the country lost

the gamble that such conditions would persist; government undertook implicit obligations for Social

Security and Medicare that it cannot meet as they are

currently scheduled.

Assessing Prospective Policy Changes

As an experiment, CBO used the accounts to analyze

some hypothetical policy changes. In some ways the

results are what the deficit would indicate: for example, a deficit increase would worsen the lot of future

generations. The accounts, however, also show that

changes in policy can shift resources among generations without changing the deficit at all. Similarly,

different ways of changing the deficit by a given

2. See Laurence J. Kotlikoff, Generational Accounting: Knowing

Who Pays, and When, for What We Spend (New York: The Free

Press, 1992), pp. 165-191.
26 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

amount can have very different effects on any given

generation.

A Policy That Increases the Deficit. The Congressional Budget Office considered a policy that would

cut the income tax by 20 percent for five years without changing spending. That would raise the bill left

for the future. The hypothetical policy would then

raise the income tax by enough to make the bill grow

at the same rate that it would have if the tax had not

been cut.

Such a policy would benefit the middle-aged and

old at the expense of young and future generations

(see Table 3). Those about 50 years old would gain

the most. Those older than 50 would not gain as

much because their labor income has already peaked.

And those younger than 50 would not gain as much

because, after five years, they would have to pay

higher net taxes for the rest of their lives. In fact,

those younger than 30 would pay more under the policy. They would gain little or nothing from the tax

cut, but would pay higher net taxes for most of their

lives. Furthermore, future generations would lose

because the higher bill would require higher net taxes

to pay the extra interest. The policy would raise the

present value of net taxes of current newborns and

future generations by about the same amount.

Three Deficit-Neutral Policies. CBO also considered three policies that would change the mix of

taxes and transfers without changing the deficit. The

policies qualitatively resemble changes in mix that

have occurred slowly since World War II.

Table 3.

Alternative Policies That Would Change the Timing or Mix of Taxes and Transfers

(Change in present value of net taxes, in thousands of 1991 dollars)

Policy That Policies That Would Not Change the Deficit

Would Raise 20 Percent Increase in

the Deficit Social Security 30 Percent Increase in 30 Percent Increase in

Five-Year, Benefits and Equal- Payroll Taxes and Payroll Taxes and

20 Percent Revenue Rise in Equal-Revenue Cut in Equal-Revenue Cut in

Age in 1991 Income Tax Cut Payroll Taxes Excise Taxes Income Taxes

90 -0.1 -1.1 -0.4 0

80 -0.8 -9.5 -2.8 -1.0

70 -1.3 -14.4 -4.8 -2.1

60 -2.2 -12.8 -4.8 -2.8

50 -2.3 -4.9 -0.9 -2.2

40 -1.4 0.7 3.3 -0.9

30 0 3.9 5.2 0.7

20 1.3 5.1 3.3 1.6

10 1.7 3.4 -0.9 1.1

Newborn 1.0 2.4 -2.3 0.8

Future Generations 1.0 2.9 -2.1 0.8 a

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The estimates assume a real discount rate of 6 percent, a prospective annual rate of growth in productivity of 0.75 percent, and the

midgrowth path of population used by the Social Security Administration in its 1993 annual report.

The values in the tables reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional Budget Office.

a. The figures for future generations apply to those born next year. The respective figures for successive future generations would grow at the

rate of productivity.
CHAPTER THREE FINDINGS OF GENERATIONAL ACCOUNTS 27

The first policy would increase Social Security

benefits by 20 percent and raise the payroll tax to pay

for them. This policy would typically cause greater

changes on the basis of age than would the temporary

tax cut, even though the policy would not change the

deficit. For example, the accounts estimate that the

present value of net taxes of 60-year-olds would fall

by about six times as much as under the temporary

tax cut.

The lifetime net taxes of future generations

would rise by about three times as much as they

would under the temporary tax cut. The extra taxes

needed to make extra payments would pass from

generation to generation. Those who are now young

would pay their extra taxes to those now old, leaving

the deficit unaffected. But when those who are now

young became old, future generations--those not yet

born--would have to pay the extra taxes.

The second policy would raise payroll taxes by

30 percent to pay for a cut in excise (or consumption)

taxes. That policy would cost 20- to 40-year-olds the

most. Unlike the other policies, it would reduce the

net taxes of the very young because the accounts assign excise taxes according to share of family consumption. The policy would also reduce the net

taxes of future generations; there are more middleaged people to pay higher payroll taxes than old people to pay lower excise taxes. 

The third policy would raise payroll taxes by 30

percent to pay for a cut in income taxes. The switch

in taxes would benefit the old because more of their

prospective income comes from capital than from

labor. But the policy would make smaller changes

by age than would the other deficit-neutral policies

because about 80 percent of national income comes

from labor. The source is the same as the payroll tax,

so the switch in taxes would mainly shuffle the legal

base of the tax. That switch would raise net taxes of

future generations because it would reduce net taxes

of the old and middle-aged more than it would raise

those of the young.

Table 4.

Alternative Policies That Would Cut the Deficit by an Equal Amount 

(Change in present value of net taxes, in thousands of 1991 dollars)

10 Percent Cut in Increase in Increase in Increase in

Age in 1991 Social Security Benefits Capital Income Taxes Payroll Taxes Excise Taxes

90 0.5 0 0 0.1

80 4.7 1.0 0 0.5

70 7.3 2.0 0.1 1.0

60 7.0 3.3 0.6 1.5

50 4.4 4.1 1.9 2.2

40 2.7 4.0 3.1 2.6

30 1.8 3.3 3.7 2.8

20 1.2 2.4 3.7 3.1

10 0.9 1.6 2.6 2.7

Newborn 0.6 1.0 1.8 2.1

Future Generations -9.8 -9.4 -8.4 -8.0 a

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: The estimates assume a real discount rate of 6 percent, a prospective annual rate of growth in productivity of 0.75 percent, and the

midgrowth path of population used by the Social Security Administration in its 1993 annual report.

The values in the tables reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional Budget Office.

a. The figures for future generations apply to those born next year. The respective figures for successive future generations would grow at the

rate of productivity.
28 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Policies That Reduce the Deficit. Finally, CBO

also examined four policies that would cut the deficit

by a given amount (about $29 billion in the first

year). The first policy would permanently cut Social

Security benefits by 10 percent; the others would

raise capital income, payroll, or excise taxes to lower

the deficit by the same amount as the cut in benefits.

Those policies would have different effects on

people who are now alive, even though they would

have the same effect on the deficit (see Table 4). The

cuts in benefits would cost those who are about 60 or

70 years old the most because they are at or near the

end of their working lives and have most of their retirement ahead. (A phased-in reduction could spread

the costs more evenly.) The tax increases, however,

would cost those who are about 20 or 30 years old

the most. They are still far from retirement and will

pay taxes for many years.

The policies would have slightly different effects

on future generations even though they would cut the

deficit by the same amount. That result occurs because the policies would change the timing of taxes

and transfers that pass from generation to generation.

For example, cuts in Social Security benefits and increases in capital income taxes fall more heavily on

the old, so those policies would eventually make all

living generations pay more toward the bill than

would raising payroll or excise taxes.

Such exercises show how little information the

deficit gives about the effects of policy on different

generations. Generational accounts keep track of

such effects, some of which may not be apparent

without the tools that the accounts provide. The next

question is, how accurate and reliable are the accounts?
H

Chapter Four

Uncertainties in Generational Accounts

ow much do the fundamental findings of

generational accounts depend on the assumptions that go into them? To find out,

the Congressional Budget Office used "sensitivity

analysis"--that is, it calculated the accounts under a

range of assumptions. Quantitatively, the results can

depend heavily on such assumptions; qualitatively,

however, the conclusion remains that prevailing policy is not sustainable.

Sensitivity of Results to 

Economic and Demographic

Assumptions

CBO chose three alternatives for each of the main

assumptions about the population and economy. For

population growth, the Social Security Administration's low-, mid-, and high-growth projections were

used. For productivity and the discount rate, the 1

alternatives span a range that is typically used for

generational accounts. In each case, the middle of 2

the range represents the base assumption of the

accounts.

Choosing Alternative Assumptions

The population paths incorporate rates of fertility,

death, and net migration that are lowest on the lowgrowth path and highest on the high-growth path.

Therefore, for example, on the low-growth path, low

rates of fertility and immigration keep the growth of

the workforce low, but low death rates keep the

growth of the aged population high. As a result, the

fraction of the population that is 65 years old or older

increases from about 13 percent today to about 31

percent by 2080 for the low-growth path, 24 percent

for the mid-growth path, and 18 percent for the highgrowth path.

CBO considered three rates of growth in productivity: 0.25 percent, 0.75 percent, and 1.25 percent.

The average rate since the oil shock of 1973 has been

about 0.75 percent; since World War II, about 1.5

percent; and since 1900, about 1.25 percent.

Real discount rates of 3 percent, 6 percent, and 9

percent were used. Those roughly match average

historical rates of return (before tax) on long-term

federal debt, equity, and private capital, respectively.

Sensitivity of Lifetime Net Tax Rates

Estimates of lifetime net tax rates vary widely, depending on assumptions (see Table 5). Despite the 3

variation, however, one conclusion stands firm: pre1. Social Security Administration, The Annual Report of the Old-Age

and Survivors' Insurance and Disability Insurance Trust Fund

(1993).

2. See Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J.

Kotlikoff, "Restoring Generational Balance in U.S. Fiscal Policy:

What Will It Take?" Economic Review, Federal Reserve Bank of

Cleveland, vol. 31, no. 1 (First Quarter 1995), pp. 2-12. 3. This study adjusted the alternative results to make them comparable to the base results (see Appendix D).
30 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

vailing policy is not sustainable--net tax rates must

rise at some time (or rates of purchases must fall) to

keep government solvent. If current generations do

not contribute more, future generations must. Indeed, the accounts suggest that in some cases prevailing policy is not feasible because it would leave a bill

for future generations that would be beyond their

means; that is, the bill would require that they pay

lifetime net taxes at a rate of more than 100 percent.

Under the range of assumptions that CBO considered, the lifetime net tax rate of the average memTable 5.

Lifetime Net Tax Rates Under Alternative Economic and Demographic Assumptions (In percent)

Real Discount Real Discount Real Discount

Rate of 3 Percent Rate of 6 Percent Rate of 9 Percent

PGR of PGR of PGR of PGR of PGR of PGR of PGR of PGR of PGR of

0.25 0.75 1.25 0.25 0.75 1.25 0.25 0.75 1.25

Population Percent Percent Percent Percent Percent Percent Percent Percent Percent a

Newborns

Low 28 26 25 41 37 34 48 44 40

Mid 28 26 25 40 37 34 47 43 39

High 28 26 25 39 36 33 46 42 39

Future Generations

Low 68 55 46 102 83 68 164 133 109

Mid 60 49 41 94 78 63 154 126 103

High 53 44 36 86 70 58 143 117 96

Difference in Lifetime Net Tax Rates of Future Generations and Current Newborns (In percentage points)

Low 40 29 21 62 46 34 116 90 69

Mid 32 23 16 54 40 29 107 83 63

High 25 17 12 47 35 25 97 75 57

Proportion by Which the Lifetime Net Tax Rate of Future Generations Exceeds That of Current Newborns

Low 143 112 84 149 124 100 242 202 173

Mid 114 88 64 135 111 85 228 193 164

High 89 69 44 121 94 76 211 179 146

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: A lifetime net tax rate is the present value at birth of lifetime net taxes as a percentage of the present value at birth of lifetime labor

income.

The rates shown are for net taxes at all levels of government combined--federal, state, and local.

Figures are averages for males and females.

The values in the table reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional Budget Office.

PGR = productivity growth rate. 

a. The low-, mid-, and high-population paths are those used by the Social Security Administration in its 1993 annual report.
CHAPTER FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 31

ber of future generations varies from 36 percent to

164 percent, and that of the average current newborn

varies from 25 percent to 48 percent. The difference

between the lifetime net tax rates of future generations and current newborns varies from 12 percentage

points to 116 percentage points. That difference

translates into having future generations pay lifetime

net taxes at a rate that is between 44 percent and 242

percent higher than that of current newborns. The

discount rate accounts for most of the variation; productivity and population account for successively

less variation, especially for current newborns.

Such uncertainty afflicts any long-term projection. For instance, the Social Security Administration projects that its trust fund will probably go bankrupt by 2030, but that it could grow indefinitely under plausibly optimistic assumptions.4

Alternative assumptions change the results predictably. Other things being equal, the higher the

discount rate, the higher the difference between lifetime net tax rates of future generations and current

newborns. That result will hold as long as the sum of

net government debt and the present value of prospective purchases exceeds the present value of net

taxes of current generations (which is minuscule in

relation to prospective purchases). Essentially,

higher discount rates make the bill for future generations compound faster.

By contrast, other things being equal, the higher

the growth of productivity or population, the lower

the difference in lifetime net tax rates. Higher productivity leads to higher tax collections, but does not

increase the benefits of today's retirees. That factor

reduces the bill left for the future. It is not reduced

by much, however, because the accounts assume that

after 2004, government purchases (adjusted for age)

would grow at the same rate as output. Higher population (by assumption) would mean a lower ratio of

retirees to workers; hence, there would be lower

transfers in relation to taxes. That also reduces the

bill left for the future.

The lifetime net tax rates of future generations

are more sensitive to alternative assumptions than are

those of current newborns. That sensitivity reflects

the way the accounts define prevailing policy, as well

as the influence of compound interest. The accounts

assume that current tax and spending rates continue

to apply to all living generations, some of whose

members may live for 90 years or more. Thus, even

apparently slight deviations from a sustainable policy

can produce great differences in the results.

Productivity and population do not matter much

for the lifetime net tax rate of current newborns.

Given the definition of prevailing policy, alternative

assumptions about productivity move the net taxes

and incomes of current newborns nearly in step,

which keeps their lifetime net tax rates fairly steady.

An assumption of higher productivity reduces the

lifetime net taxes of current newborns because the

accounts assign excise taxes to children. Given the

nature of the sensitivity exercise, newborns would

pay the same excise taxes for 10 years as they would

without the higher productivity. But the higher productivity raises their lifetime income. Therefore,

their lifetime excise taxes fall in relation to their income. Different population paths change lifetime net

taxes of current newborns only because different assumed mortality rates lead to different projected

lifespans.

Alternative assumptions for health costs and defense spending could also significantly affect the difference in lifetime net tax rates of future generations

and current newborns. For example, suppose that

medical costs per patient grew at the rate that the

Health Care Financing Administration predicts until

2004, and after that at the rate of productivity growth.

Then the reported difference in lifetime net tax rates

would fall by about 15 percentage points. Similarly, 5

the reported difference in lifetime net tax rates would

fall by about 10 percentage points if real defense

spending grew at the rate that the Office of Management and Budget projects through 2004 and remained

at that level afterwards. (Both calculations assume

4. Social Security Administration, The Annual Report of the Old-Age

and Survivors' Insurance and Disability Insurance Trust Fund

(1995).

5. Slower growth in health costs would raise the net taxes of current

generations because it would reduce the cash value of transfers they

will receive. It is not clear, however, how much rapidly growing

health costs represent faster growth in prices or in real services.

Therefore, the reduction in net income may pass to providers of

health care rather than to patients.
32 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

base values for population, productivity, and the discount rate.)

Sensitivity of Policies to 

Achieve Sustainability

If government purchases were reduced to reach a sustainable policy, how much would the spending cut

depend on alternative assumptions? Under the range

of assumptions considered, purchases would have to

fall by $165 billion to $473 billion--a permanent cut

of 13 percent to 38 percent (see Table 6). (CBO

chose to experiment with purchases because it could

do so at far lower computer cost than with taxes or

transfers. The numerical results for taxes or transfers

would differ, but the pattern of results probably

would not.)

A small spending cut is needed when the discount rate is high, even though a high discount rate

makes the initial difference in lifetime net tax rates

large. The reason is that a higher discount rate makes

the bill for the future accumulate faster. Therefore, a

spending cut has more leverage when the discount

rate is higher, just as it does when the spending program grows faster. Similarly, when the discount rate

is higher, alternative assumptions for population and

productivity matter less for the necessary spending

cut, but more for the initial difference in lifetime net

tax rates.

Sensitivity of Results of Specific 

Policy Experiments

The policy experiments considered in Chapter 3 do

not always yield similar patterns of sensitivity to alternative assumptions. The variation in results can

differ among generations and need not be related to

what happens to the deficit.

A Policy That Raises the Deficit. The pattern of

results for the temporary income tax cut is fairly well

defined. For that policy, 15-year-olds incur the

greatest cost under base assumptions and experience

the most variation under alternative assumptions.

(See Figure 3, which shows how much the results

vary under alternative assumptions. For instance, the

present value of net taxes of 15-year-olds would rise

Table 6.

Hypothetical Proportionate Cut in Government Purchases Required in 1991 to Reach

a Sustainable Policy (In billions of 1991 dollars)

Real Discount Real Discount Real Discount

Rate of 3 Percent Rate of 6 Percent Rate of 9 Percent

PGR of PGR of PGR of PGR of PGR of PGR of PGR of PGR of PGR of

0.25 0.75 1.25 0.25 0.75 1.25 0.25 0.75 1.25

Population Percent Percent Percent Percent Percent Percent Percent Percent Percent a

Low 473 435 396 250 231 211 187 176 165

Mid 440 397 351 248 229 207 189 179 168

High 403 353 298 245 224 202 191 180 169

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: A feasible policy is sustainable if it implies no difference in the lifetime net tax rates of future generations and current newborns. The

values in the tables reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional

Budget Office.

PGR = productivity growth rate.

a. The low-, mid-, and high-population paths are those used by the Social Security Administration in its 1993 annual report.
15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30 

-25

-20

-15

-10

-5

0

5 

10

Twenty Percent Cut in Income Taxes for Five Years

Thousands of Dollars

CHAPTER FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 33

by $1,870 under base assumptions, but could rise by

between $600 and $3,300 under alternative assumptions.) The variation lessens progressively as generations are either older or younger than 15 years old.

There is little variation for the very old because the

change in the net taxes they will pay for the rest of

their lives is discounted over a short time.

Figure 3.

A Policy That Raises the Deficit: Variation in

Results Under Alternative Assumptions

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described

in Alan J. Auerbach, Jagadeesh Gokhale, and

Laurence J. Kotlikoff, $Generational Accounts: A

Meaningful Alternative to Deficit Accounting,# in David

Bradford, ed., Tax Policy and the Economy, vol. 5

(Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: Change in the present value of net taxes (average for

males and females).

The discount rate varies from 3 percent to 9 percent; the

growth rate of productivity varies from 0.25 percent to

1.25 percent; and population varies from the low-population path to the high-population path used by the Social

Security Administration in its 1993 annual report.

Crossmarks indicate values under the base assumptions: 6 percent real discount rate, 0.75 percent rate of

productivity growth, and midpopulation path.

The figures for future generations apply to those born

next year. The respective figures for successive future

generations would grow at the rate of productivity.

The values in the figure reflect the implication of generational accounts as constructed, not necessarily the

views of the Congressional Budget Office.

N = newborns.

Different combinations of assumptions tend to

shift the results uniformly up or down for current

generations. For example, if a set of assumptions

yields a change in the present value of net taxes for

one current generation that is near the low end of its

range of variation, that set will usually do the same

for other current generations. That effect is usually

true for all the policies considered.

Deficit-Neutral Policy Changes. Alternative assumptions produce more variation when both Social

Security benefits and payroll taxes are increased than

when the income tax is temporarily cut (see Figure

4). For example, the results for 60-year-olds vary by

as much as $9,000 under the range of assumptions

considered for the increase in benefits and taxes (the

difference between a fall of $9,400 and a fall of

$18,400). By contrast, the results for 60-year-olds

vary by only $800 under the temporary tax cut. Unlike the case of the temporary tax cut, the generation

whose net resources change the most under base assumptions is not the one whose change in resources

varies the most under alternative assumptions. The

change is greatest for 65-year-olds, but the variation

is greatest for 55-year-olds.

For most older generations, alternative assumptions generate less variation under a shift from payroll taxes to excise taxes than under an increase in

benefits and payroll taxes. But the results for the

shift in taxes show more variation than for the increase in benefits and taxes for very young and future

generations. That result may depend on the fact that

the accounts assign part of excise taxes to children. 

Replacing income taxes with payroll taxes would

cause little variation in results, mostly because the

policy would produce slight change overall.

Policies That Reduce the Deficit. Alternative assumptions make the results for these policies vary

greatly, especially for future generations (see Figure

5). Differences in the discount rate produce most of

the variation. That effect is especially true for future

generations as the discount rate moves from 6 percent to 9 percent. Alternative assumptions for population and productivity account for trivial variation

for current generations, little variation for future gen-
15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30 

-25

-20

-15

-10

-5

0

5

10 

Thousands of Dollars

15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30

-25

-20

-15

-10

-5

0

5

10 

Thousands of Dollars

15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35 

-30

-25

-20

-15

-10

-5

0 

5

10

Thousands of Dollars

34 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Thirty Percent Increase in Payroll Taxes

to Finance an Equal-Revenue Cut in Excise Taxes

Thirty Percent Increase in Payroll Taxes

to Finance an Equal-Revenue Cut in Income Taxes

Figure 4.

Policies That Do Not Affect the Deficit: Variation in Results Under Alternative Assumptions

Twenty Percent Increase in Social Security Benefits

Financed by an Equal-Yield Increase in Payroll Taxes

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: Change in the present value of net taxes (average for males and females).

The discount rate varies from 3 percent to 9 percent; the growth rate of productivity varies from 0.25 percent to 1.25 percent; and

population varies from the low-population path to the high-population path used by the Social Security Administration in its 1993

annual report.

Crossmarks indicate values under the base assumptions: 6 percent real discount rate, 0.75 percent rate of productivity growth, and

midpopulation path.

The figures for future generations apply to those born next year. The respective figures for successive future generations would

grow at the rate of productivity.

The values in the figure reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional Budget Office.

N = newborns.
15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30

-25

-20

-15

-10

-5

0

5 

10 

Thousands of Dollars

15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30

-25

-20

-15

-10 

-5

0

5 

10

Thousands of Dollars

15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35 

-30

-25

-20

-15

-10

-5

0

5

10

Thousands of Dollars

15

90 80 70 60 50 40 30 20 10 N Future 

Age in 1991

-35

-30

-25

-20 

-15

-10

-5

0

5

10

Thousands of Dollars

CHAPTER FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 35

Increase in Taxes on Capital Income

Increase in Excise Taxes Increase in Payroll Taxes

Figure 5.

Policies That Cut the Deficit by an Equal Amount: Variation in Results Under Alternative Assumptions

Ten Percent Cut in Social Security Benefits

SOURCE: Congressional Budget Office, using a computer program and data provided by the authors as described in Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounts: A Meaningful Alternative to Deficit Accounting," in David

Bradford, ed., Tax Policy and the Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 55-110.

NOTES: Change in the present value of net taxes (average for males and females).

The discount rate varies from 3 percent to 9 percent; the growth rate of productivity varies from 0.25 percent to 1.25 percent; and

population varies from the low-population path to the high-population path used by the Social Security Administration in its 1993

annual report.

Crossmarks indicate values under the base assumptions: 6 percent real discount rate, 0.75 percent rate of productivity growth, and

midpopulation path.

The figures for future generations apply to those born next year. The respective figures for successive future generations would

grow at the rate of productivity.

The values in the figure reflect the implication of generational accounts as constructed, not necessarily the views of the Congressional Budget Office.

N = newborns.
1900 1920 1940 1960 1980

1.00

1.25

1.50

1.75

Common Logarithms

Trend

Actual

36 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

erations at a high discount rate, and much variation

for future generations at a low discount rate.

Evaluation of the Sensitivity Results

The sensitivity results are only illustrative. Ideally,

the results would yield a numerical statement of the

uncertainty inherent in the accounts. For example, a

standard method of expressing uncertainty is to state

how likely it is that the actual outcome will fall

within some range of the predicted outcome. That

cannot usually be done because analysts cannot

readily assign numbers to most of the sources of uncertainty in the accounts.

But two sources of uncertainty--population and

productivity--are more amenable to numerical analysis. Informal analysis suggests that the ranges considered for population and productivity represent a

fair description of their uncertainty. (Chapter 5 examines how reasonable is the range considered for

the discount rate.)

Population. There is a significant chance that population will grow beyond the bounds examined in this

study. Within 10 years, for example, there is about

one chance in six that population will be greater than

in the high-growth projection, and a similar chance

that population will be less than in the low-growth

projection. That assessment is highly tentative be- 6

cause it is based on only about 30 years of forecasting population growth.

Furthermore, the composition of the population,

as well as its total, affects the accounts. For example, it matters whether growth occurs among the old

because of lower death rates, among the middle-aged

because of higher immigration rates, or among the

young because of higher fertility rates. Uncertainty

about the ratio of retirees to workers may be greater

than is implied by the range of population projections

considered in this study.7

Productivity. The history of productivity indicates

the difficulty of forecasting its growth over long periods. Since 1902, productivity has grown at an average annual rate of 1.3 percent, but that period appears

to cover four different epochs of growth (see Figure

6). Productivity grew at an average annual rate of

1.3 percent from 1902 to 1929, 1.2 percent from 1929

to 1948, 2.7 percent from 1948 to 1966, and 0.6 percent from 1966 through 1990. (Those particular

years were chosen to determine trend lines because,

except for 1966, they contain business-cycle peaks.

It is generally agreed that the trend in productivity

changed in about 1966.)

Furthermore, growth rates within those epochs

sometimes varied considerably. In the most extreme

instance, the period from 1929 to 1947 saw a sharp

decline in productivity during the Depression,

superheated growth just before and during World

War II, followed by another decline. Although a repetition of that unusual experience is unlikely, the reasons for the differences in growth epochs are not well

understood.

Figure 6.

Productivity and Its Trends

(Real gross national product per worker)

SOURCES: Bureau of the Census, Historical Statistics of the

United States: Colonial Times to 1970 (1975), pp.

126-127, 224; Department of Commerce, Bureau of

Economic Analysis; Department of Labor, Bureau of

Labor Statistics; Congressional Budget Office.

6. Based on unpublished data provided by the Bureau of the Census.

7. Ronald D. Lee and Shripad Tuljapurkar, "Stochastic Population

Forecasts for the United States: Beyond High, Medium, and Low,"

Journal of the American Statistical Association, vol. 89, no. 428

(December 1994), pp. 1175-1889.
CHAPTER FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 37

All in all, a projection of productivity growth of

0.75 percent--the base rate in the accounts after 2004

--seems reasonable, but is no more than an extrapolation of the average growth since about 1973. Given

the sizable and largely unexplained variations seen in

the past, any forecast is uncertain. Based on statistical experiments that CBO has conducted, there might

well be one chance in three that productivity growth

could fall outside the bounds considered here.

Sensitivity of Results to 

Other Sources of Uncertainty

Uncertainty in the accounts also arises from their assumptions about the structure of the economy and the

incidence of taxes and transfers--that is, who pays or

receives their cash value. The relative-age profiles

for taxes and transfers, which effectively define the

structure of the economy, may change significantly.

That would change the results quantitatively, although probably not qualitatively. By contrast, alternative assumptions about incidence could change

some results qualitatively as well as quantitatively.

Fixed Relative-Age Profiles

In at least one respect, the assumption of fixed

relative-age profiles will certainly be wrong, although that may have only a minor effect. The labor

earnings of women will climb as more women work

for pay and as their wages and salaries rise in relation

to men's. The OMB projection of total labor earnings

would contain such information, however. Therefore, the accounts should have the right totals through

2004, but would have them assigned to the wrong

groups by age and sex. The results would be numerically wrong, but would probably tell the correct story

overall, especially when averaged between males and

females.

The assumption of fixed relative-age profiles

could be wrong in other ways. For example, as baby

boomers have aged, they have not seen their wages

grow as fast as their parents did, although the source

of that slowdown is unclear. If wages of people who

are now young grow faster as they age than did the

wages of baby boomers, both young and future generations will benefit. Of course, such shifts could

help or harm any given generation. Thus, the uncertainty for any one generation is greater than that for

all generations together.

There is no reason in principle that the accounts

must use fixed relative-age profiles. They are simply

an expedient in the absence of better information. If

enough evidence and data (and need) existed to construct profiles that vary over time, the accounts could

accommodate them.

Incidence of Taxes and Transfers

Assumptions about the incidence of taxes and transfers also lead to uncertainty. The accounts are especially open to questions about the incidence of capital

income taxes, the "capitalization" of taxes (the way

in which the value of an asset reflects the prospective

taxes due on its income), and the effect of a change

in investment incentives. Different assumptions

about those issues would lead to different estimates

of the generational effects of policy because the old

own most capital.

Economists generally agree about the incidence

of excise and payroll or labor income taxes. In the

long run, consumers and workers probably pay nearly

all of those taxes, as the accounts assume. Little is

known about the sliding of transfers (the process by

which government benefits substitute for support

from family or society). Uncertainty about those issues could be addressed with sensitivity analysis,

although this study did not do so.

Taxes on Capital Income. The accounts effectively

assume that the supply of capital to domestic business is fixed and that business property taxes are

passed to consumers in the same way as sales taxes.

But those assumptions are open to question.8

8. See Richard A. Kasten and Eric Toder, "CBO's Methodology for

Distributional Analysis" (paper presented to the American Enterprise Institute's conference on distributional analysis, December 16,

1993); and Joseph Pechman, Who Paid the Taxes, 1966-85?

(Washington, D.C.: Brookings Institution, 1985). Corporations

could shift the tax to consumers only if competition is imperfect in

product markets. Generational accounts essentially assume perfect

competition by the way they assign excess taxes to existing capital.
38 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

First, capital can cross national borders. Thus,

even if the domestic supply of capital is inelastic, the

world supply to the domestic market may not be.

Owners of capital may therefore shift part of the tax

to workers. Second, the property tax on business is

generally considered to act more like a tax on capital

income than a tax on sales, as the accounts assume.

Owners of capital therefore probably bear part of the

tax that the accounts assign to consumers.

The net effect of these possibilities on generational distribution is not obvious. In the first case,

the old (as owners of most capital) would pay less of

the tax and the young (as workers or homeowners)

would pay more. But in the second case, the old

would pay less and the young or very old would pay

more as consumers. 

The Capitalization of Taxes. The accounts do not

generally reflect the way in which the value of existing capital includes prospective taxes on its income.

The problem arises because the law imposes taxes on

income from different assets at different rates. For

example, income from some assets may be taxed at

two levels (corporate and personal), whereas income

from other assets (homes or municipal bonds) may be

untaxed. The values of those assets will reflect their

different tax treatments. Moreover, the assets tend to

be owned by people of different ages, so a change in

tax treatment will affect different generations differently.

The tax distinction between homes and business

capital provides one example. Each type of asset

provides a stream of services during its life--shelter

in the case of homes and production in the case of

business capital. And the market value of the asset

will equal the present value of the net returns from

the stream of services. But the implicit income from

homes is not taxed, whereas the market income from

business capital is. Therefore, if the income tax falls,

the market value of homes should fall in relation to

that of business capital because homes will have lost

some of their tax advantage.

The accounts do not include that effect, which

would shift resources from current homeowners to

current capital owners. Similarly, the accounts do

not reflect the fact that a change in the tax rate on

corporate income would directly affect the value of

corporate shares, but not other assets, such as savings

accounts, bonds, and homes. A rise in the corporate

tax rate would therefore shift resources from current

owners to prospective owners, as well as to owners of

other assets. (The property tax on homes also raises

capitalization issues, but that is a local tax, so it is not

considered here.)

Issues of capitalization are commonly ignored,

especially when analyzing short-run incidence. It

may take a long time for their effects to play out,

which increases the importance of capitalization in

long-term analysis.

Investment Incentives. Generational accounts may

also err in their treatment of investment incentives.

The accounts rely on the theory that existing capital

would suffer a drop in value when an investment incentive rose, in the same way that a bond would if

the interest rate rose.

The theory must be modified, however, if a firm

incurs significant costs when it changes the amount

or mix of its capital. It costs little beyond the purchase price to add a bond to a portfolio, but installing

capital entails hidden costs. Doing so may disrupt

other work, require oversight that could have gone

elsewhere, necessitate training or trial-and-error

learning for workers, and so on. Thus, installing capital costs more than just the purchase price; the true

cost also includes "adjustment costs"--the costs of

diverting resources from other uses. And usually, the

larger the investment, the greater the adjustment

costs.

Opposing effects are at work. Although the incentive reduces the effective price of investment, adjustment costs raise the cost of installing it. And the

added incentive makes any investment that an existing firm has already planned cheaper than it would

have been. Therefore, how much added investment

incentives will transfer resources from old to young

is an empirical matter.

Evidence indicates that the issue is important.

One study that assumed an apparently plausible value

for adjustment costs suggests that the true cost to the

elderly of policies that enhance capital formation
CHAPTER FOUR UNCERTAINTIES IN GENERATIONAL ACCOUNTS 39

could be about 50 percent of what the accounts report. More direct evidence suggests that added in- 9

vestment incentives raise, rather than lower, the

value of existing firms. If so, added investment 10

incentives make the old better off at the expense of

the young rather than the other way around.

The issue matters only for the transfer of resources among young and old; in either case, the

added incentive would raise the net taxes of future

generations by reducing the total taxes of current

ones. (The accounts do not, however, include the

effect that the added incentive would have on the size

and composition of the capital stock that the future

would inherit.) The one-time levy under current law

that the accounts assign to current owners is probably

appropriate in either case; existing capital has already

overcome the adjustment costs of installing it.

The Sliding of Transfers. Little is known about

how or how much transfers slide. The few studies

that exist suggest that most of Social Security benefits may not slide; that is, they may not significantly

reduce support from or increase bequests to others.11

Those studies do not imply that the aged and their

children do not already make private transfers between themselves, only that an extra dollar to the

aged would not slide to their children.

The study that examined support of the aged,

however, considered only elderly people living apart

from relatives. Most people who significantly aid

old relatives probably do so by taking them into their

homes. From 1960 to 1984, the proportion of elderly

living independently rose from 55 percent to 76 percent. Much of that rise is associated with an accompanying rise in their incomes, caused in part by

higher benefits from Social Security and Medicare.

Of course, the elderly typically want to live independently, so higher benefits could have made both them

and their children better off.

More sliding seems to take place for public

spending on education and health; parents and private

groups would otherwise provide some education for

children, and doctors and hospitals (and ultimately

paying patients) would otherwise forgive the bad

debts of needy patients. One study estimates that 12

more public support of nursing home care for the elderly significantly reduces the support that they receive from their children.13 9. Hans Fehr and Laurence J. Kotlikoff, "Generational Accounting in

General Equilibrium," Working Paper No. 5090 (Cambridge,

Mass.: National Bureau of Economic Research, April 1995).

10. Andrew B. Lyon, "The Effect of the Investment Tax Credit on the

Value of the Firm," Journal of Public Economics, vol. 38 (1989),

pp. 227-247; Thomas W. Downs and Hassan Tehranian, "Predicting Stock Price Responses to Tax Policy Changes," American Economic Review, vol. 78, no. 5 (December 1988), pp. 1118-1130;

David M. Cutler, "Tax Reform and the Stock Market: An Asset

Price Approach," American Economic Review, vol. 78, no. 5 (December 1988), pp. 1107-1117; Thomas W. Downs, "An Alternative

Approach to Fundamental Analysis: The Asset Side of the Equation," Journal of Portfolio Management (Winter 1991), pp. 6-16;

and Andrew B. Lyon, "The Effect of Changes in the Percentage

Depletion Allowance on Oil Firm Stock Prices," The Energy Journal, vol. 10, no. 4 (1989), pp. 101-116.

11. Joseph J. Altonji, Fumio Hayashi, and Laurence J. Kotlikoff, "Is

the Extended Family Altruistically Linked?: Direct Tests Using

Micro Data," American Economic Review, vol. 82, no. 5 (December 1992), pp. 1177-1198; and Martin David and Paul Menchik,

"The Effect of Social Security on Lifetime Wealth Accumulation

and Bequests," Economic Inquiry, vol. 58, no. 2 (November 1985),

pp. 421-434.

12. Robert Lampman and Timothy Smeeding, "Interfamily Transfers

as Alternatives to Government Transfers to Persons," Review of Income and Wealth, series 29, no. 1 (March 1983), pp. 45-66.

13. David Cutler and Louise M. Sheiner, "Policy Options for LongTerm Care," Working Paper No. 4302 (Cambridge, Mass.: National

Bureau of Economic Research, March 1993).

I

Chapter Five

Ambiguities in Generational Accounts

n generational accounts, problems of interpretation arise that cannot be resolved numerically or

otherwise addressed within their framework.1

The choice of discount rate, which is central to the

accounts, causes most of the ambiguity. The assumption that prospective income is fixed can bias

the results, sometimes substantially. The accounts

also suffer from various problems of interpretation

that often afflict other tools of analysis. Such issues

underscore the need to treat the results of the accounts with care.

There Is No Uniquely 

Right Discount Rate

Choosing a discount rate raises problems because the

accounts must allow for the cost of risk inherent in

prospective streams of net taxes. Problems of inter- 2

pretation may also arise because the accounts assume

that capital markets are "efficient." That is, the calculation of present value implicitly assumes that

everyone can borrow or lend any amount (subject to

prospective income) at the given rate of discount.

The Cost of Risk

The discount rate in the accounts can represent more

than just the cost of waiting (postponing consumption

or net income). There is an additional cost: the risk

that net income may be lost, rather than merely postponed. For example, unexpected economic or demographic events may make the total net taxes that government collects lower than expected. In that case,

some generations will have to pay more net taxes

than scheduled to keep government solvent. Moreover, there is a risk that the mix of taxes and transfers

might change--for example, by replacing the income

tax with a consumption tax.

Thus, anyone must consider prospective net taxes

to be risky. Moreover, the risks of separate generations are interrelated. Both young and old are at risk

if they do not know whether deficits will be cut by

raising taxes on the young or by cutting transfers for

the old.

1. Many of the points raised in this chapter appear in Robert

Haveman, "Should Generational Accounts Replace Public Budgets

and Deficits?" Journal of Economic Perspectives, vol. 8, no. 1

(Winter 1994), pp. 95-111; Robert Haveman and Christopher

Barker, "Evaluating the Generational Effects of Public Policy: Potentials and Pitfalls" (paper presented to the meetings of the Association for Public Policy Analysis and Management, Washington,

D.C., October 29, 1993); David Cutler, "Book Review: Generational Accounting," National Tax Journal, vol. 46, no. 1 (March

1993), pp. 61-67; Willem H. Buiter, "Generational Accounts, Aggregate Saving and Intergenerational Distribution," Working Paper

No. 5087 (Cambridge, Mass.: National Bureau of Economic Research, April 1995); and Dean Baker, Robbing the Cradle?: A Critical Assessment of Generational Accounting (Washington, D.C.:

Economic Policy Institute, 1995). But also see Alan J. Auerbach,

Jagadeesh Gokhale, and Laurence J. Kotlikoff, "Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy," Journal of

Economic Perspectives, vol. 8, no. 1 (Winter 1994), pp. 73-94.

2. For a discussion of many of the issues that arise, see Robert C.

Lind, "A Primer on the Major Issues Relating to the Discount Rate

for Evaluating National Energy Options," in Robert C. Lind and

Kenneth J. Arrow, eds., Discounting for Time and Risk in Energy

Policy (Washington, D.C.: Resources for the Future, 1982), pp. 21-

94.
42 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

As with any other source of risk, uncertainty

about net taxes imposes a cost. If people could, they

would pay higher net taxes than scheduled if those

net taxes were guaranteed, rather than uncertain.

That is, people would pay a premium to insure

against risk.

The accounts combine in a single discount rate

the costs of risk and waiting. Moreover, the accounts

apply the same discount rate to all streams of net

taxes for all generations. Both of those treatments

lead to problems.

Combining the Costs of Risk and Waiting. Ideally,

the accounts would treat the costs of risk and waiting

separately. Roughly speaking, for each year that a

payment is postponed, the cost of waiting accumulates at a constant rate, whereas the cost of risk accumulates at a declining rate. (The cost of waiting for a

year is often taken to be the real rate of return on

short-term government debt--between 1 percent and

2 percent.) For technical reasons, however, the accounts use a standard expedient and combine the two

costs as if the cost of risk also accumulated at a constant rate each year.

Applying the Same Discount Rate to All Prospective Net Taxes. The use of a single discount rate is

problematic; people at different ages may not regard

the prospective payment of a given tax or transfer as

equally risky, and they may not regard a given degree

of risk as equally costly. For example, a 70-year-old

can probably be more sure of receiving Social Security benefits as currently scheduled than can a 30-

year-old. But a 70-year-old may well regard a particular chance of losing the benefits as more costly than

would a 30-year-old. There is no reason that these

separate effects should offset each other.

In general, therefore, people would not all be

willing to pay the same premium to insure against the

cost of risk. The amount they would be willing to

pay would depend on their age and the particular tax

or transfer involved. Moreover, young and future

generations will be richer than older generations.

Richer generations would assign less cost to a given

probability of losing a given amount of net income.

As a result, a single discount rate will typically

misstate the present values of net taxes. Furthermore, the error will vary by different amounts for

different generations. And it is not possible to use

market information to infer the degree of error. People cannot trade claims on prospective taxes and

transfers in markets in the way that they can trade

claims on prospective income from stocks or bonds.

Interpreting a Discount Rate That Includes a Premium for Risk. Including risk in the discount rate

makes the rate of discount greater than the rate of

interest on government debt. Holders of government

debt need not demand a rate premium to insure

against the risk of default (although they must allow

for the risk that the real value of the debt may

change). They are sure of receiving the dollar

amount that is promised, unlike taxpayers, who cannot be sure of paying taxes or receiving transfers at

currently scheduled rates. (Some transfers, such as

Social Security benefits, however, may be safer than

government debt in the sense that they are indexed

for inflation.) If net tax revenues fall below what is

expected, some taxpayers will have to pay net taxes

that are higher than scheduled in order to pay bondholders what is promised them.

A discount rate higher than the rate on government debt complicates the meaning of a lifetime net

tax rate. For example, suppose this year's deficit

goes up and raises the lifetime net tax rate of future

generations. The extra payment that future generations would have to make would actually accumulate

at the government rate of interest. But the accounts

make it appear that the extra payment would accumulate even faster if they use a discount rate that is

higher than the government rate. Therefore, the

higher the discount rate that the accounts use, the

higher the lifetime net taxes of future generations that

the accounts report.

In effect, the accounts treat the cost of risk that is

excluded from the government rate as an implicit tax.

Therefore, the lifetime net tax rate reported for future

generations reflects two separate effects: the cost of

lifetime net taxes that are actually expected, and the

cost of risk that they will differ from those that are

expected. By using the same discount rate for all

generations, the accounts assume that all face the

same risk, which appears as an implicit tax.
CHAPTER FIVE AMBIGUITIES IN GENERATIONAL ACCOUNTS 43

Finally, a practical issue arises in interpreting the

treatment of risk in the accounts. For their base case,

the accounts use a discount rate of 6 percent--the historical average rate of return on equity. But that rate

is much higher than economists can explain on the

basis of equity risk. Thus, using that rate to discount 3

prospective net taxes implies that they are far more

risky than equity without having any empirical way

to justify the choice.

Efficiency of Markets

As an approximation, the assumption of efficient

markets may be reasonable for many people, but not

for everyone. The assumption is especially unlikely

to be true of the temporarily poor--most often the

young or unemployed--who expect higher incomes

later. Such people may want to consume more than

their current income and assets allow, but cannot

borrow enough to do so. Even if such consumers

could repay a loan out of their prospective earnings,

lenders might not extend one because it could not be

secured by a real asset. Those consumers are cashconstrained--they cannot consume much more than

their current income.

For cash-constrained consumers, present value

calculated at a market rate of discount misstates what

they think cash flows are worth. Those consumers

would be willing to pay a higher-than-market rate of

interest to consume more now and less later. They

therefore place a higher value on current net taxes

and a lower value on prospective net taxes than the

accounts would imply.

Perhaps more than one-quarter of the population

is cash-constrained, and those people are concentrated among the young. Many studies indicate that a

large fraction of consumers, perhaps up to one-half,

respond too much to changes in their current incomes

and too little to changes in their lifetime incomes.4

Moreover, most people cannot borrow at the same

rate that they can lend. Those general observations

are consistent with cash constraints.

Some economists, however, argue that cash constraints are more apparent than real. Factors other

than cash constraints may explain some of the results

reported above. For instance, consumers may respond too much to changes in current income because they are short-sighted or follow simple rules of

thumb instead of making complex calculations of

lifetime income. One study estimates that only 6 percent of the population is actually cash-constrained.5

Another argues that cash constraints appear more

important in the short than in the long run. In effect, 6

that argument concludes that lenders would devise

new credit instruments to meet the new loan demand

that would arise if a change in policy reduced the

current and raised the prospective income of the

cash-constrained.

But bankruptcy laws make it difficult or costly to

devise ways to secure loans against prospective labor

or transfer income. Moreover, even if it could be

done, it would take time to develop new credit instruments. In the meantime, cash-constrained consumers

would remain constrained, and the accounts would

misstate the values that they place on their prospective flows of net taxes.

If people are cash-constrained, the accounts are

ambiguous. The more important cash constraints are,

the more difficult it is to estimate the value that consumers who are not cash-constrained place on current

3. Rajnish Mehra and Edward Prescott, "The Equity Premium: A Puzzle," Journal of Monetary Economics, vol. 15, no. 2 (March 1985),

pp. 145-162.

4. Robert E. Hall and Frederic S. Mishkin, "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on

Households," Economica, vol 50 (March 1982); John Y. Campbell

and N. Gregory Mankiw, "Consumption, Income, and Interest

Rates," in Olivier Jean Blanchard and Stanley Fischer, eds., NBER

Macroeconomic Annual 1989, vol. 4 (Cambridge, Mass.: MIT

Press, 1989), pp. 185-216; Marjorie Flavin, "Excess Sensitivity of

Consumption to Current Income: Liquidity Constraints or Myopia?" Canadian Journal of Economics, vol. 18 (February 1985);

David W. Wilcox, "Household Spending and Saving: Measurement, Trends, and Analysis," Federal Reserve Bulletin (January

1991), pp. 1-17; and Stephen P. Zeldes, "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political

Economy, vol. 97 (April 1989), pp. 305-346.

5. Daniel T. Slesnick, "Gaining Ground: Poverty in the Postwar

United States," Journal of Political Economy, vol. 101, no. 1 (February 1993), pp. 1-38.

6. Fumio Hayashi, "Tests for Liquidity Constraints: A Critical Survey

and Some New Observations," in Truman Bewley, ed., Advances in

Econometrics II, Fifth World Congress (Cambridge, England:

Cambridge University Press, 1987), pp. 91-120.
44 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

income versus prospective income. And it is even

more difficult to do so for the cash-constrained.

The Accounts Assume That

Prospective Income Is Fixed

Fiscal policy affects prospective income before tax,

but the accounts do not reflect that fact. Policy can

do so directly, as when deficits crowd out private

assets, or indirectly, as when changes in the mix of

taxes and spending affect incentives to work, save,

hire, and invest. Because the accounts ignore those

long-run effects, they may yield inaccurate--or even

misleading--results, especially for young and future

generations. (Some economists argue that deficits do

not crowd out private assets because people match

increases in deficits with increases of private saving.

That would ensure that they--or their descendants--

would be able to pay the extra taxes that would eventually be needed to pay interest on the extra debt.

Most economists find this theory implausible and its

evidence unpersuasive. )7

Fiscal policies that increase incentives to save or

invest act slowly as more assets accumulate to produce more income. Therefore, ignoring such effects

should usually introduce larger errors for young and

future generations than for older generations.8

That conclusion is often true, according to experiments with an economic model that includes the incentive effects of policy. According to experiments 9

with that model, generational accounts usually provide a good or fair approximation of the actual outcome for all but the very young and future generations. For them, however, the cash value that the accounts report for some policies may be 75 percent of

its true value to current newborns and 35 percent to

generations in the distant future. In those cases, the

accounts establish a lower bound for the benefits of

deficit reduction to young and future generations

(and an upper bound to the cost that today's adults

would have to undergo to reach a sustainable policy).

In another instance, however, a change from a proportional to a progressive income tax would make

future generations worse off, whereas the accounts

would say that they were modestly better off.

In the short run, fiscal policy affects output and

pretax income primarily through its effect on demand--directly by changing government purchases,

or indirectly by changing people's net taxes. Those

short-run effects are transient, however; in about

three years, income arrives at the level it would have

reached without the short-term stimulus or restraint.

Therefore, ignoring the short-run effects of fiscal policy causes little error.

Issues Common to Other 

Tools of Analysis

Generational accounts, like traditional tools of analysis, ignore some issues that affect the distribution of

resources, either among or within generations. Moreover, as with deficit projections, the accounts might

reflect any biases or uncertain judgments of those

who prepare them.

7. See Robert R. Barro, "Are Government Bonds Net Worth?" Journal of Political Economy, vol. 82, no. 6 (November/December

1974), pp. 1095-1117; R. Douglas Bernheim, "Ricardian Equivalence: An Evaluation of Theory and Evidence" and accompanying

comments and discussion, in Stanley Fischer, ed., NBER Macroeconomics Annual 1987 (Cambridge, Mass.: MIT Press, 1987), pp.

263-315; and Kent Andrew Smetters, "Ricardian Equivalence:

Short-Run Shipwreck; Long-Run Leviathan" (Ph.D. dissertation,

Harvard University, 1995).

8. The effect of policy could be greater and more rapid than standard

theory predicts if the benefits of a firm's investment spill over to

other firms. See Congressional Budget Office, The Economic and

Budget Outlook: Fiscal Years 1990-1994 (January 1989), pp. 79-

94.

9. See Hans Fehr and Laurence J. Kotlikoff, "Generational Accounting in General Equilibrium," Working Paper No. 5090 (Cambridge,

Mass.: National Bureau of Economic Research, April 1995), from

which the discussion draws.
CHAPTER FIVE AMBIGUITIES IN GENERATIONAL ACCOUNTS 45

Generational Accounts 

Ignore Some Issues

The accounts ignore the ways in which government

purchases, regulations, and price inflation can distribute resources among generations. In principle, generational accounts could encompass some of those issues, but at the cost of additional complicated and

controversial assumptions. The accounts are also

silent on issues of equity.

Government Purchases. Generational accounts do

not assign the benefits of government purchases to

specific generations. If net taxes were raised to pay

for purchases, the accounts would assign only the

cost of the higher net taxes to various generations;

the benefits would be ignored. And the generations

that pay the extra taxes may not be the ones that receive the benefits of the extra purchases. By contrast, purchases rose to fight World War II without a

fully corresponding rise in net taxes. But the resulting deficits were neither a boon to the generations

who fought the war nor a bane to later ones.

For those reasons, the accounts are most informative when they look at a change in the growth of

taxes or transfers and there is no change in the

growth of government purchases. (Knowing which

generations pay, however, does provide half of the

answers to questions of distribution by age.) 

In the same vein, the accounts assume that an

increase in productivity will boost government purchases in the same proportion (other things remaining equal). For that reason, higher growth of productivity does little to reduce the lifetime net taxes of

future generations (see Chapter 4). But the accounts

ignore the benefits of more government purchases

that higher productivity would enable future generations to enjoy.

Trying to assign the benefits of most purchases to

specific generations, however, is impracticable.

Most government purchases are made to provide

public services--such as a legal system or national

defense--that are used collectively rather than individually. That makes it virtually impossible to sort

out who benefits and by how much. The problem is

even more acute when the purchases will yield prospective benefits. For example, today's spending for

highways, schools, research, conservation, or defense

could yield benefits for many years and to current

and future generations.

Moreover, benefits of government purchases can

"spill over"--that is, go to groups that do not use them

directly. For example, education directly benefits

children, but other generations benefit indirectly because the children will be literate when they enter

society. Furthermore, much--though hardly all--public spending for education slides to parents and private groups, who would see that children got some

education in any case.

The accounts would not accurately reflect the

benefits of spending for education even if those benefits did not spill over or slide and were assigned by

age. Teaching, like many services, does not seem to

grow more productive as rapidly as does the rest of

the economy. For example, it now takes a teacher

about as much time to explain the rules of grammar

to a class as it did at the turn of the century. But

schools must raise the pay of teachers about as fast as

the pay of workers in the private sector; otherwise

teachers would leave the public sector. Therefore,

the real spending to educate a child in each successive generation would grow, even if the children received the same education.

The general problem is not unique to the accounts. Benefits are often misstated or measured less

accurately than costs. For example, analysts can

measure the costs of medicine, education, or pollution control much better than they can measure the

benefits. Similarly, the deficit reflects the full purchase cost of a public asset when it is bought, but not

the value of its services when it is used; the national

income and product accounts measure the cost of

government workers, but not the value of their work.

Government Regulations. Government regulations

often require spending by one group to benefit others.

For example, safety and environmental regulations

make firms spend money to benefit their workers or

the public at large. But it is not always clear who

pays. A regulation can act as an excise tax if the firm

passes the extra cost to consumers, or as a tax on specific capital and labor if the firm moves abroad or

goes out of business. Nor is it always clear who ben-
46 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

efits or by how much. For instance, pollution controls may disproportionately benefit young asthmatics, old heart patients, or future generations.

Government regulations may also favor some

groups at the cost of others without requiring spending. For example, import quotas, acreage allotments,

and marketing orders favor selected producers (and

perhaps their workers or suppliers) at a cost to their

customers. Similarly, a law that made firms charge

premiums for health insurance without regard to age

would favor the old at the expense of the young.10

And the military draft imposed costs--sometimes

dire--on young men to serve the country as a whole.11

Inflation. A change in the rate of inflation can redistribute resources among generations because it

changes the relative values of existing assets and liabilities. If inflation rises unexpectedly, borrowers

gain and lenders lose because the real value of interest and repayment is less than either expected. In

particular, higher-than-expected inflation reduces the

real value of government debt. Such a reduction benefits future generations at the expense of current

bondholders.

 Even if people fully expect higher inflation, its

interaction with tax law can lead to changes in asset

values. Lenders have to pay tax on the inflation

premium--the additional return that would keep their

real assets whole--so the effective rate of tax on their

real income rises. By contrast, implicit income from

owner-occupied housing remains untaxed, giving

homes a better tax advantage than before. Thus, the

market value of homes would fall in relation to that

of debt claims.

Among current generations, the effects of higher

inflation--expected or unexpected--tend to favor the

young at the expense of the old. The young are likely

to be borrowers and homeowners rather than lenders

and bondholders. Of course, if inflation comes

down, those effects work in the other direction.

Equity. The accounts cannot determine what distributions among generations are fair. For example, the

accounts cannot in themselves address the following

questions: if future generations will be better off than

current newborns, should future generations pay net

taxes at higher lifetime rates? Do future generations

owe a special debt to the generations that won World

War II or the Cold War? Should baby boomers be

given special consideration because their numbers

reduced the growth of their lifetime incomes below

the trend? Questions like those can be answered only

with value judgments.

Furthermore, the accounts treat only the average

member of each generation; they do not consider distribution by income or wealth, either within or among

generations. Averages can be misleading because

income, and especially wealth, is unevenly distributed. For example, reducing Medicaid spending for

prenatal visits would benefit future generations, on

average, but not those unborn who would need the

visits. (It is possible, however, to construct the accounts so that they treat distribution according to

both age and income of the living.)

Generational Accounts 

Can Ignore Reality

By design or default, generational accounts may not

reflect reality. Like deficit projections, the accounts

can be manipulated and will contain only the information that humans put into them.

Generational Accounts Can be Manipulated. It is

at least as easy to present optimistic generational accounts as it is to present optimistic deficit forecasts.

For example, the Gramm-Rudman-Hollings law set

deficit targets to balance the budget by 1991, and

generational accounts would have reported a substantial reduction in the lifetime net taxes of future

generations. But the law did not specify how to meet

those targets. That task was left to future Congresses, which failed to hit the targets. So the reported reduction in lifetime net taxes of future

generations would not have materialized.

Moreover, it would be possible to manipulate

policy in a way that would make generational ac10. Congressional Budget Office, An Analysis of the Administration's

Health Proposal (February 1994).

11. See Baker, Robbing the Cradle? p. 24.
CHAPTER FIVE AMBIGUITIES IN GENERATIONAL ACCOUNTS 47

counts, but not the deficit, misleading. For example,

suppose a policy specified higher spending for 10

years, followed by permanently lower spending.

Such a policy could be chosen so that generational

accounts showed lower lifetime net taxes for future

generations, whereas 10-year projection showed

higher deficits. The accounts would be misleading if

the spending cuts turned out to be as elusive as the

Gramm-Rudman-Hollings targets.

It is also possible to get different results from the

accounts by constructing them differently. For example, the accounts would report much lower lifetime net taxes for every generation if they assigned

the benefits of spending for education as a transfer to

the young. (The lifetime net tax rates of future generations and current newborns, however, would drop

by similar amounts--an identical amount if real

spending per pupil is projected to grow at the same

rate as productivity. Thus, the difference in lifetime

net tax rates of future generations and current newborns might change little or not at all.) Or an alternative version of the accounts might assign by age the

costs of inflation or unfunded mandates. In fact, if

the accounts were used in official budget presentations, there would probably be as many proposed adjustments to them as there are to the deficit.

Generational Accounts May Reflect Limited Foresight. As with any other calculation, generational

accounts do not have to be right just because they

come out of a computer. The accounts use mechanical rules to consolidate and extrapolate official projections. If those rules or projections do not accurately reflect the probable state of the world, neither

will the accounts. If the best information is not there

to begin with, the accounts will not add it.

For example, if the Office of Management and

Budget had not foreseen that a savings and loan crisis

was probable, the accounts would not have included

the expected liability associated with it. Similarly,

past forecasts of medical costs have consistently been

too optimistic. The accounts cannot anticipate the

liabilities of the Pension Benefit Guaranty Corporation or foresee unpredictable events, such as disasters

or discoveries.

A

Chapter Six

Conclusion

s with most tools of policy analysis, generational accounts offer a useful perspective,

but serve as an imperfect indicator. The

accounts can often suggest a rough magnitude and

general pattern of results, but uncertainty and ambiguity would always remain.

The accounts present a great deal of information

in a compact way. Furthermore, they reduce the results to appealing dimensions--one-time cash payments or lifetime net tax rates. At the same time,

however, the accounts hide the details that produce

the results. For that reason, and because the results

must be interpreted with care, the accounts only serve

as a guide to further analysis or consideration.

Even with their limitations, the accounts stress

three concerns that should inform policy analysis.

First, they estimate the way in which policy directly

distributes resources among generations. The effort

to form that estimate highlights what is reasonably

known about the effects of policy by age and what is

left to learn. Second, the accounts use the zero-sum

constraint to pose issues in terms of sustainable policy. Using the constraint shifts focus from arbitrarily

chosen goals, such as current deficit targets, to ultimate limits on government. Furthermore, the constraint enables the accounts to represent future generations explicitly. Third, the accounts expose the

issue of economic and policy risk, which is not accounted for in the rate of interest on government

debt. To ignore issues of risk would bias policy

choices by giving too much weight to estimates of

prospective payments and receipts.

But the accounts rest on unresolved issues and

present an incomplete picture. Although it is not

clear what discount rate to choose--or even whether a

single rate is appropriate--the numerical results depend importantly on that choice. And in seeking to

show the effect of today's fiscal policy on young and

future generations, the accounts omit the mechanism

that most analysts emphasize--borrowing today reduces income tomorrow. The loss of prospective

income caused by current deficits might be twice as

large as the purely budgetary effects on which the

accounts focus.

Those conditions lead the Congressional Budget

Office to conclude that generational accounts should

not take a place with its regular budget baselines.

Instead, CBO regards the accounts as a tool for examining broad policy options, rather than as an accounting statement.

Appendixes

A

Appendix A

Is the Zero-Sum Constraint Necessary?

ccording to standard theory, the ratio of debt

to output would threaten to grow out of control if government did not observe the zerosum constraint. The ratio might remain stable under

a less stringent condition, however. In that case, the

lifetime net taxes of future generations under prevailing policy would be much lower than generational

accounts state. But it would be a gamble at best to

rely on that possibility.

What Does the Zero-Sum 

Constraint Imply?

In terms of present value, imposing the zero-sum

constraint is the same as requiring that the debt be

retired at some time (or that interest be paid from

taxes rather than further borrowing). The zero-sum

constraint requires that an increase in debt be

matched in present value by an increase in future net

taxes. But the increase in debt is simply the present

value of its interest and repayment (if it is ever repaid). Therefore, paying the higher net taxes in the

future is equivalent in present value to either retiring

the debt or paying the interest forever.

In traditional analysis, the zero-sum constraint is

necessary if the interest rate on debt is greater than

the growth rate of output. To illustrate, suppose that

there is an initial debt and that the "primary deficit"

(the deficit excluding interest payments) is zero.

With a primary deficit of zero, current net taxes

would exactly pay for current purchases. But the

ratio of debt to output would rise; the debt would

grow at the rate of interest, and output would grow at

a lower rate. Furthermore, a vicious cycle would

start because the higher debt would require higher

interest payments, which would make the debt grow

even more in relation to output, which would raise

the interest rate, and so on.

Keeping debt from growing in relation to output

would require a primary surplus equal to the interest

on the debt. A primary deficit of that amount would

require a permanent increase in net taxes equal to

interest on the debt. Being equal, they would have

the same present value, which is simply the value of

the debt. That condition is just the zero-sum constraint--the higher net taxes needed to maintain stability are equivalent in present value to retiring the

debt.

Why Does the Zero-Sum 

Constraint Matter?

In principle, some conditions might enable government to keep the ratio of debt to output stable when

"rolling over" the debt; that is, government could forever issue new debt to pay interest on old instead of

raising net taxes (or cutting purchases) to pay interest. In that case, each generation would inherit debt

from previous generations, add to it, and pass it to
54 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

following generations. In present value, the debt

would never be retired.

Traditionally, economists have thought that two

conditions would make persistent rollover feasible.

First, the rate of interest on debt must be lower than

the rate of growth of output. Second, the primary

deficit must not be too large as a share of output. To

illustrate, suppose the interest rate is less than the

growth rate, and the primary deficit is zero. Then the

ratio of debt to output will fall because debt grows at

the rate of interest, whereas output grows at a higher

rate. If the primary deficit was greater than zero, it

would also add to debt. Consequently, the ratio of

debt to output could remain stable--neither rise nor

fall--if the primary deficit was greater than zero, as

long as it was not too much greater. (Of course, the

debt would still displace capital that the public would

otherwise own.)

More recently, some economists have considered

models in which rollover is feasible even if the interest rate is greater than the growth rate. That possibility arises when public debt gives people a chance to

pool risk in a way that private markets cannot.1

Holding public debt is less risky than holding private

assets. If private markets cannot satisfy the demand

for less risky assets, public debt provides a link for

pooling risk between current and future generations.

One observation suggests that this could be the

case. Compared with bonds, equity shares seem to

earn far too high a rate of return to justify the difference on the basis of their relative risk. (Alterna- 2

tively, the price of equities is too low in relation to

that of bonds to explain easily the difference on the

basis of risk.) Thus, there could be an unfilled demand for less risky assets that private markets cannot

satisfy, although other factors might also explain the

observation.

Clearly, whether or not the zero-sum constraint is

necessary matters a great deal. If it is, current generations will have to contribute more or future generations will have to pay a huge bill. But if the zerosum constraint is not necessary and the primary deficit is not too big, all future generations could pay net

taxes at the same lifetime rate as current newborns

and roll over the debt. Neither current nor future

generations would ever have to make a sacrifice.

Can We Roll Over Debt?

Although it might succeed, trying to roll over the

debt would be a gamble. So imposing the zero-sum

constraint is like buying generational insurance.3

Debt incurred now irrevocably commits the government to make payments (as interest or repayment of

debt). If rollover turned out not to be feasible, the

government could make the payments when they

came due only by reducing spending or raising net

taxes. Reducing debt (and implicit obligations) now

reduces the risk that this choice will be forced on society later.

A number of considerations suggest that a rollover policy would be risky. First, the interest rate

has been above the growth rate since about 1980, and

the Congressional Budget Office projects that it will

remain so for the foreseeable future. Of course, those

forecasts are highly uncertain, and the interest rate

may fall below the growth rate. But history suggests

that such a result cannot be relied upon.4

Second, the interest rate could rise above the

growth rate in many periods even if it remained below the growth rate on average. Given a very long

time horizon, it becomes virtually certain that the

interest rate will exceed the growth rate for a long

enough time to bankrupt the government if it flouts

the zero-sum constraint by running primary deficits.

1. Olivier Blanchard and Philippe Weil, "Dynamic Efficiency, the

Riskless Rate, and Debt Ponzi Games Under Uncertainty," Working Paper No. 3992 (Cambridge, Mass.: National Bureau of Economic Research, February 1992).

2. Rajnish Mehra and Edward Prescott, "The Equity Premium: A Puzzle," Journal of Monetary Economics, vol. 15, no. 2 (March 1985),

pp. 145-162.

3. This analogy appears in Laurence Ball, Douglas W. Elmendorf, and

N. Gregory Mankiw, "The Deficit Gamble," Working Paper No.

5015 (Cambridge, Mass.: National Bureau of Economic Research,

February 1995).

4. Ibid.
APPENDIX A IS THE ZERO-SUM CONSTRAINT NECESSARY? 55

Third, it is not clear whether public debt fills an

unmet demand for less risky assets and makes rollover feasible. The general conditions under which it

is feasible are not known; there are only specific theoretical examples of economies for which it is feasible, and their relevance to the U.S. economy is not

clear.

In any case, rollover is not feasible under prevailing policy; the primary deficit would grow too large

in relation to output to allow rollover even if the rate

of interest remained below the rate of growth. Moreover, the rate of interest is not necessarily the cost of

transferring resources between periods, even if it is

the relevant rate for stability of the debt. If risk

makes the cost of transferring resources between periods greater than the rate of growth, rollover may be

undesirable even if it is feasible.

T

Appendix B

How Generational Accounts Treat Taxes

on Income from Capital

he accelerated depreciation allowances of the

tax code imply that income from existing

capital is taxed at a higher rate than income

from new capital (investment). Thus, generational

accounts must adjust prospective taxes on income

from capital in order to assign them to the right generations.

Tax Law Treats Income from

New and Existing Capital 

Differently

The current annual tax rate on "economic income"

from a unit of capital rises as it ages and eventually

exceeds the statutory rate. (Economic income is capital income after subtracting economic depreciation--

actual depreciation adjusted for inflation.) At first,

accelerated tax depreciation allows firms to deduct

more than economic depreciation. That shields economic income from tax and reduces the current tax

rate. But as accelerated allowances are used (and as

inflation erodes their real value), firms must deduct

an ever-smaller share of economic depreciation.

That exposes an ever-larger share of economic income to tax and raises the current tax rate. The current rate stops rising when tax depreciation allowances are used up, and by then it exceeds the statutory rate.

The same logic also applies for an investment tax

credit because it is a special case of accelerated

depreciation. That is, given an investment tax credit,

the current tax rate on economic income is higher for

existing than for new capital. (Investment tax credits

do not apply under current law but have applied in

the past.) 

Firms cannot avoid higher current tax rates by

selling existing capital to each other or by selling

existing capital and buying new capital. If they did,

they could start deducting tax depreciation on the

capital they bought as if it were new. But the tax

code has recapture and antichurning rules that make

such a scheme unprofitable. (And investment tax

credits in the past have effectively applied only to

newly made capital.) Therefore, the accounts assume

that firms never sell existing capital because the law

makes the tax come out as if they never do.

But people can buy and sell shares in firms that

own existing capital. Because the economic income

of existing capital is taxed more heavily than that of

new capital, owners and buyers assign a lower value

to a firm's existing capital than to otherwise equivalent new capital. The difference in value is the present value of the higher taxes to be paid on the income

from existing capital over its life.
58 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Generational Accounts 

Allow for the Difference 

in Treatment

In order to sort out the effects of investment incentives among generations, the accounts use the concepts of "normal" and "excess" taxes. (The terms 1

describe what tax law implies; they do not suggest

that the normal rate is the "right" rate or that taxes on

existing capital are "too high.")

Defining Normal and Excess Taxes

Normal taxes are defined by the taxes to be paid over

the life of new capital. That is, the normal tax rate is

the present value of taxes on income from new capital as a percentage of the present value of its economic income. Normal taxes each year are the taxes

that would be paid on economic income at the constant normal rate. If tax depreciation matched economic depreciation, the normal rate and each year's

current rate would equal the statutory rate. But under

current law (and rates of inflation), the current tax

rate is below normal in early years and above normal

later (because firms can deduct more than economic

depreciation early and less than economic depreciation later). And the normal rate is below the statutory rate because present value gives more weight to

earlier, below-normal taxes than to later, above-normal taxes. 

Excess taxes each year are the difference between that year's actual taxes and normal taxes.

Thus, excess taxes are negative early in the life of the

capital and positive later. By the nature of the tax

law, the present value of excess taxes on existing

capital is always positive (assuming inflation is positive). Moreover, by the nature of its construction, the

present value of prospective excess taxes at any time

is equal to the negative of the present value of past

excess taxes. (When the capital is new, the present

value of its excess taxes is zero. Therefore, the present values at any time of past and prospective taxes

must cancel each other.) That is, taxes paid at a rate

below normal will have to be made up later with interest.

Assigning Taxes on Income 

from Capital

To assign prospective taxes on income from capital

under current law, the accounts break it into two conceptual parts. The first is a one-time levy; it is the

present value of excess taxes on income from nowexisting capital. According to the accounts, the levy

in 1991 amounted to $684 billion, which is prorated

to current owners. The second is an annual flow; it is

the tax that would be collected each year if the normal rate applied to income from all capital, existing

now or installed later. The flow is prorated to prospective owners (including current owners who continue to hold their capital).

The adjustments account for all prospective taxes

on income from capital. Current owners pay all excess taxes and pay normal taxes for as long as they

hold their capital. All later owners (including current

owners who buy more) pay taxes at the normal rate;

they will have bought either new capital or old capital at a discounted price.

The adjustments also account for cases in which

later buyers subsequently sell. Whether they bought

new or then-existing capital, they will have paid a

price that reflected the present value of taxes at the

normal rate. And at the time they sell, the present

value of prospective excess taxes is simply the negative of the present value of past excess taxes. The

effect, therefore, is the same as if all later buyers always pay taxes at the normal rate. 

A change in law that raises investment incentives

also raises excess taxes on income from existing capital; its prospective taxes remain as before, but the

normal rate falls. That raises the present value of

excess taxes for current owners and reduces the annual tax at the normal rate for prospective owners.

Thus, according to the accounts, the increase in incentives transfers resources from current owners

(mostly old) to prospective owners (mostly young).

1. See Alan J. Auerbach, Jagadeesh Gokhale, and Laurence J.

Kotlikoff, "Generational Accounts: A Meaningful Alternative to

Deficit Accounting," in David Bradford, ed., Tax Policy and the

Economy, vol. 5 (Cambridge, Mass.: MIT Press, 1991), pp. 67-69

and 93-96.
S

Appendix C

The Roles of Generational Accounts

and the Standard Budget Accounts

ome advocates propose that debate over fiscal

policy should focus on how it would affect

generational accounts rather than the reported

deficit. But arguments for that proposal overstate the

merits of generational accounts and the faults of the

deficit. Each measure addresses relevant issues that

the other does not. Therefore, information provided

by generational accounts could complement, but not

displace, that provided by the deficit.

The Case for Generational 

Accounts

Some proponents argue on empirical and theoretical

grounds that generational accounts are relevant to

policy debate and the deficit is not. Empirically, proponents claim that generational accounts show the

degree of fiscal stimulus better than does the deficit.

Theoretically, they maintain that the reported deficit

is ill defined and that generational accounts are well

founded.

Empirical Issues

Traditionally, economists believe that several elements of the standard budget accounts indicate the

short-term thrust of policy. The deficit indicates the

pressure on interest rates by showing how much government is borrowing in capital markets. Spending

and taxes indicate pressure on the economy by showing how much government purchases are adding to

total demand and how much net taxes are taking from

people's incomes. 

Yet many studies find no link between deficits

and interest rates, and advocates claim that no such

link exists because the deficit is ill defined. Further- 1

more, they argue that current after-tax income is a

poor guide to how much people currently consume.

Instead, the life-cycle model (a standard theory) concludes that as people grow older each year, other

things being equal, they consume a greater fraction of

their remaining resources (present value of prospective net income).

Advocates of generational accounts say, therefore, that the deficit does not show whether fiscal

policy is tight or loose. They would call a policy

loose not if it raises the deficit, but if it sends lifetime

resources to generations who consume them at a high

rate. The advocates conclude that because generational accounts track resources by age, they indicate

how policy affects current consumption better than

do the budget accounts.

1. Laurence J. Kotlikoff, Generational Accounting: Knowing Who

Pays, and When, for What We Spend (New York: The Free Press,

1992), pp. 65-87.
60 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

Box C-1.

How Labels Can Affect Measures of Fiscal Policy

Suppose that the government starts a new program

that will collect $100 from Ms. A in 1995 and repay it

in 2005. For convenience, the interest rate is assumed

to be zero. The government might label the new payments and receipts in any number of ways. For example, it might label:

o The $100 received in 1995 as taxes, and the $100

paid in 2005 as transfers;

o The $100 received in 1995 as borrowing, and the

$100 paid in 2005 as return of principal; or

o The $100 received in 1995 as $200 of borrowing

less $100 of transfers paid, and the $100 paid in

2005 as $200 of return of principal less $100 of

taxes received.

The reported deficit in either year may rise, stay

the same, or fall even though the net cash flows are

the same in each case (see table below). In the first

case, the extra $100 of taxes in 1995 reduces the deficit (additional debt) by the same amount. Similarly,

the extra $100 of transfers paid in 2005 increases the

deficit by the same amount.

In the second case, nothing happens to the deficit

in either year. In 1995, the government issues $100 of

debt in exchange for the extra $100 it receives from

Ms. A. But that extra $100 received offsets what the

government would otherwise have borrowed from

someone else. Therefore, the deficit in 1995 remains

as it would have been without the program. Similarly,

the return of principal in 2005 offsets what the govExamples of How the Government Deficit Could Depend on Labeling (In dollars)

1995 2005

Change in Cash Change in Cash

Flow to Effect on Flow to Effect on

Case Label Government Deficit Label Government Deficit a a

Case 1 Taxes 100 -100 Transfers -100 100

Case 2 Borrowing 100 0 Return of principal -100 0

Case 3 Borrowing 200 0 Return of principal -200 0

Transfers -100 100 Taxes 100 -100

Total for Case 3 100 100 Total for Case 3 -100 -100

SOURCE: Congressional Budget Office.

NOTE: Table shows government receipts from and outlays to a given person in two different years under alternative labels.

a. Government receipts (cash flow to government) are positive; government outlays (cash flow from government) are negative.

Theoretical Issues

According to proponents of generational accounts,

the deficit is ill defined because it depends arbitrarily

on the way that government labels its payments and

receipts.

The Social Security system provides an example.

In a legal sense, contributions are taxes and benefits

are transfers. But the system could also be viewed as

a compulsory savings program for workers because

they contribute expecting to receive benefits when

they retire. If the system were a compulsory savings

program, contributions might legally be labeled as

loans to government and benefits might be labeled as

payment of interest and principal.
APPENDIX C THE ROLES OF GENERATIONAL ACCOUNTS AND THE STANDARD BUDGET ACCOUNTS 61

Box C-1.

Continued

ernment would have paid to those from whom it

would otherwise have borrowed in 1995. Thus, the

deficit in 2005 remains as it would have been in the

absence of the new policy.

In the third case, the deficit rises in 1995 by the

amount of transfers and falls in 2005 by the amount of

taxes. Neither the borrowing in 1995 nor the return of

principal in 2005 affects the deficit, as they do not in

the second case.

The third case may seem contrived because Ms. A

pays and receives money in the same year, but such

exchanges happen. For example, students pay excise

taxes and receive loans through the government; investors buy government bonds and shares in corporations that receive tax breaks; and retirees pay taxes,

buy government bonds, and receive Social Security

benefits.

By contrast, labels do not affect generational accounts because they are stated in terms of present

value. Using the previous example, generational accounts would be the same even if the labels were different (see table below). Given that the interest rate is

zero, $100 is the 1995 present value of the government's extra net receipts in 1995 and net payments in

2005.

Of course, the generational accounts for Ms. A

simply mirror those of the government. That is, $100

is the 1995 present value of her extra net payments in

1995 and net receipts in 2005.

Examples of How the Generational Accounts Do Not Depend on Labeling (In dollars)

1995 2005

Change in Cash Present Change in Cash Present

Flow to Value Flow to Value

Case Label Government in 1995 Label Government in 1995 a a

Case 1 Taxes 100 -100 Transfers -100 100

Case 2 Borrowing 100 -100 Return of principal -100 100

Case 3 Borrowing 200 -200 Return of principal -200 200

Transfers -100 100 Taxes 100 -100

Total for Case 3 100 -100 Total for Case 3 -100 100

SOURCE: Congressional Budget Office.

NOTE: Table shows government receipts from and outlays to a given person in two different years under alternative labels.

a. Government receipts (cash flow to government) are positive; government outlays (cash flow from government) are negative.

The policy is the same in either case: people

make the same payments, receive the same benefits,

face the same incentives. But the reported deficit is

not the same. In the first case, higher prospective

benefits do not raise the current deficit. In the second case, however, the promise to pay higher benefits later would increase the deficit because it would

increase government's unfunded obligations. Therefore, the current deficit depends on whether government labels its receipts as taxes or borrowing and its

payments as transfers or payment of principal and

interest.

In principle, the example of Social Security is not

unique. For example, taxes for unemployment insurance could be labeled as borrowing to provide prospective unemployment compensation, whereas unemployment compensation could be called interest
62 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

and repayment of principal. Excise taxes for gasoline

could be labeled as borrowing to provide highway

travel. The change in labels may have no legal basis,

but that does not matter for the economic functions

that the tax and spending programs serve. Indeed,

from an economic perspective, the government could

choose labels that would enable it to report any given

current deficit for any given fiscal policy. By con- 2

trast, only one set of figures could be reported for

generational accounts under any given policy, regardless of labels (see Box C-1 on page 60).

The possibility of changing labels has some practical significance. For example, a recent proposal to

establish family savings accounts (FSAs) represented

a change of labels. FSAs are equivalent in present

value (and economic effect) to individual retirement

accounts (IRAs). FSAs exempt interest earned in the

account from tax; IRAs exempt the contribution but

tax the withdrawal. Compared with an FSA, an IRA

raises the deficit initially (because the contribution is

tax-exempt) and reduces the deficit later (because the

withdrawal is taxed). The incentive to save and the

eventual effect on government finances are the same;

only labels and deficits are different.

As currently constructed, generational accounts

cannot show the effects of FSAs or IRAs any better

than the standard budget accounts. In fact, the effects

of deferred taxes on IRAs are so small that generational accounts do not even keep track of them, although they could be adapted to do so if such effects

were large enough to be significant. 

Generational accounts, however, are not entirely

immune from arbitrary labeling. They depend on

whether spending is called a transfer or a purchase:

transfers reduce net taxes, whereas purchases do not.

For example, in 1985, the Department of Commerce

(the labels of which are generally accepted by the

accounts) relabeled spending for Medicaid as a transfer rather than a purchase of medical services for the

poor. In the 1991 base year, that difference in labels

reduced current net taxes by $100 billion--about 10

percent of the total. By contrast, the change in labels

did not affect deficits, current or prospective.

The Case for the Standard

Budget Accounts

Although the charges leveled at the deficit have some

merit, they do not justify the claim that the standard

budget accounts are irrelevant. The debt and deficit

remain relevant in fact and in theory.

Empirical Issues

The argument that the deficit is misleading as a measure of fiscal stimulus depends on empirical evidence. That is, how much do deficits affect interest

rates, and how well does the life-cycle model predict

consumption?

The debt and deficit provide more information

about interest rates than the advocates of generational

accounts claim. Studies that use monthly or quarterly data usually fail to find a systematic link between the deficit and short-term interest rates. But

studies that use yearly data usually find a significant

link between the debt and long-term interest rates.3

In any case, no evidence indicates that generational

accounts would do better.

The deficit is even more clearly relevant for consumption. The life-cycle model, although broadly

consistent with the data, does not fully explain how

much people consume. Perhaps as many as half of 4

consumers respond more to changes in current income and less to changes in lifetime income than the

2. See Kotlikoff, Generational Accounting, pp. 149-163, or Laurence

J. Kotlikoff, "From Deficit Delusion to the Fiscal Balance Rule,"

Working Paper No. 2841 (Cambridge, Mass.: National Bureau of

Economic Research, March 1989). 

3. Congressional Budget Office, $Deficits and Interest Rates: Theoretical Issues and Empirical Evidence,# CBO Staff Working Paper

(January 1989).

4. See Franco Modigliani and Arlie Sterling, "Government Debt,

Government Spending, and Private Sector Behavior: Comment,"

American Economic Review, vol. 76 (December 1986), pp. 1168-

1179; Martin Feldstein and Douglas Elmendorf, "Government

Debt, Government Spending, and Private Sector Behavior Revisited: Comment," American Economic Review, vol. 80 (June 1990),

pp. 589-599; and Roger C. Kormendi and Philip Meguire, "Government Debt, Government Spending, and Private Sector Behavior:

Reply and Update," American Economic Review, vol. 80 (June

1990), pp. 604-617.
APPENDIX C THE ROLES OF GENERATIONAL ACCOUNTS AND THE STANDARD BUDGET ACCOUNTS 63

life-cycle model predicts. As a practical matter, 5

changes in the deficit record changes in current cash

flows between government and the people. For that

reason, the deficit helps explain consumption because

it indicates current income.

In some cases, changes in cash flows may not

alter people's behavior. For example, government

payments to honor obligations for deposit insurance

raised the deficit, but did not change the asset position of depositors. Such cases can readily be identified, however, and budget reports can be presented to

reflect such conditions--as CBO has done.

Experience following the Social Security

Amendments of 1983 suggests how generational accounts could misstate short-term policy stimulus.

According to generational accounts, the amendments

cost workers at the time about $1 trillion--the increase in present value of their net taxes. The life- 6

cycle theory predicts that workers should have permanently reduced their annual consumption by a

fraction of the $1 trillion. For example, by one estimate, a loss of $1 trillion in the value of private assets would reduce consumption and raise saving by

about $80 billion a year.7

But there is no clear evidence that the amendments had any effect at all on consumption. If not,

there may be two explanations, neither of which is

encompassed by generational accounts. First, people

might have been short-sighted, so they disregarded

the prospect of lower after-tax incomes. But using

generational accounts to predict how much people

consume today assumes that they are far-sighted and

that they forecast and discount all prospective income and outgo. Second, people might have expected the law to pass and have changed how much

they worked or consumed accordingly before the

amendments became law. But generational accounts

are based on prevailing, not expected, policy.

Theoretical Issues

The argument that the deficit is irrelevant also fails

theoretically. Even if all their ideal assumptions are 8

granted, generational accounts could not fully state

the effect of fiscal policy, and the deficit would remain relevant.

For example, generational accounts assume that

prevailing policy applies to everyone now living.

But most people know that prevailing policy cannot

last; nor do they expect it to. Trying to follow the

rates of taxes and spending that were current in 1994

would severely disrupt the economy well within the

lives of most current generations. Therefore, at least 9

some current generations will probably have to pay a

larger share of the bill than is now scheduled.

Moreover, people's expectations regarding how,

how much, and when they will have to pay will affect

how, how much, and when they work, save, hire, and

invest. For example, if they expect prospective payroll taxes to rise, they may decide to work more now

and retire earlier. If they expect prospective taxes on

capital income to rise, they may decide to consume

more now (save less) and consume less later. Therefore, estimates of generational accounts under prevailing policy do not show the effect of policy because they do not indicate how people expect policy

to evolve.

5. Robert E. Hall and Frederic S. Mishkin, "The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on

Households," Economica, vol. 50 (March 1982); John Y. Campbell

and N. Gregory Mankiw, "Consumption, Income, and Interest

Rates," in Olivier Jean Blanchard and Stanley Fischer, eds., NBER

Macroeconomic Annual 1989, vol. 4 (Cambridge, Mass.: MIT

Press, 1989), pp. 185-216; Marjorie Flavin, "Excess Sensitivity of

Consumption to Current Income: Liquidity Constraints or Myopia?" Canadian Journal of Economics, vol. 18 (February 1985);

David W. Wilcox, "Household Spending and Saving: Measurement, Trends, and Analysis," Federal Reserve Bulletin (January

1991), pp. 1-17; and Stephen P. Zeldes, "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political

Economy, vol. 97 (April 1989), pp. 305-346.

6. Kotlikoff, Generational Accounting, p. 182.

7. Laurence H. Meyer and Associates, The WUMM Model Book (St.

Louis: L.H. Meyer and Associates, June 1994).

8. The following paragraphs draw from Allan Drazen, "Problems of

Government Accounting: A Comment," in Allan H. Meltzer and

Charles I. Plosser, eds., Carnegie Rochester Conference Series on

Public Policy, vol. 37 (December 1992), p. 90; Henning Bohn,

"Budget Deficits and Government Accounting," in Allan H.

Meltzer and Charles I. Plosser, eds., Carnegie Rochester Conference Series on Public Policy, vol. 37 (December 1992), pp. 6-18;

and Willem Buiter, "Public Debt in the USA: How Much, How

Bad, and Who Pays?" Working Paper No. 4362 (Cambridge, Mass.:

National Bureau of Economic Research, May 1993), pp. 29-36.

9. General Accounting Office, The Deficit and the Economy: An Update of Long-Term Simulations (April 1995).
64 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

The fact that prevailing policy cannot last also

implies that labels still matter. If they did not, it

would make no difference whether government made

living generations pay more by raising net taxes or by

defaulting on its debt (or by selectively taxing people

who hold debt). But sovereign default is out of the

question; it is the last resort of a bankrupt regime, not

the rational choice of a stable polity. Therefore, people will react differently to debt--the explicit promise

to pay interest and principal--than they will to an implicit promise to levy a tax or pay a transfer. Indeed,

that is the reason that advocates of generational accounts argue that prospective net taxes entail more

risk than government debt. (The federal government

could indirectly default through inflation. But it

could not selectively reduce the real value of its debt

or tax the holders in the same way that it can selectively change the real value of net taxes.)

Debt constrains the behavior of government. The

implicit promise to levy a tax or pay a transfer is reversible, but the explicit promise to repay debt is irrevocable. For instance, government might label a

promise to make a future payment as either debt or a

prospective transfer. And it is possible in theory to

choose labels that make either promise equally risky

when it is made. But events that occur between the

times the promise is made and the payment is due

may force the government to reduce its payments.

The labels determine which promise the government

must honor; they establish whether government can

make a choice now and reverse it later. Such a constraint affects how government can act and how people expect it to act--effects that generational accounts

do not recognize.

Conclusion

The claim that the deficit is irrelevant stems from a

theoretical result that requires ideal conditions not

seen in the real world. The result suggests interesting

lines of research that may eventually deepen our understanding of the ways in which policy and the

economy work. But generational accounts cannot

inform policymakers to the exclusion of the deficit;

the deficit contains relevant information that generational accounts do not. Thus, generational accounts

might complement but cannot replace the deficit.
T

Appendix D

How Generational Accounts Were

Developed Under Alternative Economic

and Demographic Assumptions

he Congressional Budget Office used a conservative method to determine how sensitive

the accounts are to alternative assumptions

about population, productivity, or the discount rate.

The procedure involved extending official projections of alternative population paths, running the program that calculates the accounts under alternative

assumptions, and adjusting the results for each alternative to make them comparable with each other.

Extending Alternative 

Population Projections

CBO extended the population projections of the Social Security Administration by the same method

used for the base case in the accounts. The accounts

extend the mid-growth projection to 2200 by assuming that the rates of birth, death, and immigration in

2080 would continue to prevail through 2200. Those

rates are such that the projections of both total population and its composition by age and sex would remain nearly constant through the 22nd century. Total

population would reach 370 million in 2080 and 388

million in 2200. After 2200, it is assumed that both

total population and its composition by age and sex

would remain at the values estimated for 2200.

To extend the low- and high-growth paths, CBO

assumed that the rates of birth, death, and immigration for the midgrowth path in 2080 would prevail on

the other paths through 2200. That assumption eventually holds population stable on both paths. Until

2080, population would fall to 286 million on the

low-growth path and rise to 489 million on the highgrowth path. After 2080, population on the lowgrowth path would fall to 260 million in 2125, then

rise to 288 million by 2200. After 2080, population

on the high-growth path would rise slowly to 526

million in 2200. For both paths it was assumed that

after 2200, total population and its composition by

age and sex would remain at their values for 2200.

Projecting Taxes 

and Transfers

CBO assumed that the total of each real tax or transfer would grow as projected by the Office of Management and Budget (OMB) for 10 years. After 10

years, real taxes and transfers for the average person

of each age and sex are assumed to grow at the same

rate as productivity. Thus, after 10 years, real growth

of the respective totals would depend on growth of

productivity and population.
66 WHO PAYS AND WHEN? AN ASSESSMENT OF GENERATIONAL ACCOUNTING November 1995

The method that CBO used understates the influence of alternative assumptions for productivity and

population. In practice, different productivity or

population assumptions within the 10-year horizon of

the OMB forecast would generate different projected

totals for most taxes and transfers. But the method

used only allows alternative assumptions about productivity or population to affect the growth of projected totals after 10 years have passed.

Although the method understates sensitivity to

productivity and population, it does not qualitatively

affect the results. Experiments show that if all taxes

and spending vary immediately with population and

productivity, differences in the discount rate still account for most of the differences in results.

Adjusting the Results

The results must be adjusted to make them comparable because they start from different bases. For

example, consider what happens to the average 30-

year-old man when a 20 percent increase in Social

Security benefits is financed by payroll taxes. The

present value of his prospective net taxes rises by

$8,200 when the discount rate is 3 percent and by

$7,400 when it is 6 percent. (Both cases assume that

productivity grows at 0.75 percent and population

follows the midgrowth path.) The raw increase in

present value is greater when the discount rate is 3

percent.

But the man's resources differ in the two cases.

Human capital--the present value of prospective labor income--is $938,000 when the discount rate is 3

percent, but only $545,000 when it is 6 percent. His

stream of labor income is the same in both cases, but

it is given less weight by the higher discount rate.

Total resources--human capital plus other assets--

amount to $967,000 when the discount rate is 3 percent and $555,000 when it is 6 percent. Hence, the

increase in the present value of the man's net taxes is

greater in relation to his resources when the discount

rate is 6 percent.

Similar issues arise when productivity or population differs from its base value. For example, faster

growth in productivity raises the growth of labor income and, hence, human capital. By contrast, faster

population growth reduces human capital because the

assumed higher death rate reduces the probability

that people will live to any given age.

CBO adjusted the results so that they are all comparable to the base case--6 percent discount rate, 0.75

percent average annual productivity growth, and

midgrowth population path. In the example above,

the raw change in present value of net taxes of the

average 30-year-old man is 0.85 percent of total resources when the discount rate is 3 percent. Therefore, the adjusted result is $4,700, which is 0.85 percent of total resources for the base case. Results for

all generations under all alternative assumptions are

adjusted in the same way.

This method is not unique, of course. For example, if a 3 percent discount rate was the base, the

results for the 3 percent case would remain unadjusted at $8,200, and the adjusted results for the 6

percent case would become $12,900--1.3 percent of

$967,000.

No adjustment is needed when results are expressed in terms of lifetime net tax rates. In that

case, results for the average member of each generation are already given directly as a percentage of resources (human capital) at birth.