Generational Accounting and the Future of Fiscal Sustainability

Generational accounting is a way to measure the impact of government policies on different generations. It takes into account the taxes paid by each generation and the benefits they receive, creating a more accurate picture of fiscal sustainability.

The idea is to calculate the net burden of government spending on each generation, considering both the taxes they pay and the benefits they receive. This helps policymakers understand how their decisions will affect future generations.

Generational accounting can be complex, but it's essential for making informed decisions about government spending and taxation. By considering the long-term effects of their policies, policymakers can create a more sustainable fiscal future.

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The Portuguese economy has been characterized by lower economic growth and successive current account deficits over the past years, leading to a situation of instability that became unsustainable with the global financial and sovereign debt crises.

Portugal signed a three-year European Union-International Monetary Fund (EU-IMF) program of financial assistance in May 2011 to implement structural reforms and balance the budget.

The government's reported size of its official debt is not economically well defined, but the value of the fiscal burden confronting future generations is invariant to the government's fiscal labeling.

Generational accounts represent the sum of the present values of the future net taxes that members of a birth cohort can expect to pay over their remaining lifetimes if current policy is continued.

The government's intertemporal budget constraint can be written as A + B = C + D, where A is the sum of the generational accounts of future generations valued to the present, and B is the sum of the generational accounts of those now alive.

The U.S. federal fiscal imbalance (FI) calculated under current fiscal laws and purchases policies over the next 75 years equals $104.3 trillion, which is 8.0 percent of the present value of projected GDP (PVGDP) over that time horizon.

The Portuguese economy's low interest rates provided an easier access to credit in international markets, but the decreasing levels of savings led to consumption and investment being financed through increasing levels of public and private debt.

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Generational accounting measures the imbalance in generational policy by comparing the lifetime net tax rate of current newborns with the projected net tax rate on future newborns.

The difference between the lifetime net tax rate of current newborns and the projected net tax rate on future newborns measures the imbalance in generational policy and indicates whether current policy is unsustainable.

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The population size and age structure play a crucial role in generational accounting, as they affect the distribution of net taxes and the servicing of debt.

Generational accounts are per capita net taxes in present terms, so the size of the population influences the amount of net taxes needed to cover government expenditures and debt.

As the population is expected to decrease in the coming years, the total amount of net taxes will be divided by a smaller number of people.

The projections used to compute the generational accounts are based on the 2009 population projection estimates by age and gender provided by INE from 2010 until 2060.

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These estimates provide four different scenarios, but the authors of the study decided to use the scenario without migration for population projections.

The scenario without migration is considered more reliable, as the other scenarios have questionable assumptions about future migration rates.

The population projections were extended to 2110, as the study aims to analyze a 100-year period.

The authors estimated birth rates and age-specific death rates for each age group, by year, gender, and age, from 2010 to 2060.

These rates were then used to estimate a trend function for each age group, and this function was used to estimate the birth rates and age-specific death rates from 2061 to 2110.

The population structure critically influences the absolute amount of net taxes, as most taxes paid and transfers received are age-specific or highly related to a person's age.

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Intergenerational inequality is a pressing concern, with the potential to increase the burden for future generations. The IMF's Christine Lagarde has expressed concerns about this issue, highlighting the growing gap between youth and elderly income levels post-crisis.

Income inequality levels have been relatively stable in European countries since the financial crisis, but the gap between young and old is widening. Incomes for young people have not grown since the 2007 crisis, but they have increased by 10% for people at 65 or older.

The OECD warns that future generations will be largely affected by population ageing and rising inequality.

Inequality is a pressing concern that affects not just Portugal, but many other developed countries as well. The head of the IMF, Christine Lagarde, expressed concerns about this issue in a conference in Davos, in January, 2018.

Income inequality levels have been relatively stable in European countries since the financial crisis, but there is a significant growing gap between the youth and the elderly income levels post-crisis. This gap is concerning because it suggests that future generations will face lower income levels, higher unemployment, and more debt.

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The IMF points out that incomes for young people have not grown since the 2007 crisis, but they have increased by 10% for people at 65 or older. This is a stark contrast that highlights the challenges faced by younger generations.

Nearly one in five young people in Europe are still looking for work, and when they find a job, it will likely be at lower wages and with lower security. This is a concerning trend that suggests the labor market is not providing adequate opportunities for young people.

The younger generation has the highest debt relative to their assets of any age group, which makes it even more challenging for them to achieve financial stability.

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The life cycle hypothesis suggests that people plan their consumption and savings behavior throughout their lives, taking into account their expected lifetime resources.

This theory assumes that people are rational and can incorporate all relevant information into their planning, including the present value of their future income.

The present value of future income is calculated by discounting it according to a discount factor, which is a way of adjusting for the time value of money.

According to the life cycle hypothesis, people will not change their consumption behavior as long as the present value of their future income does not change.

However, there are three main criticisms of this theory: altruism, myopia, and liquidity constraints.

Altruism implies that people care about the well-being of other generations, which can lead to intergenerational transfers.

These private intergenerational transfers are not taken into account by generational accounts, which may overestimate the burden left to future generations.

The Congressional Budget Office found significant evidence that people give more importance to current income and less to lifetime income than the life cycle model predicts, suggesting that the myopic criticism is supported by data.

This implies that the timing of taxes and transfers can affect people's utility, contradicting the life cycle hypothesis.

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In generational accounting, data analysis is crucial to understand the intertemporal budget constraint. We consider a 100 years range of analysis, from 2010 to 2110.

The base year is established as 2010, but it doesn't limit the information used in calculations. We take into account government budgets from 2010 until the last year available.

The choice of the base year has two main purposes: to split between current and future generations, and to discount future values of variables until the base year.

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Generational accounting has its limitations, and it's essential to understand them to make the most of this tool.

The theoretical framework behind generational accounting is not without its criticisms, with two main concerns being the validity of the underlying life-cycle hypothesis and the incidence assumptions. This means that the way we consume and the way taxes and transfers are distributed might not be accurately captured.

The empirical limitations of generational accounting are also significant, with many objections related to the assumptions made about population and economic projections. For instance, the assumption that current government behavior is static and will remain unchanged is unlikely to hold.

The sensitivity of the results to the values of future growth rates and discount rates is a concern, with the choice of these rates being a difficult decision due to the difficulty in accessing the average future growth rate of the economy.

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Theoretical limitations of generational accounting are a crucial aspect to consider. According to Raffelhüschen and Walliser (1999), the two main criticisms regarding the theoretical framework behind generational accounting are the validity of the underlying life-cycle hypothesis, which impacts consumption patterns.

This life-cycle hypothesis is a fundamental assumption in generational accounting, but its validity is questionable. The underlying incidence assumptions are also a point of contention.

These assumptions can significantly affect the accuracy of generational accounting results.

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Many of the empirical objections to generational accounting are related to the assumptions regarding the projections of variables, particularly economic ones.

The assumption that current government behavior is static is a major concern, as Haveman (1994) points out.

Fiscal policy tends to be reactive, and changes in government policies can significantly impact projections.

The assumption that only future generations will bear the fiscal burden of necessary adjustments is unlikely to hold.

Population projections, which do not assume a static population size and structure, are still subject to errors.

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Underestimating life expectancy and old age dependency ratios can lead to inaccurate projections, as seen in some studies.

The choice of growth rates and discount rates is a difficult decision, as they remain constant throughout the analysis window.

The constant rate assumption implies that micro-profiles, taxes, and transfers remain constant, which is unlikely.

The ambiguity of the choice of these rates and their sensitivity to the values of these rates are major concerns.

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Generational accounts represent the sum of the present values of the future net taxes that members of a birth cohort can expect to pay over their remaining lifetimes if current policy is continued.

The government's bills are essentially the sum of all its future purchases of goods and services plus its official net debt. This is the government's intertemporal budget constraint, which can be written as A + B = C + D.

The government's official net debt is represented by A, while C is the sum of future government purchases valued to the present. The sum of generational accounts of those now alive is represented by B, and the sum of generational accounts of future generations valued to the present is represented by A.

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Achieving balance is crucial to ensure that future generations are not burdened with excessive debt. The calculation of generational imbalance is an informative counterfactual that delivers a clear message about the need for policy adjustments.

To achieve generational balance, we can consider alternative means of adjusting government purchases or income tax revenues. An immediate and permanent cut in the annual flow of government purchases by a certain percentage can help achieve balance.

This percentage reduction would lower the size of A, which represents the collective generational accounts of those yet to be born. The precise size of the percentage income tax hike needed to achieve generational balance is found when the growth-adjusted generational accounts of future generations equal those of newborns.

In other words, if current policy is continued, the sum of the generational accounts of all members of all living generations indicates how much people who are now alive will pay toward the government's bills. This sum is equal to the government's bills, which include future purchases of goods and services and its official net debt.

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To make it more concrete, let's say the government's official net debt is $100 billion. If the sum of future government purchases valued to the present is $200 billion, the government's bills would be $300 billion. This means that the sum of the generational accounts of those now alive must be $300 billion to achieve generational balance.

If the sum of the generational accounts of those now alive is less than $300 billion, the sum of the generational accounts of future generations must be larger to make up for the difference. This is the zero-sum nature of the government's intertemporal budget constraint.

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Generational accounting is a valuable tool for understanding the financial implications of government policies on different generations.

In Portugal, researchers have applied generational accounting to analyze the country's fiscal situation.

Generational accounting for Portugal was conducted by Jorge Pinheiro in 2021 and published in the Portuguese Economic Journal.

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The study found that generational accounting is a useful tool for evaluating the impact of fiscal policies on different age groups in Portugal.

The research highlights the need for policymakers to consider the intergenerational implications of their decisions.

Portugal's generational accounting study provides a detailed analysis of the country's fiscal situation, including the impact of government spending on different age groups.

Generational accounting can help policymakers make more informed decisions about taxation and government spending, ensuring that the burden is shared fairly across generations.

Here is a list of the key findings from the study: