CONGRESSIONAL LEADERS have to move beyond the Balanced Budget Amendment. It’s an intellectual error and a political loser. As evidence, consider the recent debate about the amendment, which had a through-the-looking-glass quality. It wasn’t just the politicians running between hearing rooms and television interviews like the Mad Hatter, but what they were saying that was so surreal. They all wanted to balance the budget, and they all knew exactly which budget to balance. Trouble is, they were all talking about different budgets. This one wanted Social Security in the budget; that one wanted to exclude capital expenditures; a third wanted to control for inflation, and on and on.
The Mad Hatters are, in fact, making three fundamental mistakes in considering our fiscal policy. Their first mistake is the belief that the deficit measures something economic. Despite the commonplace belief that a government’s budget deficit is a meaningful measure of its fiscal policy, economic theory tells us it is not. Indeed, the deficit is a simple reflection of our vocabulary. A good example of the arbitrary nature of fiscal labels arises in the case of Social Security. The U.S. government labels our Social Security contributions “taxes” and our Social Security benefits “transfers.” Suppose, instead, it started calling our Social Security contributions “loans to the government” and our Social Security benefits “return of principal plus interest” (the difference between the two being an “old-age tax”). With these labels, which make just as much sense as the standard ones, the reported federal deficit would be entirely different. Indeed, were we to start using this choice of words, last year’s federal deficit would have been more than $ 350 billion larger than the amount actually reported!
The labeling of Social Security contributions is not an isolated example. Literally every dollar the government takes in or pays out is labeled in an economically arbitrary manner. As a consequence, the so-called unified deficit that is now used in Washington is simply one of an infinite number of possible deficits, each of which depends on the issue of what words (not actions) the government chooses.
Thus the problem of defining the deficit runs much deeper than most people believe. This includes many, if not most, economists who continue to believe that the government’s deficit is connected to the level of interest rates, the trade deficit, national saving, and inflation. This deficit delusion is hard to shake because virtually everyone is using the term “budget deficit” as if it had real meaning.
What’s needed, therefore, is a change in the terms of the debate. Instead of focusing on the budget, we should start focusing on generational balance.
Generational balance, simply put, means future generations will not be forced to pay confiscatory tax rates, while receiving dramatically reduced health and retirement benefits, solely because those of us alive today choose not to bear the true burden of paying for the goods and services we demand from the government.
Assessing whether current fiscal policy is generationally balanced requires the use of generational accounting, which is economic theory’s prescription for how we should assess the fiscal treatment of current and future generations. Generational accounting starts from the premise that there is no such thing as a free lunch — that either current or future generations will have to pay the government’s bills. Generational accounting (which is being done by the governments of, among others, Japan, the United Kingdom, Norway, New Zealand, Italy, and Chile) is quite similar to the methodology employed by the Social Security trustees in formulating their annual assessment of the entitlement’s long-term finances.
A convenient way to summarize the findings of generational accounting is in terms of each generation’s lifetime net tax rates. These have increased from 24 percent for the generation born at the turn of the century to 34 percent for children who have just been born. More depressing, the lifetime net tax rate facing future generations — assuming current living generations, including today’s children, end up paying the net tax rate implied by current policy — is a colossal 84 percent. By the way, these generational-accounting calculations are based on the government’s own projections.
The difference between the 84 percent net tax rate of future generations and the 34 percent net tax rate of today’s newborns tells us two things. First, current fiscal policy is not sustainable. We cannot tax successive new generations at only a 34 percent net rate and still pay the government’s bills. Second, the size of the net tax rate facing future generations is so large (over twice that facing current newborns) that it simply cannot be, and will not be, collected.
The Hatters’ second mistake — equating budget balance with generational balance — follows from their first. So-called pay-as-you-go Social Security provides the most striking example of why budget balance and generational balance have no necessary relationship. Under pay-as-you-go Social Security, the government chooses its words so that its expropriation from young and future generations never shows up in its reported budget deficit. This extortion occurs by forcing young and future generations to participate in a very bad investment.
Consider today’s young Americans. As a group, they’ll be lucky if they receive Social Security retirement and other benefits that are as large as their lifetime contributions to Social Security; i.e., they’ll be lucky if they recover the principal on their forced investment in the program. In contrast, were today’s young Americans free to invest their contributions in U.S. financial markets, particularly the equity market, the value in retirement of their investment would, in all likelihood, equal at least four times their contributions. Since young and future generations can be made equally worse off if (a) they are forced to participate in lousy investment deals or (b) they are free to invest their savings but are forced to pay high taxes to cover the interest on official government debt, we need a fiscal measure that captures their burdens, regardless of its official description.
Would passage of the Balanced Budget Amendment ensure generational balance? Not a chance. Consider the 1995 Republican budget vetoed by the president. The proposal entailed cutting all outlays, except defense and Social Security. Balancing “the” budget in this manner, while slightly raising the net taxation of existing generations, reduces the fiscal burden on future generations from 84 percent to (a still enormous) 72 percent.
Thus, in looking at the unified deficit, Congress is getting the impression that far less fiscal restraint is needed than is actually the case. The problem is that neither the unified budget nor the unified budget excluding Social Security is the right budget to balance. The right budget to balance is the government’s long-term, or intertemporal, budget on which generational accounting is based. From this perspective what is needed is not a constitutional amendment to achieve budget balance, but one that ensures generational balance.
The third mistake is assuming that we can achieve generational balance without the help of the elderly. Well, why not largely spare the elderly and just cut government spending to achieve generational balance? The answer is that virtually all (97 percent) of federal government purchases would have to be cut to lower the net tax rate facing future generations from 84 to 34 percent. This is unrealistic for several reasons, not the least of which is that, relative to GDP, federal purchases are, by historical standards, already quite low. Even were federal purchases held constant in real terms from that point onward, future generations would still face an exorbitant net tax rate — about 73 percent.
The simple fact of the matter is that today’s elderly must bear a higher net tax burden if we are to remove the fiscal Sword of Damocles hanging over the heads of future generations. The most important and least painful way for the elderly to make their contribution is for them to demand that growth of Medicare and Medicaid be limited to the amount warranted by growth in labor productivity and demographic change. (In the case of Medicare, benefits per beneficiary have risen in inflation-adjusted dollars by over one quarter in just the last four years.) Such stabilization of Medicare and Medicaid spending would lower the net tax rate facing future generations from 84 percent to about 51 percent.
We could also raise taxes. The requisite immediate and permanent hike in federal income taxes (personal and corporate) needed to achieve generational balance is 52 percent! The corresponding payroll tax hike is 64 percent. Other options are an immediate and permanent 95 percent cut in Social Security benefits or, as mentioned, an immediate and permanent 97 percent cut in federal government purchases.
Notwithstanding all the attention it receives, budget balance is largely beside the point when it comes to considering the fiscal burden we are placing on young and future Americans. Most of this burden is missed by the conventional unified budget deficit because of the choice of fiscal language. If we are really serious about sparing our children and grandchildren a fiscal nightmare, we need to discard the budget deficit as a measure of generational policy. Instead, it’s high time that public policymakers use generational accounting on an ongoing basis so that they, as well as the general public, will have a clear understanding of the extent to which current fiscal policy is endangering the next generations.
Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis; Laurence J. Kotlikoff is professor of economics at Boston University. The views expressed are those of the authors and not necessarily those of the institutions they represent.
