Living High at Our Children’s Peril

The United States is in a feel-good mood. The stock market’s up, the economy’s booming, the government’s running a surplus and we have a host of politicians crisscrossing the country telling us to cut taxes and raise spending. There is, unfortunately, one nasty fly in the ointment. Within this decade, the first of 75 million baby boomers will start collecting Social Security benefits. A couple of years later, they’ll start collecting Medicare benefits. And those boomers who need to live in nursing homes but can’t afford them will start collecting Medicaid benefits.

Will our short-term budget surpluses, assuming they can be protected from the politicians, leave us enough money to pay these bills? The answer, as detailed in a just-released generational accounting study, is a resounding no.

The study, produced by economists at the Federal Reserve Bank of Cleveland and analysts at the Congressional Budget Office, measures the fiscal burdens that government (federal, state and local) is placing on us, our children and our descendants. Developed a decade ago by ourselves and UC Berkeley economist Alan Auerbach, generational accounting is now being done in 26 countries around the world.

Generational accounting processes a host of demographic and fiscal variables, but it ends up asking two very straightforward questions: First, how big a tax bill will our descendants inherit if current policy is maintained? Second, what tax hike is needed now to keep our children from paying higher tax rates than those we now face?

The answers to both questions depend heavily on what one views as current policy.

The new U.S. generational accounting considers a number of alternatives, but it starts with a “reference case.” This case is an updated version of the “base-case” fiscal projection presented by the CBO last year, the one that features huge budget surpluses for the next couple of decades followed by even larger budget deficits.

The reference case involves heroic assumptions about future fiscal prudence in Washington. Yet even if one assumes this prudence, our fiscal house is not in order. Indeed, under the reference case projection, future generations face a 13% higher lifetime net tax rate than the one we face. Eliminating this disparity in treatment would require an immediate and permanent 5% increase in federal income taxes.

How can our nation’s long-run finances look bad when our short-term finances look so good? The answer is that the long-run fiscal stresses we face are tremendous. If you want to see what’s coming, imagine doubling today all the spending on Social Security, Medicare and Medicaid. Why? Well, in 2030, when those born in the middle of the baby boom are in the middle of their retirements, federal spending on these programs will absorb roughly twice the share of output it does today. Not only will the entire country be as old as Florida is now, but it will stay that way for decades. In short, we are looking at a tidal wave of government obligations.

This sobering message gets worse when one considers the unbridled optimism of the reference scenario, the scenario that has captured the nation’s imagination. The reference forecast assumes that, relative to the economy, federal government purchases--covering everything from military pay to refueling Air Force One to National Institutes of Health research grants--will shrink as a share of output by more than one-fifth by the end of this decade and by almost one-third when the boomers are retired. Stated differently, much of the surpluses being projected over the next couple of decades are generated by assuming that the federal government will magically and dramatically shrink compared to the economy. Fat chance.

The new CBO director and his staff are so concerned with the plausibility of this assumption that they now present it as just one of a set of possible scenarios, rather than as a “baseline.” If we consider an alternative CBO scenario, in which federal spending keeps pace with the economy, future generations will face lifetime net tax rates that aren’t 13% larger but 55% larger than our own. In this case, a 20%, rather than a 5%, rise in federal income tax rates is needed for generational balance. Alternatively, one could achieve generational balance by immediately and permanently cutting Social Security, Medicare, Medicaid and all other government transfer payments by 15%. A third option is an immediate and permanent 14% cut in all federal, state and local government purchases. A fourth is a 43% cut in federal purchases.

These figures would be worse if the CBO incorporated more realistic assumptions about longevity improvements. The CBO gets its mortality projections from Social Security. Yet Social Security’s “intermediate” mortality assumptions would have us believe that it will take Americans almost half a century to start living as long as the Japanese live now. Top demographers across the country view this as patently absurd. Indeed, in November, the panel of experts that advises Social Security’s trustees on the system’s long-term forecasts recommended a major revision in this assumption, a revision that increases projected life expectancy by almost four years. If the panel is right, our children can expect to pay Social Security, Medicare and Medicaid benefits to 75 million boomers for a lot longer than they and we may have thought.

Alternatively ignoring and misrepresenting the long term is a time-honored tradition in Washington. Yet it will lead inexorably to the imposition of extremely high tax rates, with all their attendant economic misfortune.

Our leaders need to give as much thought to the next generation as to the next election and come up with a policy of tax hikes, benefit cuts and spending cuts that ensure our fiscal policy achieves generational balance.