Every industrial country is either considering or in the process of implementing major reforms to the web of pension, healthcare and social service programs for the aged sometimes called the ‘generational contract’. In the 1960s and 1970s, policy makers could reasonably assume that any sacrifices they imposed on younger and future generations in the name of dependent elders would be more than offset by rising incomes.
This is no longer the case. The demographic and economic challenges now facing ageing societies raise the prospect that, in some countries, non-health consumption will enter a period of decline — lasting not just for a few years, but decades — as the direct result of otherwise fiscally prudent reforms. A metric that identifies the impacts of benefit reforms on the lifetime consumption for different birth cohorts could help to avert such outcomes and, by so doing, undergird the political sustainability of residual benefit promises.
History is replete with instances where the policy mistakes of fathers have been visited unjustly upon their sons. Yet, in all but a handful of these tragedies, those setting policy did not contemplate that their actions would leave younger and future generations materially worse off. Modern economics and actuarial science provide today’s policy makers with the tools to peer into the future and assess, with reasonable credibility, the intergenerational impacts of current law and major adjustments thereto. These capabilities would be brought to bear in the Generational Impact Statement (GIS) — a measure similar in concept to the environmental impact statement — which could be used to evaluate all significant fiscal legislation.
While the GIS would be broadly applicable throughout the industrial world, for the purpose of illustration, I will confine my discussion to circumstances in the United States. The U.S. faces a particularly rapid increase in its elderly population, while health expenditures — driven disproportionately by the aged — are growing rapidly off of a very high base. There is a high probability that, in the name of good government, reformers will engineer a lengthy period of falling fortunes for today’s young and their children in turn.
2. A Troubling Baseline
What will the average American consume during his or her lifetime? Unfortunately, we cannot know, since a substantial portion of future worker income has yet to be allocated between dependents and workers. Various agencies of the U.S. Government have put the present value of unfunded liabilities for old age health and income security programs in the range of $70 trillion1, or roughly five times national income. The question of when and how these gaps will be filled is a major source of uncertainty overhanging the financial future of practically every American under age 70.
Actuarial studies updated annually by the Social Security Administration (SSA) and Center for Medicare and Medicaid Services (CMS) provide important clues as to the wellbeing of future generations through long range projections of per capita incomes and health costs that incorporate variables such as economic output, demographic change, medical inflation and the composition of public and private health spending. These calculations permit the estimation of average lifetime gross incomes for each birth cohort.
Parallel long range studies by the Congressional Budget Office (CBO) add revenue projections to this mix. This allows CBO to estimate the size of the budget gap in any given year. Significantly, however, this exercise does not incorporate the economic feedback — or ‘dynamic’ effects — of new taxes or permanent budget deficits. Established economic theory suggests that both taxes and deficits will slow the rate of economic growth, which, in turn, can depress revenues and increase deficit pressures.
The GIS baseline would estimate average per capita lifetime disposable (after tax) income for selected birth cohorts — for example, for the cohorts born in 2007, 1977 and 1947. As with environmental impact statements, these calculations would be simplistic and illustrative. But they could be accompanied by more nuanced qualitative risk assessments that take into account potential economic feedback.
The simplest method for calculating the intergenerational impacts of current law or proposed legislation would be to assume that all shortfalls will be covered by new taxes. This calculation would effectively highlight policies that transfer resources from the future to the present — such as the 2004 Medicare Part D prescription drug entitlement, which substantially increased spending on the aged without specifying a way to pay for it. Yet the assumption that tax increases will be calibrated to rising benefit costs is neither politically nor technically realistic. If the past is any guide, electorates will tend to protect their consumption by endorsing the palliative of budget deficits.
Nothing in CBO’s long range projections suggests that deficits would have an adverse intergenerational impact. In CBO’s high health-cost/low revenue scenario (in which federal revenues remain stable at about 19% of GDP, while health costs continue rising at historical rates) deficits soar to 14% of GDP in 2030 and 38% in 2050. Under this scenario, borrowing costs remain constant while incomes and consumption continue rising. Much more likely is that bond ratings would fall, debt service would soar — eventually surpassing social spending as the primary engine of deficit spending — and, at some point, perhaps in the 2020s, GDP and personal income growth would lurch dramatically into reverse.
Such a collapse would have profound intergenerational impacts; but, counter-intuitively, they would tend to favour the young. This is because a lifetime of accumulation and diminished capacity for employment make older populations more vulnerable to an economic upheaval that undermines company profits and the performance of the stock, bond and real estate markets. In the Great Depression, older generations lost the most in the downturn, but gained the least from the subsequent recovery. By 1935 there had been a vast shifting of fortunes away from the contemporary old. The memory of this shock became the touchstone for a broad based, two-generation long political movement to increase income transfers from workers to retirees.
Inclusion of an economic risk assessment in the GIS would serve a dual purpose. It would outline an alternative (some would say, more realistic) scenario, in which deficits rather than taxes are used to fund the added cost of baby boom retirement benefits. By highlighting the heightened risk of economic upheaval, it would also underscore the importance to boomers themselves of prudent reforms designed to avoid what, for them, would be a catastrophic slump.
A balanced risk assessment, however, would also include a discussion of tax-related economic risk. The baseline GIS would incorporate the CBO methodology that excludes consideration of the dynamic effects of taxes. The risk assessment could provide bounds as to what those effects might be. For example, a 1997 study by the OECD estimated that an increase in the average tax take of 10% of GDP during 1960-1995 had reduced OECD annual growth rates by about one-half percentage point2. In the U.S., a similar tax increase over the next 25 years could cut projected GDP growth rates by 26% — substantially mitigating the deficit-reducing impact of tax increases.
Two other measures might be added to the GIS in order to provide an even more comprehensive assessment of the impacts of current law and new legislation on the living standards of different birth cohorts. The first would be a measure of the lifetime health expenditure of various birth cohorts—information that can be abstracted from long range Medicare projections prepared by CMS. The second measure would subtract lifetime retirement saving from disposable income in order to calculate lifetime non-health consumption. Because health costs are projected to rise faster than wages, they are driving up the share lifetime income consumed in retirement. For example, CMS projects that out-of-pocket costs health costs for the aged will rise from 29% of the average Social Security benefit in 2006 to 42% in 2030. All other things being equal, this means that each successive cohort of workers must save a larger share of lifetime compensation in order to preserve pre-retirement living standards in old age. By taking these factors into account, the GIS could produce estimates of the full intergenerational impacts of reforms designed to contain health costs.
3. Measuring the Impacts of Legislation
The foregoing suggests that America’s 79 million member baby boom generation — currently aged 43-61 — has a strong financial interest in legislative remedies that prevent budget imbalances from triggering economic discontinuities that undermine the value of their retirement portfolios. Yet they also have an interest in shifting as much of the cost of reform as possible onto subsequent cohorts. Mitigating this latter impulse is a widely recognized, but poorly informed, legacy motive. Surveys show that older populations are willing to sacrifice in order to leave future generations better off; however, they lack authoritative information on the legacy effects of different policy choices. By providing this information, the GIS would enable legislators and the public to better align policy outcomes with stated intentions.
The potential for well-intended reforms to leave future generations worse off is large and growing. Reforms that are delayed or very gradually phased in will tend to affect later cohorts more than current ones. Meanwhile, in 2008, the first wave of baby boomers will enter a retirement that will last an average of 21 years. The typical member of this cohort has financial assets sufficient to replace barely one year’s pre-retirement income. On their current track, boomers will be more dependent on intergenerational transfers than any generation before them. Once they enter the retirement rolls, their neediness will provide a compelling rationale for exempting them from meaningful sacrifice.
The choices being forced upon us by population ageing and health cost growth will have profound intergenerational impacts. The inevitability of reform, and the important social principles at stake, mean that, no less than the environmental impact statement, the generational impact statement may be a policy tool whose time has come.
Paul S. Hewitt is Executive Director of Alliance for Generational Equity, www.age-usa.org
1 The 2007 Trustees Reports for Medicare and Social Security trust funds put the ‘infinite horizon’ liabilities for Part A of Medicare and Social Security at $27.5 trillion and $13.6 trillion, respectively. However, these estimates exclude Parts B and D of Medicare — which together are larger than Part A — and the federal portion of Medicaid — which provides long-term care — because these programs are financed out of general revenues rather than dedicated payroll taxes.
2 Leibfritz, W., Thornton, J. and Bibbee, A. (1977): “Taxation and Economic Performance”, OECD Economics Working Papers, No. 176, p. 49, See Paragraph No. 97, Paris, www.oecd.org/dataoecd/33/25/1863834.pdf.
Leibfritz, W., Thornton, J. and Bibbee, A. (1977): “Taxation and Economic Performance”, OECD Economics Working Papers, No. 176, p. 49, See Paragraph No. 97, Paris,
Tags: benefit promises, benefit reforms, generational contract, intergenerational impacts, lifetime consumption, political sustainability