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Who Pays and When? An Assessment of Generational Accounting November 1995

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 ).

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.

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 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 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.
 

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. 
 

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.
 

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 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.⁽²⁾ Perhaps more surprising, 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 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.

The first policy would increase Social Security benefits by 20 percent and raise the payroll tax to payfor 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 middle-aged 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.

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? 

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