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The Government Debt Iceberg
By Jagadeesh Gokhale The Institute of Economic Affairs
Copyright © 2014 The Institute of Economic Affairs
All rights reserved.
ISBN: 978-0-255-36698-4
CHAPTER 1
INTRODUCTION
Why we need forward-looking measures of government finances
The government's official budget accounts in most developed countries are constructed almost exclusively in terms of current cash flows – mainly government spending and receipts from taxes. In some countries there are exceptions to this. For example, in the US, official budget figures also account for the accrued values of government employee pensions and obligations from past contractual agreements for construction, defence procurement and the like. However, in many other countries – including the UK – even these items are excluded from the headline government debt numbers. As such, the government's borrowing requirement is mostly made up of the difference between current cash inflows and outgoings, although adjustments are sometimes made depending on the debt financing mechanisms in place in the country concerned. A country's national debt is, in effect, the accumulation of all the historical budget deficits. It is therefore almost entirely a backward-looking measure and does not take any account of several major future unfunded payment commitments that modern welfare states make to a country's citizens.
Sometimes it is argued that a government does not need to account for its future financial commitments because it has the power to tax future citizens to meet them, whereas limited liability companies, for example, do not have the power to extract additional funds from their investors. However, this does not mean that it is not important to have measures of a government's financial situation that look forward and demonstrate the level of future spending commitments that cannot be funded by taxes under current policies. After all, it may not be possible for a government to meet its future spending commitments if taxes cannot be raised sufficiently to meet them. Electors, and those who inform them, need to know this. They need to know whether a government can meet all of its future commitments and, if not, what policy actions could be taken. Such policy action would normally involve some combination of reneging on explicit debt, reneging on expenditure commitments to pay social benefits, provide health care and so on, and raising taxes. It is worth noting that particular substantial commitments (such as general retiree pensions and health benefits) may be politically very difficult to roll back. The public needs to know about these policy choices.
International policies that use measures of indebtedness also use backward-looking measures. The European Stability and Growth pact, for example, judges the fiscal probity of a country according to its cash-flow deficit and accumulated historical debt. Future spending commitments are not taken into account at all.
The inter-generational tensions
Comprehensive measurement of a government's long-term fiscal condition began more than two decades ago. The practical measurement of the fiscal condition, especially in the United States and Europe, followed the theoretical work of Martin Feldstein and others, who pointed out that pay-as-you-go public pension and health programmes usually cause substantial wealth redistributions across generations (see Feldstein 1974). Those redistributions occur because the first generation to retire receives windfall benefits despite not having had a history of Social Security or national insurance tax payments when working. Future generations then have benefits promised to them which will be financed by the taxes of still later generations. As the demography of a country changes, the obligations to the older generations can become greater than the taxes that will be levied on future working generations unless there are increases in tax rates.
Redistribution between generations also occurs because the provision of social insurance benefits such as pensions and health services to retired generations induces earlier retirement and higher consumption, which reduces national output, saving and bequests to younger generations (see Auerbach et al. 2001). Consumption is encouraged because it is not necessary for people to save to meet future pensions and health costs and insure against unexpected longevity. Earlier retirement is also encouraged because the individual does not incur the full cost of retiring earlier. The ancillary negative effects on capital formation, labour productivity and inheritances can therefore further impoverish younger and future generations.
These inter-generational economic effects of state pay-as-you-go pension and health-care programmes become stronger if retiree pension and health insurance programmes become more generous over time. This has occurred in both the US and Europe since World War II. This period saw frequent increases in pension benefits, the protection of benefits against inflation, the addition of new health and retirement support programmes and their extension to new population groups among older individuals, their dependants and survivors. The pattern is different in different countries but the general tenor of developments has been the same. Developed countries also experienced an almost two-decade-long baby-boom followed by a 'baby-bust' during the immediate postwar period, creating a large age cohort (the 'boomers') that is now approaching and entering retirement. With significantly faster growth of retiree cohorts compared with younger workers, these countries are now facing significant resource shortfalls when trying to maintain current pension and health commitments to retirees. Meeting the payment obligations will require much higher and economically debilitating taxes on younger generations.
Government-induced wealth redistributions between the generations are also implicit in other government tax and spending programmes. For example, switching taxes from wages to consumption, as has happened in many countries, in a revenue-neutral manner redistributes resources from older to younger generations. The deferment of tax payments by younger generations creates a wealth windfall, whereas the imposition of additional taxes on older generations' consumption leads to a loss. Another example is the recent introduction of Obamacare in the United States, where younger, healthier persons are being forced to purchase health insurance at actuarially unfair annual premiums so that health insurance coverage can be extended at lower than actuarially fair premiums to older and sicker, but hitherto uninsured, individuals. Decisions on whether to increase spending on (for example) education, provide tax relief on mortgages, and so on, also have distributional implications across generations. However, many such policies, especially pay-as-you-go pension and health obligations, are difficult to reverse because a promise has been made to future recipients of the benefit who may well choose, as a result, not to make any provision from their own resources.
The extent of government indebtedness
How large are ongoing wealth redistributions and how would they change if and when the government engages in policy reforms? Making such estimates is not without pitfalls, but approximations can be obtained by combining micro-data survey information with official budget projections to estimate lifetime taxes, transfers and public benefits for different birth (or age) cohorts. Such a reorganisation of government budget information can be used to construct fiscal and generational imbalance metrics and generational accounts, which indicate the magnitudes involved. This research monograph reports fiscal imbalances for the US and Europe calculated using official government projections of budget aggregates and micro-data survey information on how those tax and spending items are distributed across the population by age and gender.
The monograph begins by sketching out the fiscal environment in the US and Europe. The concept of inter-generational accounting is then introduced and explained. After examining and quantifying the long-term fiscal problems of the US and the contribution of recent expansions of Medicare to the fiscal imbalances, alternative policy responses are examined and the current US budget debate discussed in the context of the likely implications for future generations. After discussing the policy choices faced by the US, there is then an examination of the long-term fiscal situation in European Union countries.
For the United States, this monograph reports fiscal and generational imbalance measures and generational accounts based on the Congressional Budget Office's (CBO) March 2012 Budget Outlook Update. It finds that the fiscal imbalance embedded in the federal government's current law or baseline policies amounts to 5.4 per cent of the present value of future US GDP, or 11.7 per cent of the present value of future payrolls. However, in the past, the US government has tended to follow a less fiscally prudent pathway than that which is planned or required by existing law, for example, by not reducing spending or ending tax exemptions. For this reason, the CBO presents a more realistic alternative fiscal scenario. This suggests a federal fiscal imbalance of 9.0 per cent of the present value of all future US GDP or 19.7 per cent of the present value of US payrolls. The US fiscal imbalance is about seven times the total national debt held by the public. In other words, if current unfunded spending commitments to future generations of older people are included, the underlying national indebtedness of the US government is seven times the published figure – hence the title of this monograph, only about one seventh of the US government debt is visible to the electorate.
Measurements of fiscal imbalances are also provided for 25 European Union countries. The average fiscal imbalance in the EU is 13.5 per cent of the present value of GDP. The UK's fiscal imbalance stands at 13.6 percent, which is slightly above the EU average. Four countries – Sweden, Cyprus, Luxembourg and Estonia – have fiscal imbalances less than 8 per cent. The average fiscal imbalance in the EU translates into a 23.2 percentage point increase in the consumption tax rate if taxes are going to fully finance spending, assuming that such a rise is feasible. Alternatively, the fiscal imbalance could be closed by reducing health and social protection expenditure by about 50 per cent. In the UK, total spending would have to be cut by more than one quarter, or health and social protection expenditure by around one half compared with the level implied by current policy if all future spending is to be met through taxation under current policies. The earlier that the US and EU governments implement corrective budget policies, the better will the affected generations be able to prepare for their future economic needs and security.
It is often suggested that countries can inflate their way out of these problems. This is unlikely. Future pay-as-you-go social insurance obligations are generally price index-linked (at least) and health care involves the provision of a set of services. It is unlikely that countries will be able to grow their way out of their implicit debts either. Instead, countries will need to rein in their spending commitments and programmes if they are to avoid huge increases in taxes. Indeed, prior action to reduce unfunded – and likely unpayable – government social spending commitments may be an important precondition for improving policy stability and credibility, reigniting market confidence and triggering faster rates of sustainable economic growth. As a precursor to this, government accounting for future social insurance obligations needs to be undertaken in a much more transparent way than currently. This monograph shows how this can be done. It also indicates the policy choices that will face governments over the difficult decades ahead for public finances across the developed world.
CHAPTER 2
THE FISCAL ENVIRONMENT IN EUROPE AND THE UNITED STATES
Europe and the United States will soon begin to encounter fiscal constraints the like of which we have never seen before. In the United States, federal debt as a percentage of GDP has increased rapidly during the last few years, from 57 per cent in 2000 to well over 100 per cent by 2012. According to the US Congressional Budget Office's (CBO) latest long-term projections, total national debt is expected to remain close to 100 per cent of GDP during the next decade and begin to increase thereafter as the baby-boomers fully enter retirement and health and old-age security expenditures outpace federal revenues. Debt levels in European Union countries have surged similarly, from 60 per cent of GDP during the mid 2000s to 85 per cent of GDP today (see Figures 1 and 2). The upward march of government debt levels has continued unabated during the last decade among major EU nations: by 2012, general government debt had reached 90 per cent of GDP in the United Kingdom and France, 82 per cent in Germany, 84 per cent in Spain, and exceeded well over 100 per cent in Ireland, Greece, Italy and Portugal.
Much of the increase in explicit debt in Europe and the United States has been attributed to the Great recession. Increases in debt-to-GDP ratios were caused by large government stimulus and war spending in the United States as well as a decline followed by a slow recovery in economic growth. In several European Union countries, the debts built up in private institutions in the banking crisis were assumed by the government through bailouts. Other countries, such as Greece and Italy, faced problems because of profligate public sector spending triggered, at least in part, by easy credit availability in the euro single currency system.
Restoring both public and private sector debt to lower levels is likely to be a slow process because restoring and recycling impaired bank assets and market confidence takes time. The restoration of private sector financial balance sheets is already underway in the United States. In Europe, stalled discussion about the terms for a new banking union and rules for resolving existing impaired bank balance sheets mean that a similar recovery in the private financial sector may take longer to accomplish. In both regions, however, reducing public sector debt to the pre2000 level is likely to pose much more serious challenges. That is because explicit debt constitutes only the tip of the 'indebtedness iceberg' that most major EU nations and the United States must resolve. This monograph concerns what lies below sea level when it comes to debt, its measurement and the trade-offs in terms of policy choices involved in resolving the problem. The approach taken in reducing national indebtedness will largely determine the future economic environments in Europe and the United States, that is whether they will remain conducive to output growth and advancing living standards in both regions.
The fiscal background in the euro zone
The EU's fiscal and economic crisis has now lasted for more than three years and does not appear to be nearing a resolution. It has focused policymakers' attention on short-term measures: debt restructuring and bailouts to support fiscally over-extended countries such as Ireland, Portugal, Greece and Spain, and budget consolidations for restoring the short-term solvency of government finances. Most of the focus is on short-term fiscal objectives and measures that are intended to strengthen the European Stability and Growth Pact's criteria and enforcement mechanisms that, so far, have not functioned as expected.
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Excerpted from The Government Debt Iceberg by Jagadeesh Gokhale. Copyright © 2014 The Institute of Economic Affairs. Excerpted by permission of The Institute of Economic Affairs.
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