Is War Between Generations Inevitable?

Policy Reports | Social Security

No. 246
Friday, November 30, 2001
by Jagadeesh Gokhale and Laurence J. Kotlikoff

Generational Accounting

Table I - The Composition of Male Generational Accounts

"Generational accounts tell us how much citizens in each age group will pay toward the cost of government."

Generational accounts are present value measures. They represent the sum of the present values of the future net taxes citizens at each age can expect to pay over their remaining lifetimes, given current policy. In this context, "net taxes" are defined as taxes paid minus any transfer payments the taxpayers receive. These generational accounts tell us how much citizens in each age group will pay toward the cost of government, disregarding those programs that redistribute resources from one group to another. The cost of government refers to the present value sum of all of the government's future purchases of goods and services plus its official net debt; that is, its official financial liabilities minus its official financial assets, including the value of its public-sector enterprises. Obviously, bills not paid by current generations must be paid by future generations.7

Generational Accounts of People Alive Today. Tables I and II report a new set of generational accounts that take into account the 2001 tax cut and assume that federal discretionary spending grows with the economy. The accounts were constructed using a 4.0 percent real discount rate and assuming a 2.2 percent rate of growth of labor productivity. The discount rate is roughly the current prevailing rate on long-term inflation-indexed U.S. government bonds. The productivity growth rate, while rather high relative to the past quarter-century's experience, is the one currently projected by the CBO. The accounts are present values discounted to 2000. They incorporate the CBO's latest short- and long-term projections (apart from the adjustment for discretionary spending growth) as well as the JCT's estimates of the implications of the tax cut.

"A 65-year-old male can expect a net gain of about $71,000 from government over the rest of his life."

Table I shows the level and composition of the accounts for males. These figures are averages. They take into account the fact that some members of each cohort will pay more and others will pay less in net taxes. They are also actuarial averages, reflecting the fact that some cohort members will die earlier than others. As the table shows:

  • A male reaching 65 years of age today can expect to receive about $143,000 in benefits from Social Security and about $73,000 in benefits from Medicare by the time he dies.
  • Since he is retired or about to retire, payroll taxes and income taxes on wage income will be small from here on out, but by the time he dies he can expect to pay $41,000 in sales taxes (through consumption expenditures) and more than twice that in income taxes on his pension and investment income.
  • From all government programs, this individual can expect to receive $237,900 in transfer benefits over the rest of his life and pay $166,700 in taxes.
  • Thus his expected net gain from interacting with the government for the rest of his life is about $71,000 in present value terms.

"A 20-year-old male can expect a lifetime net loss of $312,000 from interaction with government."

A representative female at age 65 can expect less in Social Security benefits, but more from Medicare and Medicaid. [See Table II.] The reason: her lower average wages produce smaller monthly checks from Social Security, but because she is expected to live more years than a representative male, she will make greater use of the health care system. Like her male cohort, her primary taxes will be sales taxes on consumption spending and income taxes on her pension and investment income. But since the average female has accumulated less capital, taxes on her capital income are much less than for the male. All told:

Table II - The Composition of Female Generational Accounts
  • A 65-year-old female can expect to pay $85,500 in taxes for the remainder of her life, while receiving $248,000 in transfer benefits.
  • Thus her expected gain from interacting with the government is about $163,000 in present value terms, more than twice the gain for her male cohort.

"The older one is, the better the deal one can expect in transacting with government."

A very different picture confronts young people who are entering the labor market today. In present value terms, the expected benefits from Social Security and Medicare are much lower and expected taxes much higher than for those nearing their retirement years. Specifically,

  • A 20-year-old female can expect to pay $320,600 in taxes for the remainder of her life, while receiving $229,000 in transfer benefits.
  • On balance, she can expect to lose almost $92,000 through her interactions with government.
  • A 20-year-old male can expect about the same transfer benefits as his female cohort, but will pay significantly more in taxes - $518,600 by the time he dies.
  • On balance, a male worker entering the labor market today can expect to pay $312,000 more in taxes than he will receive in benefits over his lifetime - more than three times the loss expected by his female cohort.

In general, the tables show that women at all ages can expect to do significantly better in their relationship with government than will men. But a more dominant feature of the tables is the divergent interests of the young and the old.

"Women of all ages can expect to do better than men in their relationship with government."

Generational Differences. The net present values for males and females at different ages are shown in Figures I and II. In general, the figures show that the older one is, the better the deal one can expect in transacting with government. Moreover, at about age 45 for females and age 60 for males people switch from being net losers in their relationship with the state to net winners. Note, however, that the losses for those younger than age 25 become smaller the younger one is because more years are discounted before the individuals reach their peak taxpaying years. [See Tables I and II.] The accounts also become smaller for those beyond age 65 for women and age 70 for men. As the expected remaining years of life diminish, so do the expected benefits from transfer programs.

The most striking feature of Tables I and II and Figures I and II is the divergence in economic interests of the young and the old. Measured only in dollars and cents, the young would gain enormously if government transfer schemes were abolished altogether. Short of that, they have an economic interest in limiting the size of elderly entitlement programs and the taxes they pay to support them. The elderly have exactly the opposite economic interests. They gain from the expansion of elderly entitlement programs, even if they must pay somewhat higher taxes to support the expansion.

Another interesting feature of Tables I and II is how Medicare will grow relative to Social Security:

  • Today's 20-year-olds can expect to receive more in Medicare benefits than they will receive in Social Security benefits over the course of a lifetime.
  • Despite that fact, their current Social Security payroll tax rate is more than four times the tax rate for Medicare.
Figure I - U.S. Males Present Value of Future Taxes Minus Benefits from All Transfer Programs

"Our policies today will force future taxpayers to bear a burden more than twice as great as our own children."

People Alive Today vs. People Not Yet Born. Many scholars have noted that seniors on Social Security are receiving benefits far in excess of what they paid in Social Security payroll taxes. That assessment also applies to Medicare. In this sense, today's retirees did not pay their own way. They shifted much of the burden of their benefits to younger workers.

But what about everyone alive today? As a group, are we paying our own way? Or are we shifting the cost of our benefits to taxpayers not yet born? One way to answer these questions is to consider a child born today:

  • If we take the present value of expected taxes minus expected transfer benefits for a newborn and divide by the newborn's expected lifetime income, we have a measure of the child's lifetime contribution to the cost of government.
  • The lifetime tax rate for today's newborn's is 17.7 percent of income.

How does that compare to the expected lifetime tax for future newborns? One way to answer this question is to assume for the moment that we could even out the tax burden for all future generations so that every age group not yet born would face the same lifetime tax rate. The results are as follows:

  • Whereas the lifetime net tax rate for today's newborn is 17.7 percent, the average lifetime tax rate for all future newborns is 35.8 percent.
  • On the average, our policies today will force future taxpayers to bear a burden more than twice as great as the one our own children will bear!
Figure II - U.S. Females Present Value of Future Taxes Minus Benefits from All Transfer Programs

"With no change in policy, in 20 years taxpayers will face lifetime tax rates of 63 percent."

Keep in mind that the above comparison assumes that all future generations pay this same net tax rate. If instead one assumes no change in policy for the next couple of generations, the net tax rate for generations born later on will escalate rapidly. [See Figure III.] For example:

  • If there is no change in elderly entitlement programs for the next five years, the net tax burden on all future generations combined will climb to 40 percent of their lifetime income.
  • With no change in policy for 10 years, the lifetime net tax rate for future generations will reach 46 percent.
  • After 20 years of no change in policy, future taxpayers will face lifetime tax rates of 63 percent.

Clearly we are on an unsustainable path.

The comparison of the generational accounts of current newborns and the accounts of future newborns provides a precise measure of generational imbalance. The accounts of these two sets of parties are directly comparable because they involve net taxes over entire lifetimes. If future generations face, on a growth-adjusted basis, higher net tax rates than do current newborns, current policy is not only generationally imbalanced, it's also unsustainable.

Figure III - Lifetime Net Tax Rates for Future Generations

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