THE GENERATION GAME: CAN WE AFFORD PLANNED PUBLIC SPENDING?

Can we afford our planned public spending on pensions, health and education over the long run? One way of trying to find out is a new economic technique called 'Generational Accounting'. Pioneered by American economists Alan Auerbach and Laurence Kotlikoff and now applied to the UK economy by researchers at the National Institute of Economic and Social Research (NIESR), generational accounting measures the burden that current fiscal policies are likely to impose on future generations. It also identifies the set of policy reforms needed to achieve 'generational balance' - a situation in which future generations face the same lifetime net tax rates as current generations.

The first ever set of generational accounts for the UK is published in the latest issue of the Economic Journal in a study by Roberto Cardarelli, James Sefton and Laurence Kotlikoff. The results suggest that there is a relatively modest imbalance between the generations with current generations being subsidised by future generations. An increase in tax revenue (or a cut in spending) of £5 billion would close the generational imbalance.

The central premise of generational accounting is that the current budget deficit is not a good indicator of the real fiscal position. For example, if pensions are generous and the number of retired people will surge, then the position is unsustainable and future taxes will have to be higher. Generational accounting estimates the sustainability of a country's public finances by calculating the present value of all future expenditure and comparing it to the present value of all future tax returns. If expected spending exceeds expected revenues, then future generations will face higher taxes or lower spending.

With the assistance of HM Treasury and other government departments, the NIESR team has developed generational accounts for the UK. The main conclusion if this analysis is that without restraint in future government purchases or increases in the net tax payments of current British adults, future British children could well face higher lifetime net tax rates than their parents now face. The main problem is the UK's ageing population, which will push up the bill for pensions and health care in the future. But the promotion of private funded pensions means that the UK's problems are small in comparison with other industrialised countries such as the United States, Germany, France and Japan.

Of course, any assessment of the future has to make assumptions about the course of future government policy. The authors calculate generational accounts based on two possible future scenarios, both of which assume that productivity growth averages 1.75% per annum and interest rates are 5%:

Baseline Policy: this represents the authors' sense of current government policy and is marked by fiscal restraint and prudence. It assumes that social benefits, including pensions, are linked to price inflation and that there will be a slowdown in the growth of health care spending per beneficiary. The projections of government spending are based on the Government Actuary Department's projections.
Looser Policy: Under this scenario, the government is slightly less frugal. Here, pensions and other social benefits are linked to wage inflation and health care spending is increased in line with the Prime Minister's January 2000 announcement of his ambition to match the European average by 2005.
Under the baseline policy, generational balance can be achieved with a rise in income tax revenues of 5.7% - equivalent to an extra £5 billion in revenue or about a 2p increase in the basic rate of income tax. A cut in government spending of £5 billion would also balance the tax burden between generations. Alternatively, the imbalance would be completely eliminated if productivity growth averaged 2% per annum instead of 1.75%. If the government were to implement these changes immediately, the national debt to GDP ratio would fall from its current level of about 40% of GDP to below 10% of GDP by 2020 before rising again to about 40% of GDP by 2050.

Hence, the optimal policy is to pay off current debt before the dependency ratio - the percentage of working people to retired people - starts to rise in 2020, so that during the subsequent ageing of the population, the government can meet some of the increase in spending from borrowing. However, current government policy, as outlined by its Code for Fiscal Stability, is to maintain a constant national debt to GDP ratio.

Under the looser policy, because current generations pay less in net taxes (due to increased benefits), there is a larger fiscal bill left for future generations to pay. In this case, achieving generational balance would require much stronger reforms: either a substantial sustained cut in non-education and non-health government spending or an equally substantial increase in income tax revenues and a corresponding increase in social security contributions. The authors estimate that under this scenario, the tax increase should constitute a rise in income tax revenues of 31.3% and a rise in social security contributions of 46.1%.

For more information go to: www.generationalaccounting.com

Note for Editors: 'Generational Accounting in the UK' by Roberto Cardarelli, James Sefton and Laurence Kotlikoff is published in the November 2000 issue of the Economic Journal. Cardarelli and Sefton are at the National Institute of Economic and Social Research (NIESR); Kotlikoff is at Boston University. The conclusions are those of the researchers and not those of any government departments.

For Further Information: contact James Sefton on 020-7654-1931 (email: jsefton@niesr.ac.uk); RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com); or RES Media Assistant Niall Flynn on 020-7878-2919 (email: nflynn@cepr.org).