Focussing on the Debt Molehill

As I noted in an earlier posting, the recent agreement that averted a debt default crisis is, in the grand scheme of Washington's fiscal future, completely meaningless.  Dr. Laurence Kotlikoff, an esteemed Professor of Economics from Boston University has shown that the debt situation in the United States is far worse than the $16 trillion plus headline figure and that, unless extreme measures are taken, the situation is unsolvable.

Dr. Kotlikoff uses what is termed "generational accounting" to identify the size of the unfunded future liabilities of the federal government.  This method of accounting, developed in the early 1990s, provides economists (and anyone else who cares to listen) a means of estimating prospective per capita lifetime net tax burdens after receipt of government-sourced income and benefits.  Prospective means that the fiscal tax burden is evaluated over the entire lifetime of a given cohort, net tax means that government transfers (i.e. entitlements) are subtracted from taxes and lifetime means that future dollar flows are discounted back to the present.  Using this method of accounting, economists can estimate how much future entitlements will cost and how much funding (i.e. tax revenue) will be required to fulfill those obligations in the future.  The difference between the two is termed the "fiscal gap" or the gap between revenues and expenditures over a long time frame.  In simpler terms, generational accounting measures the debt burden that is left by one generation for a future generation.  Obviously, all policy decisions made by governments today have an impact on generations to come; for example, here are three of the larger obligations that we will leave to future generations of Americans:

1.) The current debt net of assets plus interest owing on that debt.

2.) The cost of government benefits that have been promised to the elderly and the ill now and in the future.

3.) The present value of all future government purchases (discretionary spending).

The gap between these three obligations and the amount of revenue in taxes that Washington collects from current and future taxpayers is the dreaded fiscal gap.  Currently, the present value of the burden being passed along to future generations is far larger than the present value of their future labour income, suggesting that future generations will face twice the tax burden that those of us who are alive today are facing just to cover the fiscal gap.  What makes the situation dire is the fact that the number of Americans who will collect an average of $40,000 annually in entitlement benefits is expected to grow enormously over the next three decades as baby boomers reach their sunset years.

How big is this fiscal gap?  In 2011, Dr. Kotlikoff estimated that the fiscal gap was $222 trillion, nearly 12 times the current official intragovernment and external government debt.  It is also 12 times the nation's entire gross domestic product.  Here is a bar graph showing how the fiscal gap has grown over the past decade:

Here's a look at one of the key repercussions of the current fiscal situation on younger Americans.  A study by the IMF from 2010 looks at how severe this problem will be, a problem that, again, is exacerbated by the rapid growth in the older population, a group that utilizes more of the social safety net.  The study shows that those Americans that are currently older will receive far more in benefits than they paid in taxes as shown in this chart:

For example, the real net income (lifetime benefits received minus lifetime taxes paid) of a person who was 70 years old in 2010 was 305 (i.e. they receive far more in benefits than what they paid into the system in taxes over their lifetime) compared to only 19.6 for someone who was 25 in 2010 (i.e. they receive far less in benefits than what they paid into the system in taxes over their lifetime). 

Clearly, future generations of Americans will have painful choices to make.  They will have three choices, none of which is without pain (except the last which pretty much sums up what we're doing now):

1.) Pay more for their entitlements in the form of much higher taxes.

2.) Reform the size of government benefits (likely reducing them).

3.) Pass the burden along to future generations.

The generational imbalance between future revenue and future benefits is magnified by the recent drop in government revenues as taxation levels have dropped since 2001.  Because the drop in revenue is not being matched by a drop in spending, the cost will be redistributed from current to future generations.

Out of a sense of alarm, Dr. Kotlikoff and a host of Nobel Prize-winning economists created the INFORM or Intergenerational Financial Obligations Reform Act, a bipartisan piece of legislation that was designed to incorporate the concept of generational accounting and the fiscal gap into future laws.  By implementing this act, legislators would be forced to look at the impact of any legislation on the long-term fiscal imbalance, that is, think beyond the two/four year election cycle rather than kicking the can down the road as they are prone to do now.  Unfortunately, after being introduced as House Resolution 2976 on August 1, 2013, this is where the INFORM Act now lies:

I'd call that Dead On Arrival, wouldn't you?  According to Govtrack.us, there is a 23 percent chance that this breath of fiscal fresh air will get past the House Budget Committee stage and a measly 7 percent chance that it will actually be enacted.

Lastly and to put all things into perspective, here's a chart showing the size of spending cuts or revenue increases that will be required to eliminate the current fiscal gap:

You'll notice that the longer Congress waits to solve the country's fiscal illness, the more painful the cure becomes.  How would any taxpayer feel about a 55 percent increase in taxes now and forever?

When we hear about the never-ending debt and deficit negotiations in Washington, it's important that we put the whole situation into longer term context.  As you can see from this posting, the entirety of Congress and the President are tied up in knots, trying to flatten a fiscal molehill when, in fact, it is a fiscal mountain that is going to come back to haunt us all.