Unfunded Obligation Measures for EU Countries. Jagadeesh Gokhale Senior Fellow Cato Institute Washington D.C. September 10, 2006

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1 Unfunded Obligaion Measures for EU Counries by Jagadeesh Gokhale Senior Fellow Cao Insiue Washingon D.C. Sepember 10, 2006 Preliminary Draf No for Quoaion This paper was prepared for a workshop on fiscal susainabiliy measures sponsored by he European Commission s Direcorae General for Economic and Financial Affairs, Brussels, Belgium, Sepember 22, The auhor hanks Joao Nogueira-Marins, William Niskanen, and Peer Vandoren for helpful discussions during he preparaion of his manuscrip and Joanne Fung for excellen research assisance. Use of daa from Eurosa and he UK s Economic and Social Daa Service is hereby acknowledged. All opinions expressed herein are hose of he auhor and no necessarily hose of he Cao Insiue.

2 1. Inroducion Europe is undergoing wo major ransiions demographic and economic. Firs, he populaions of many European economies are aging rapidly as heir baby-boom generaions approach and ener reiremen, human longeviy coninues o increase, and feriliy raes remain well below replacemen. Second, welve European counries have joined in a moneary union (EMU) by adoping he Euro as a common currency and more counries are o join he EMU during he nex few years. The objecive of moneary union is o eliminae exchange rae risks and sreamline produc pricing and price comparisons across similar goods and services across member naions o induce greaer compeiive efficiencies. Enering a moneary union implies surrendering conrol over moneary policymaking bu all curren and prospecive EMU naions would reain sovereigny in seing fiscal policies. Boh ransiions will place remendous bu conflicing pressures on member naions domesic naional budges. Decision makers will face growing demands o increase public expendiures and fulfill promises of reiremen and healh care benefis o reirees precisely when growh in labor forces and ax bases slows. Tha poins oward larger fuure fiscal deficis and growing deb levels. A he same ime, fiscal policymakers will face srong pressures from he EMU club o mainain low deficis o preven increases in ineres raes and mainain European invesmen levels. Exercising proper economic sewardship during hese win ransiions will become more difficul if policymakers remain poorly informed abou he likely consequences of making alernaive policy choices.

3 To sreamline he process of moneary union, prospecive EMU member counries adoped he Sabiliy and Growh Pac in 1997 (SGP-97). Along wih he Treay of he European Union, SGP-97 provided he framework of rules for coordinaing fiscal policies across EMU members boh curren and prospecive ones. I was presumed ha wihou such coordinaion, member saes would have sronger incenives o follow shorsighed fiscal policies causing chronic budge deficis and higher deb-o-gdp raios. If carried oo far, such policies would erode European Cenral Bank s abiliy o mainain he Euro s purchasing power and neuralize he advanages of esablishing a moneary union. Beginning in 2002, however, he SGP-97 s defici and deb consrains and is prevenive and correcive mechanisms proved unaccepable. 1 SGP-97 called for correcive fiscal policies o be adoped if a breach of deficis or deb limis appeared imminen regardless of he member naion s posiion in he business cycle and poenial for GDP growh. A revised Sabiliy and Growh Pac is now in effec since March 2005 (SGP-05) incorporaing consrains and objecives (ime pahs of fuure deficis and deb) ailored o he economic condiions ha each member counry is faced wih. The revised agreemen inroduces greaer flexibiliy in implemening he SGP s consrains and allows implemenaion of prevenive and correcive mechanisms o be deferred in case a member counry faces emporary economic difficulies. Some observers conend, however, ha alhough SGP-05 coninues o define consrains in erms of radiional defici and deb-o-gdp levels, i really represens an abandonmen of hose consrains [Feldsein (2006) and Wiers e al (2006)]. If heir view is correc, i would consiue good news. This paper s hesis is ha radiional fiscal measures 1 The defici consrain requires each member sae o mainain annual deficis a 3 percen of GDP or less. Each member sae is also required o mainain a oal deb-o-gdp raio of 60 percen or less. These consrains were specified in he original Maasrich reay of he European Union. 3

4 annual deficis and deb-o-gdp levels are boh poenially misleading indicaors of a counry s fiscal sance. The SGP also calls for he developmen of long-erm fiscal indicaors for policy surveillance of member counries. This effor should consider recenly developed fiscal measures ha are heoreically sound and policy-relevan. They would beer inform EU policymakers of he condiion of each member counry s curren fiscal sance and provide a basis for an apples-o-apples comparison of he policy opions and rade-offs ha each counry faces. This paper firs addresses issues relaing o he proper accouning and reporing of he governmen s ne prospecive paymen obligaions. I compares alernaive long-erm measures of a counry s fiscal sance and discusses heir heoreical soundness, applicabiliy o budge reporing, and abiliy o reveal informaion relevan o he rue economic choices ha policymakers face. Four ypes of measures are considered -- radiional defici and deb measures, accrual accouning measures, and wo measures based on acuarial accouning. The laer include Generaional Accouning and Fiscal and Generaional Imbalance measures. The paper argues for he adopion of Fiscal and Generaional Imbalances by inegraing hese measures ino exising counry budge repors. The paper provides brief examples of how Fiscal- and Generaional-Imbalance measures could help policymakers o define he feasible se of policy choices and he rade-offs involved in selecing from among hem. This paper also aemps o quanify he size of he long-erm fiscal challenges confroning EU counries by reporing esimaes of Fiscal Imbalances for 23 EU 4

5 counries. The FI esimaes sugges sizable gap beween he fiscal shorfalls repored under radiional backward-looking deb and defici measures and hose implied by forward-looking Fiscal Imbalance measures. The paper concludes by suggesing ha European counries need o underake a hird ransiion o sep back from he curren broad provision of social insurances and allow greaer scope for individual deerminaion and privae provision of hese services. Inroducing his imporan elemen in srucural reforms by encouraging significan reducions in public spending commimens appears o be he only economically feasible way of addressing fuure fiscal challenges. The alernaive of furher increasing axes and imposing addiional regulaory resricions on member counries o preserve he saus quo in social proecion programs likely o prove counerproducive. 2. Unfunded Obligaion Measures Concern abou fiscal susainabiliy arising ou of he curren demographic srucure among developed counries has spurred ineres in developing forward-looking measures of fiscal policy. Several alernaives exis for depicing he fuure course of federal budge balances. The firs and mos obvious measure is a projecion of fuure oal governmen revenues, expendiures, and he annual gap beween he wo. Alhough fuure projecions of his ype are repored in he official budges of many counries, he projecions are usually limied o he nex 5 or 10 years. For example, he annual budge repors of he UK Treasury repor (HM Treasury, 2006) adop a 5-year ime horizon 5

6 wih he horizon advancing by 1 year every year. The same is rue of he official budge repors of many oher EU counries. 2 Given he obvious inadequacy of such shor-erm budge projecions for designing long-erm policy reforms, several measures have been proposed by budge praciioners and academic economiss. They include (1) simply exending he ime horizon of radiional defici and deb measures, (2) accrual accouning, (3) generaional accouning, and (4) fiscal and generaional imbalances. This secion provides a discussion of heir srenghs and weaknesses. A. Tradiional Measures Governmen Deficis and Deb Tradiional shor-erm defici and deb measures of he naional fiscal sance are grounded in Keynesian macroeconomic heory ha considers he gap beween revenues and expendiures as providing a fiscal impulse ha could be calibraed for macroeconomic sabilizaion over business cycle ime horizons. Given he naure of welfare programs and he wide prevalence of progressive income axaion, annual budge deficis naurally move couner-cyclically. Discreionary elemens of revenues and expendiures could be used, however, o enhance hese couner-cyclical movemens o yield even larger macroeconomic impulses o dampen business cycles and sabilize he pace economic aciviy and growh. A large and growing lieraure has aemped o measure he economic impulses from discreionary fiscal policy using annual deficis as he key measure of fiscal impulses provided by governmen policies [Gali and Peroi (2003), Alesina and Peroi (1995)]. 2 See federal budge repors, for example, Danmark Naional Bank (2005), General Adminisraion of he Treasury, Kingdom of Belgium (2005), Minisry of Finance, Sweden (2005) and of several oher EU counries. 6

7 Fiscal policymakers and budge praciioners have an abiding ineres in mainaining hese definiions and ools for exercising shor-erm operaional conrol over governmen budges. Hence, if shor-horizon fiscal measures prove inadequae for analyzing long-erm fiscal susainabiliy and srucural reform issues, he simples soluion is o exend he ime horizon over which radiional deficis and deb are projeced. Thus, one proposal is o projec and repor governmen revenues, expendiures, and surplus/deficis over he nex 50 or 75 years under alernaive economic and demographic assumpions. These measures can be calculaed for boh he general governmen as a whole and for sub-programs ha are financed ou of dedicaed revenues such as reiremen and healh programs. B. Accrual Accouning Measures For mos EU counries, he fuure oulay increases on reiremen and healh benefis ha will pu upward pressure on deficis are already buil ino fiscal sysems. Hence, curren evaluaions of he fiscal sance should explicily recognize hose coss -- as addiional deb. One way of doing so is o adop accrual accouning o add up fuure obligaions ne of asses o calculae unfunded accrued obligaions. Accrual accouning considers he governmen s financial obligaions and asses ha have been earned or booked based on evens ha have occurred hrough he curren period wheher or no he funds associaed wih hose evens have as ye been paid or received. In he conex of governmen finances, here could be considerable uncerainy (and conroversy) abou wha consiues an obligaion-riggering even. A common example is ha of public pension programs ha link benefis payable in he fuure o 7

8 curren or pas labor-force paricipaion, earnings, or ax paymens. However, when social ransfers scheduled under oday s laws may be changed by changing hose laws in he fuure, i remains unclear wheher pas employmen, ax paymens ec. are by hemselves sufficien o rigger fuure benefis and, herefore, wheher hose pas evens jusify including curren-law obligaions as unfunded accrued obligaions. This problem could be resolved by disinguishing beween he informaionprovision role of budge measures from he liabiliy recogniion funcion usually associaed wih budge accouning and reporing. Fulfilling he former need no imply he laer and his difference could be clearly communicaed as well. The objecive under he former would be o characerize he sance of curren fiscal policy wihou implying any addiional recogniion of liabiliies ha are on par wih ousanding explici deb. Hence, as a budge measures, he inclusion of accrued obligaions in accouning for he governmen s financial condiion would reflec he implicaions of exising policies. Under his assumpion, if mainaining curren policies would resul in fuure benefi paymens given pas riggering-evens, hose accruals should be included in measuring he governmen s oal obligaions. Similarly, evens ha would rigger larger fuure governmen receips under oday s policies would increase he governmen s oal asses. Some governmen programs may already be using accrual accouning o evaluae he budge coss of loans and loan-guaranees, insurance and underwriing coss ec. And several developed counries have adoped accrual accouning for heir governmen budges alhough only a couple of counries have adoped i in a 8

9 comprehensive manner (New Zealand and Sweden). 3 Accrual accouning could be broadly applied o public pension and oher programs ha cause larger governmen obligaions bu are excluded from radiional deb and defici measures. C. Generaional Accouning Generaional accouning uses acuarial calculaions and reorganizes governmen budge informaion o reveal he implicaions of curren fiscal policies along generaional lines (Auerbach, Gokhale, and Kolikoff (1991, 1994). Generaional accouning is moivaed by he life-cycle economic paradigm which posis ha raional agens curren economic decisions (consumpion and labor-supply) are based on a forward looking evaluaion of heir lifeime resources. Those resources are influenced by many facors including agens posiions in heir life cycles and heir curren and expeced fuure financial ransacions wih governmen. Tha makes i imporan o measure he exen and direcion of fiscally engineered redisribuion of resources across agens siuaed in differen life-cycle sages, and generaional accouning implemens such a measuremen. 4 Generaional accouning also analyzes he long-erm susainabiliy of curren fiscal policy by considering he governmen s ineremporal budge consrain from an 3 For example, New Zealand applies accrual accouning o is budge process and fiscal managemen, adhering o he sandard principles of generally acceped accouning pracice (Richardson, 1996); Canadian provincial governmens shifed from cash o accrual accouning mehods during he 1980s (Hiller 1996); Germany s Länder have insiued pilo programs o explore new budge accouning convenions including accrual based budgeing (Lüder, 2002); Sweden has inroduced accrual accouning and reporing wihou exending he same o is appropriaions process (Swedish Naional Financial Auhoriy, 2001); he Unied Kingdom adops accrual accouning for governmen agencies and is exending such accouning o broader governmen operaions in sages (Inernaional Federaion of Accounans, 1995). Recen changes inroduced by he Governmen Accouning Sandards Board (GASB) require sae governmens in he Unied Saes o repor oher pos-employmen benefis (which include healh care benefis) under accrual accouning. 4 Ricardian moives ha effecively exend he ime horizon beyond one s own lifeime are found o be empirically inoperaive a leas in he case of he Unied Saes. Lile research exiss on his issue in he European conex. 9

10 ex-pos perspecive. Allowing PV_P c o represen he presen value of oal governmen purchases of fuure public goods under curren policies (subscriped by c), PV_L c o represen he oal presen value of prospecive lifeime ne ax paymens (ax paymens minus ransfer receips) by living generaions under curren policies, PV_F h o represen he oal lifeime ne axes of fuure-born generaions under a hypoheical policy (subscriped by h) for achieving budge balance, and NW c o represen he governmen s curren financial ne wealh, he governmen s ex-pos ineremporal budge consrain can be specified as: (1) PV_P c NW c + PV_L c + PV_F h Equaion (1) says ha ex-pos ha is, considering all paymens under concurren policies curren ones (denoed by c) for living generaions and fuure hypoheical ones (denoed by h) for fuure generaions he governmen s ineremporal budge consrain mus be balanced -- by consrucion. Here, his approach is called ex-pos because he consrain is closed by imposing he paricular (hypoheical) fiscal reamen of fuure generaions ha delivers a balanced ineremporal governmen budge. I should be noed ha he objecive of his exercise is o discover which hypoheical policies mus be imposed on fuure generaions o deliver ex-pos budge balance. Presen values are calculaed by using an ineres rae reflecing privae agens (average) opporuniy cos of invesmen. The presen value of all fuure governmen purchases, PV_P c, minus he presen value of fuure ne ax paymens by living generaions, PV_L c and minus he governmen s curren financial ne wealh, NW c, yields a residual unfunded obligaion ha fuure generaions mus pay. Curren policies imply a lifeime ne ax rae on curren 10

11 newborns given heir projeced lifeime (presen valued) earnings. Earnings projecions are made using an assumed rae of labor-produciviy growh. If he residual unfunded obligaion is imposed exclusively on fuure generaions, hey imply a per-capia lifeime ne ax rae assuming he same labor-produciviy and earnings growh coninues hroughou he fuure. Curren fiscal policy is considered o be balanced and susainable if, given (1) governmen spending projecions, (2) governmen financial asses, and (3) lifeime ne ax raes esimaed under curren fiscal policies for oday s newborns, he governmen s ineremporal budge consrain can be balanced using a hypoheical fiscal policy for fuure generaions ha implies he same lifeime ne ax raes for fuure generaions. The appendix provides a descripion of generaional accouning mehodology in greaer deail D. Fiscal and Generaional Imbalances Fiscal and generaional imbalance measures are an offshoo of generaional accouning. They are designed o parsimoniously capure he mos imporan elemens of generaional accouning wih an eye oward simpliciy and policy relevance. The Fiscal Imbalance (FI) measure is he presen value of governmen financial shorfalls projeced o occur hroughou he fuure under he assumpion ha curren policies remain unchanged. However, unlike generaional accouning s disincion beween he fiscal reamen of living and fuure-born generaions, he FI measure calculaes all (including fuure) generaions axes and ransfers under curren policies. In oher words, i views he governmen s ineremporal budge consrain from an exclusively curren policy (ex-ane raher han ex pos) perspecive. Noe, ha (1) he governmen budge remains 11

12 unbalanced under his fiscal reamen of fuure generaions and (2) ha he poin of he exercise is o measure he size of he oal imbalance buil ino curren fiscal policies. The FI measure equals he presen value of prospecive lifeime ne benefis of all living and fuure generaions plus he presen value of projeced governmen purchases and minus he governmen s curren ne financial asses. Thus, (2) FI = PV_P c + PV_L c + PV_F c NW c Since i is he governmen s budge choices ha are being evaluaed, presen values are calculaed using he governmen s opporuniy cos of funds he ineres rae expeced o prevail on he longes-erm governmen bonds. Because PV_P c represens fuure purchases of public goods, his iem canno (wihou making srong assumpions) be decomposed according o he generaions ha benefi from such spending. However, hose governmen programs ha exclusively provide ransfers o privae individuals (old-age reiremen benefis, for example) and are financed ou of dedicaed revenues (a payroll ax, for example) do no involve any direc purchases of durable public goods. The axes and expendiures of such programs are aribuable o paricular generaions. (3) FI ss = PV_L ss,c PV_F ss,c NW ss,c Here, he subscrip ss refers o a generic Social Securiy program ha conforms o he financing condiions described above. The moivaion for he Generaional Imbalance (GI) measure is he same as ha of generaional accouning o analyze he generaional redisribuion of resources implied under curren fiscal policies. GI represens he simples decomposiion of FI he collecive conribuion o FI by pas and living generaions. The GI measure is 12

13 alernaively known as he closed group unfunded obligaion where he closed group includes pas and living generaions and excludes hose o be born in he fuure. 5 The significance and policy-relevance of he generaional imbalance is no widely undersood among budge praciioners. Many believe ha i is similar o unfunded accrued obligaion concep and is relevan only in he conex of fully funded pension programs such as hose offered by privae companies. 6 However, he GI measure is also relevan and useful wihin he conex of a pay-asyou-go public pension sysem. I indicaes he amoun of oal ousanding obligaions ha arise on accoun of pas and living generaions. Those arising from pas generaions ransacions wih he governmen (hose already dead) and from pas ransacions of living generaions are incorporaed in he governmen s accumulaed ne financial asses. Fuure paymen obligaions under curren policies riggered by pas evens involving living generaions and fuure paymen obligaions ha would be riggered by fuure evens involving living generaions are also included in he GI imbalance measure. The size of GI reveals he amoun of benefis living generaions may expec o receive from he governmen under curren policies in excess of heir pas and fuure expeced axes or conribuions oward funding hem. This measure remains policy-relevan because i represens a ne (expeced) wealh gain for living generaions. As such, has he 5 The fiscal imbalance and generaional imbalance conceps correspond o he accouning conceps of open group and closed group unfunded obligaions respecively. The open-group unfunded obligaion refers o governmen obligaions o all individuals regardless of heir cohor affiliaion (ha is, heir daes birh) wheher in he pas or in he (infinie) fuure. Limied horizon open-group obligaions are also calculaed by excluding he ne obligaions arising afer a specific (fuure) dae. Closed group obligaion measures include he ne obligaions o a subse of individuals for example, hose born before a cerain dae. However all pas ne paymens and fuure ne obligaions o such individuals are included in he calculaion 6 Privae secor firms ha offer pension benefis o employees may be subjec o regulaions abou funding adequacy. Tha requires measuremen of exising funding levels for comparison wih regulaed hresholds and accrual accouning is normally used o provide he benchmark for 100 percen funding. 13

14 poenial o influence hose generaions curren economic choices (consumpion and labor-supply). Hence, analyzing he poenial behavioral implicaions of he curren fiscal sance requires a measure of he public provision of ne benefis o living generaions. Noe ha his measure is also forward-looking and fundamenally differen from he radiional backward-looking deb and defici measures. 3. Evaluaing Unfunded Obligaion Measures A. Long-erm Projecions of Revenues, Expendiures, and Annual Deficis Time series of annual budge cash flow projecions revenues, expendiures, deficis, and deb -- have a few advanages bu also a few shorcomings: Their advanage lies in clearly exhibiing he ime profile of fuure revenue shorfalls given projeced discreionary and ageing relaed spending. Such projecions are useful for showing how quickly large financial shorfalls are likely o emerge under curren policies. For example, Figure 1 shows a nominal revenue ime series and wo alernaive nominal expendiure ime series. Under he Expendiures-I alernaive, moderae deficis accrue during he firs decade and hen rise rapidly as a resul of ageing relaed expenses. Under he Expendiure-II alernaive, however, he gap beween revenues and expendiures is very small during he firs 10 years, bu expands more rapidly hereafer compared o he Expendiure-I alernaive. The difference in he iming and accrual raes of ageingrelaed deficis consiues useful and policy-relevan informaion. 14

15 Percen of GDP Figure 1: Projeced Toal Expendiures and Recepis (Hypoheical Daa) Expendiures - I Receips Expendiures - II Year One obvious shorcoming of such ime-profiles of nominal revenues, expendiures, and deficis, is ha hey do no place curren and fuure dollars on a level playing field. Alhough, fuure nominal deficis appear o be larger, heir real values may no be as large if projeced inflaion plus real ineres raes are high. Second, nominal deficis and deb levels do no appear o hold a significan and sable relaionship wih oher economic variables of ineres namely ineres raes, currency values, inflaion, produciviy growh ec. Hence, sric fiscal rules based on deficis and deb may no be sufficien o ensure fiscal sabiliy and long-erm susainabiliy. Third, some counries could follow policies ha mainain or even reduce explici deficis and deb levels while simulaneously increasing prospecive deficis (he so-called one-off measures). Such policies would aler he iming of defici accruals bu are unlikely o be associaed wih any measurable regulariy in real fiscal impulses. 15

16 The reason for such a conclusion is ha a paricular ime-series of governmen ne cash flows may be associaed wih a myriad ways of arranging he sizes and iming of differen axes and expendiures each of which may generae differen expecaions among he public abou wheher hey are emporary or permanen, and each of which could be associaed wih differen disribuions of fiscal burdens among differenly siuaed privae agens. Hence, a paricular ime series of deficis and deb may be associaed wih wildly differen real underlying fiscal policies ha is, associaed wih differen real flows and disribuion of consumpion, saving, invesmen, and oupu, and differen levels of real ineres raes, inflaion, and exchange raes. These differences in real economic oucomes would emerge primarily because each disinc policy would exer differenial effecs on differen subgroups of individuals disinguished, especially, wih regard o heir life-cycle sage. 7 To provide a simple example, consider a sricly pay-as-you-go expansion of a public pension program. Reiree benefis are increased immediaely and permanenly by $X each year and hose increases are financed by addiional receips of $X each year sourced from workers payrolls. Figure 2 shows sylized profiles of public pension benefis and wage earnings by age. Those profiles show ha he pay-as-you-go policy of pension increases would benefi older generaions and he labor-ax increases would impose addiional financial burdens on younger workers. By consrucion, however, here would be no change in he ime series of he projeced difference beween oal annual receips 7 For a relaed discussion see Gokhale (2004). 16

17 Figure 2: Social Securiy Benefi and Wage Profiles by Age Euros/Year Social Securiy Benefis Wages Age and oulays as a resul of his policy change. One could argue ha showing he governmen s fuure funding gap as he difference beween oal receips and oulays would, indeed, capure such a policy change as an upward shif in boh he oal revenue and oal expendiure ime series. However, oher feasible policies exis ha would mainain boh he projeced levels of revenues and expendiures and he gap beween hem (annual deficis) and ye exer real economic effecs by redisribuing resource across generaions. Consider Figure 2, which shows sylized profiles by age of labor and consumpion ax paymens. Because he consumpion-ax profile is flaer and exends across older individuals, a pay-as-you-go srucural ax change ha is, a revenue-neural swich an increase in labor income axes and a reducion of consumpion axes -- ha is mainained for a long ime could accomplish a sizable redisribuion of ax burdens (and wealh). 17

18 Figure 3: Consumpion and Wage Profiles by Age Euros/Year Consumpion Wages Age As in he case of he pay-as-you-go expansion of public pensions, his policy also provides a windfall benefi o curren older generaions bu reduces he lifeime resources of younger and fuure generaions. 8 However, such a policy change would be compleely invisible o Figure 1 s fiscal measure -- he ime-series of projeced revenues, expendiures, and deficis. If here are differences in he consumpion propensiies ou of resources beween older and younger generaions, such redisribuive policy changes if expeced o be permanen -- are likely o exer real economic effecs hrough ime affecing saving, capial formaion, ineres raes, and evenually inflaion and exchange raes. 8 Generally, a reducion of consumpion axes would make all exising asses more valuable because he consumpion financed hrough heir sale now faces a lower ax rae. Much of he immediae increase in asse values arising from his policy would benefi exising older generaions who hold mos of he counry s wealh. 18

19 Policymakers may enac diverse fiscal changes designed o aler he ime profile of expendiures and revenues o reduce shor-erm deficis. Bu only some of hose policies may be refleced in fiscal measures such as Figure 1. The ne resul of such policies may be larger or smaller long-erm deficis and deb and possibly erosions or increases in naional saving and capial formaion regardless of he impac on shor- and long-erm deficis. Because Figure 1 does no fully reflec he impac of all policy changes, i remains a poor guide for decision makers and should be complemened wih addiional informaion. In he words of Auerbach and Kolikoff, convenional defici measures may cause alarm when alarm is no warraned and, conversely, may calm observers when alarm is mos appropriae. 9 B. Accrual Accouning As menioned earlier, accrual accouning books obligaions and asses based on riggering evens hrough he curren period. Since he objecive of accrual accouning for he budge would be o characerize curren policy, fuure pension benefis based on pas birhs, labor-force paricipaion, earnings, and ax paymens (ino defined benefi public pension sysems) would resul in fuure pension obligaions ha should be couned among governmen obligaions. Even in he case of healh care benefis, fuure paymens based on average cos paymens and cos growh may be included o ge a fuller esimae of he governmen financial obligaions under curren policies. 9 See Auerbach and Kolikoff (1987). They make he case ha deficis and naional deb are no heoreically well grounded fiscal conceps and ha heir values over ime reflec lile more han he paricular accouning convenions used for labeling differen governmen ransacions as axes and ransfers versus loans and repaymens of principal plus ineres. These argumens are amplified in Kolikoff (1989) 19

20 Proposals o adop accrual accouning for measuring he governmen s ineremporal budge balance are generally moivaed by he aracive symmery of applying he same accouning rules o he governmen as are applied o privae companies when evaluaing heir pension and oher obligaions. However, he governmen as an economic eniy is sufficienly differen from privae eniies o warran a differen accouning sandard. In paricular, privae eniies can poenially fail and erminae a any ime whereas he governmen, a leas in principle, is infiniely lived. Moreover, unlike privae eniies, governmens possess he sovereign power o levy axes. The purpose of accrual accouning for a privae firm is o reveal he exen of funds ha mus be se aside o mee conracual deferred liabiliies pensions and healh coverage for reired employees, ec. Mos such liabiliies are creaed from pas employee performance and can be measured hrough explici formulas. In conras, he objecive of long-erm budge accouning is o evaluae he susainabiliy of curren ax and spending rules as opposed o evaluaing i liabiliies if he governmen fails. Given is power o levy axes, he governmen need no necessarily se funds aside o mee is fuure obligaions. Applying accrual accouning o governmen liabiliies could, herefore, creae he impression ha he governmen s fuure obligaions o pay pension, healh, and welfare benefis somehow are conracual obligaions or liabiliies ha can never be reduced Discussions abou federal financial reporing sandards in he Unied Saes go ino grea deail abou precisely defining liabiliy recogniion crieria and he naure of evens ha rigger a recognizable federal liabiliy. Such discussions are obviously driven by concerns ha if he reporing sandards adoped broader definiions abou even and liabiliy recogniion crieria, he public may come o view hose liabiliies as conracual and immuable raher han simply legal ha is, based on he laws prevailing when he paymen comes due (which may be differen in he fuure relaive o curren laws). For example, see Federal Accouning Sandards Advisory Board (2004). 20

21 Moreover, accrual accouning measures are also (parially) backward looking because hey include only hose fuure fiscal flows (axes and ransfers) ha would resul from pas riggering evens. Given he infiniely lived naure of governmens however, i does no appear legiimae o ignore fuure obligaion-riggering evens -- labor force paricipaion, earnings, ax-paymens ec. -- by living and fuure generaions if curren policies are coninued. Indeed, if accrued ne obligaions are posiive bu coninuing curren fiscal policies would generae ne fuure receips, reporing accrued ne obligaions would indicae a posiive ne liabiliy posiion even hough curren policies are susainable. C. Generaional Accouning Generaional accouning s acuarial (as opposed o accrual) approach includes an evaluaion of fuure governmen obligaions and resources. This mehod provides a comprehensive perspecive for evaluaing curren fiscal policy. However, is ex pos perspecive on he governmen ineremporal budge consrain implies ha conceps associaed wih generaional accouning such as generaional balance involve suble hough experimens ha are difficul o communicae. Tha hough-experimen involves consideraion of a hypoheical and non-implemenable policy of reaing all fuure born-generaions under a differen fiscal policy compared o he reamen of living generaions under exising fiscal policy. In addiion, generaional accouns are calculaed from he perspecive of privae individuals raher han of he governmen s financial consrains. Tha makes generaional accouns difficul o inegrae wih exising budge 21

22 repors, which usually include shor-erm projeced annual aggregae cash flows (revenues, expendiures, and budge deficis) and oal ousanding ne deb. Generaional accouns are calculaed and used as complemenary indicaors of fiscal policy in several counries. They are repored in considerable deail in mos generaional accouning sudies for individual age-sex cohors (Auerbach, Kolikoff, and Leibfriz, 1999). Generaional accouning also repors he generaional lifeime fiscal burdens ha would prevail under policy adjusmens for achieving a susainable fiscal policy. Alernaively, i repors he menu of pain policy changes ha would be required o resore susainabiliy. However, he key informaion becomes obscured by he focus (and confusion) associaed wih he mulipliciy of generaional accoun numbers. 11 D. Fiscal and Generaional Imbalances a. Fiscal Imbalance The FI measure assumes coninuaion of curren policy hroughou he fuure ha is, i involves no complicaed hough-experimens. I provides a summary measure of oal budge shorfalls he sum accrued shorfalls o dae and prospecive shorfalls under curren policy evaluaed wihou a ime limi. Because budge shorfalls hrough he infinie horizon projeced under he bes available economic and demographic assumpions are discouned back o he presen, his measure represens a comprehensive assessmen of he governmen s financial posiion under curren 11 For example, generaional accouns are supposed o represen each cohor s lifeime ne fiscal burden under curren policies. However, when he mea-message is ha curren policies are no susainable he value of focusing on he accouns repored becomes dilued. Generaional accouns have been subjec o several oher criicisms in he fiscal policy lieraure. See Culer (1993), Diamond [1996], and Haveman [1994]). 22

23 policies. If calculaed for governmen agencies a all levels, i would also be a complee measure. The FI measure is also easy o communicae: I is he amoun of addiional resources ha he governmen mus have on hand oday, invesed a ineres, in order o coninue curren policies indefiniely. Alernaively, FI equals he equivalen addiional amoun of ne receips ha he governmen mus obain hrough fuure policy adjusmens. 12 Many praciioners express doubs abou calculaing and reporing fiscal imbalances hrough he infinie fuure. Their main objecion is ha fuure projecions are uncerain and he degree of uncerainy increases he farher forward budge projecions are carried. Hence, mos agencies ha repor FI base hem on projecions runcaed afer 25, 50, or 75 years ino he fuure. 13 Alhough hese objecions appear valid, argumens favoring infinie horizon calculaions seem o be sronger. Firs, seing any specific limi on he projecion horizon implies, a bes, he assumpion ha he governmen budge is in balanced beyond ha horizon. However, if curren policies would resul in large imbalances persising beyond he projecion horizon, runcaing he horizon would be equivalen o ignoring fuure uncerainy exacly he opposie of mos recommendaions abou how o deal wih uncerainy. A beer approach would be o repor hose imbalances in addiion o he imbalance calculaed under a runcaed projecion horizon. 12 Finally, unlike radiional measures of deficis and deb, his measure is no subjec o change because of he way cerain governmen receips and oulays are labeled as axes and ransfers, respecively, or borrowing and repaymen of principal wih ineres respecively. 13 However, boh he Social Securiy and Medicare Trusees in he Unied Saes have been reporing infinie horizon measures of hose program s financial shorfalls precisely he fiscal imbalance measure. They also repor generaional imbalances for boh programs. The 2003 Technical Advisory Panel ha makes recommendaions o he Trusees of Social Securiy and Medicare have endorsed boh measures as providing useful addiional informaion. 23

24 Second, runcaing he horizon usually leads o he rolling-window problem. Reforms implemened o achieve budge balance hrough a pre-deermined ime horizon would be hrown off balance by he mere passage of ime and relaively quickly. 14 If fuure imbalances are large and growing as is likely o be he case in counries wih rapidly aging populaions i would necessiae repeaed reforms o pull he governmen s financial condiion back ino balance o avoid escalaing fiscal burdens. The mos imporan bu ofen leas appreciaed reason for adoping infinie horizon calculaions is ha runcaed budge projecions would inroduce a bias in policymaking. The bias can be described using a simple example of a reform proposal o esablish Social Securiy personal accouns creaed by divering a porion of exising wage axes (assumed o be dedicaed o Social Securiy) for invesmen in privae securiies. In exchange for allowing individuals o inves a par of heir payroll axes ino personal accouns, hey would be required o agree o acuarially fair reducions in heir fuure Social Securiy benefis. Acuarially fair means ha for every euro of payroll axes deposied ino personal accouns, fuure benefis worh one euro in presen value would be surrendered, where presen values would be calculaed using he governmen s longerm borrowing rae and average moraliy facors. Under such a reform, he governmen s financial posiion is clearly unchanged he loss in ax revenues is exacly mached in presen value by a reducion in fuure benefi commimens. However, if a runcaed esimae of governmen s fiscal imbalance were used, i would show a worsening in he governmen s financial posiion: Revenue losses during he shor erm would be couned when evaluaing he governmen s posiion, bu 14 This is a well-recognized phenomenon in he conex of Unied Saes Social Securiy program which was reformed in 1983 o achieve balance hrough Now, however, he program face a sizable 75-year shorfall because he new horizon includes financial shorfalls beween 1959 and

25 reducions in benefi paymens accruing beyond he runcaed horizon would be excluded. Hence, a runcaed calculaion of fiscal imbalance would bias policymakers ino avoiding a personal accouns reform of public pensions even hough i would leaves he governmen s rue financial posiion unchanged. This example could be carried one sep furher. If he public pension sysem is iniially financially unsusainable, i could be improved hrough he reform described earlier: The governmen could offer a personal accouns reform wherein fuure benefis are reduced by more han dollar-for-dollar in presen value. Some individuals may agree o he exchange of smaller fuure benefis for obaining personal accouns ha hey would own and conrol. Implemening such an exchange would imply a larger reducion in fuure governmen oulay commimens compared o he immediae reducion in wage ax receips. However, again, he reduced revenues in he shor-erm would be included under a runcaed projecion horizon bu he larger decline in fuure obligaions would be excluded. Hence, focusing exclusively on a runcaed FI measure would bias policymakers ino rejecing a reform ha improves he governmen s financial condiion. This example also provides he final raionale for adoping an infinie-horizon fiscal imbalance measure in preference o a runcaed horizon measure. The FI measure faciliaes an apples-o-apples comparison of differen policy opions. If wo budge reforms opions are financially equivalen in presen value erms bu opion A involves higher coss in he shor-erm compared o opion B, policymaking would be biased in favor of opion B if he evaluaion were based on a runcaed projecion horizon. Alernaively, reform opion A migh be financially sounder han opion B, bu he laer may involve larger shor-erm financial gains and larger long-erm coss. If he long-erm 25

26 coss remain hidden under a runcaed projecion horizon, policymakers would be biased in favor of opion B. These consideraions are likely o be quie imporan in he EU and EMU conex because of he many differences in member counries endowmens, fiscal policies, and demographic profiles. Hence, long-erm fiscal surveillance should be based on a comprehensive, complee, and policy-neural fiscal measures and evaluaions of policy reform opions mus be made under merics ha allow apples-o-apples comparisons among available choices. b. Generaional Imbalance As noed earlier, he fiscal imbalance measure shows he oal financial shorfall in presen value covering all generaions pas, presen, and fuure (see Appendix A for a deailed explanaion). The generaional imbalance measure shows he amoun of ransfers ha pas and living generaions may expec o receive under curren policies in excess of heir pas and fuure ax paymens oward funding hem. In general, he generaional imbalance measure can be calculaed only for programs no involving pure public goods and ha are fully or parially financed ou of dedicaed governmen receips. Mos European counries have pension and healh care programs ha are parly financed ou of dedicaed axes. Excess oulays over dedicaed revenues are financed ou of ransfers from he general budge accoun. Alhough such programs are usually considered o be in balance by definiion, he fiscal imbalance measure can be used o show he exen o which he general governmen is obligaed o cover fuure financial shorfalls in dedicaed revenues compared o benefi paymens under curren fiscal policies. In such cases, GI calculaed using jus dedicaed axes would indicae he exen 26

27 o which pas and living generaions ne benefis are responsible for creaing general governmen obligaions for financing he program. 15 GI calculaions provide informaion ha is complemenary o FI. FI would ell policymakers how much addiional resources mus be raised o resore a susainable fiscal policy. Bu FI canno indicae which among he myriad ways of raising he necessary resources would be preferable. However, because GI provides informaion abou how a given policy would change he ne benefis of living generaions, i can be used as a measure for selecing among alernaive policies. Essenially, GI would inform policymakers abou he rade-offs involved in raising resources from curren versus fuure generaions for achieving fiscal susainabiliy. For example, suppose FI= 2,000 billion and GI= 1,600 billion. This implies ha pas and living generaions accoun for 1,600 of he $2,000 oal imbalance and fuure generaions accoun for $400 billion. 16 Policymakers could choose o enac ax and benefi changes ha reduce GI o $600 billion and reduce fuure generaions conribuion o FI o 600 billion. Such a policy would reduce FI = GI + (FI-GI) o zero. Or hey could adop an alernaive combinaion of axes and benefis ha impose a larger addiional burden on living generaions and a smaller addiional burden on fuure generaions for example, by reducing GI o 400 billion and (FI-GI) o 400 billion. 15 Alernaively, boh FI and GI could be calculaed by allocaing boh dedicaed and general axes according o he generaions ha pay hose axes. This calculaion would reveal he par of (zero-valued) FI ha pas and living generaions conribue and he par fuure generaions would conribue under curren policies. Noe ha even if FI=0 by definiion because of funding ou of general revenues, GI (and FI-GI) need no also equal zero. 16 Noe ha if X<Y, curren policies would award living generaions ne benefis ha exceed he oal fiscal imbalance, implying ha fuure generaions would pay axes on ne. 27

28 Hence, adoping he combinaion of FI and GI as indicaors of he overall financial condiion and generaional sance, respecively, of curren fiscal policies would provide powerful ool for evaluaing he available policy alernaives. 4. General Consideraions on FI and GI Measures for EU Counries Official adopion of measures such as FI and GI should no lead o he conclusion ha hose amouns are immuable liabiliies of he governmen ha happen o be currenly unfunded. 17 Insead, hey should be viewed as policy guideposs designed o help in implemening appropriae changes o fuure fiscal policies including fuure axes, pensions, and oher governmen oulays wih he aim of resoring a susainable fiscal oulook. Second, i is obvious ha FI and GI are saic measures. Adoping FI and GI for esimaing counry fiscal posiions is only he firs sep in policy formulaion wihin he EMU conex. Obviously, saic counry-specific esimaes are insufficien in he conex of a moneary union among counries ha remain in a long-erm economic disequilibrium. Even wihou any policy changes were ha possible demographic ransiions a differenial raes would engender iner-eu-counry and inernaional capial flows and labor migraions. Those flows and fuure policy adjusmens may invalidae he economic and demographic assumpions on which FI and GI calculaions are based. Neverheless, he saic FI and GI esimaes consiue useful informaion in he formulaion of fuure policies because hey indicae he exen of pressure generaed by he curren fiscal sance ha would induce privae secor adjusmens. If mainained and 17 Concern ha he public would view he adopion of such measures as recogniion ha hey sand on par wih ousanding governmen deb -- as immuable governmen liabiliies appears o be a chief reason cied by hose opposing heir adopion. 28

29 allowed o grow, large fiscal and generaional imbalances may imply larger fuure axes and higher ineres raes and may cause larger privae secor adjusmens in capial and labor flows. 18 FI and GI numbers presened in erms of billions (or rillions) of Euros are no easily comprehensible. To provide a reference for comparison, i is useful o calculae hem as raios of GDP or he wage ax base ou of which hey would have o be financed. Since FI and GI refer o presen values of fuure fiscal flows, i is appropriae o use he presen values of GDP or he presen value of he wage ax base when forming such raios. These raios would show he addiional percenage of fuure GDP or wages ha mus be devoed o resore a balanced fiscal policy. Using alernaive ax or expendiures as a reference bases such as oal public plus privae consumpion, personal plus corporae income, social ransfers ec. would show he size of he fiscal adjusmen required for achieving a balanced policy in erms of hose economic flows. Such measures would provide broader undersanding of he rade-offs involved under alernaive combinaions of fuure fiscal adjusmens. Appendix A clarifies ha if policy adjusmens are posponed for a few years, he value of FI would grow larger as ime passes. This occurs because FI is similar o a corpus of ousanding deb or asses. Lef unchecked, FI grows larger because of accruing ineres. Hence, a non-zero FI represens a fiscal disequilibrium ha would force fuure policy adjusmens. As Appendix B shows, ha FI 0 represens an unsusainable 18 For example, Boersch-Supan e al model he impac of capial mobiliy on raes of reurn and find 29

30 policy even when i is expressed as a raio o GDP or some oher ax base ha grows over ime. 19 Alhough i was argued earlier ha he FI measure would be comprehensive only if calculaed over he infinie horizon, doing so in he European conex is very difficul. Tha is because low feriliy in EU counries and low ne exernal immigraion cause projeced populaions o implode over ime for some EU counries. Hence, as a firs sep, he FI measures repored in sub-secion 5B below are calculaed over a finie horizon hrough he erminal year of populaion projecions available from Eurosa Finally, FI and GI could be decomposed according o he conribuions of alernaive raes of populaion aging and alernaive fiscal srucures adoped by EU member counries. The moivaion for his lies in pas experience: The SGP focused on shor and medium erm objecives was revised in 2005 o ake accoun of counry specific economic feaures. The same need is likely o arise if and when he curren consrains force furher consideraion of longer-erm srucural adjusmens o faciliae convergence oward a balanced fiscal sance across EU counries. Reporing he conribuions of demographics and counry-specific fiscal srucures o long-erm fiscal imbalances would reveal he feasibiliy and desirabiliy of adoping differenial adjusmens by differen EU member naions. 5. FI Esimaes for EU Counries 19 This resul obains from he normal condiion of a dynamically efficien economy where he ineres rae exceeds he growh rae. For he US conex, see Abel e al ( 20 As noed earlier, runcaing he projecion horizon a 2051 implies ha a fully apples-o-apples comparison of policy opions would no be feasible because cos and benefis of alernaive policies beyond 2051 would be excluded from he calculaions. However, adoping such long-horizon measures remains beer han runcaing he horizon afer jus 5 or 10 years. 30