Debating the deficit

Over the next half century, the US will face the most serious fiscal challenge in its history. The problem can be stated simply: if population, labour productivity and per capita healthcare spending grow at plausible rates, if retirement ages remain unchanged, if the rest of government spending claims a roughly constant share of national income, and if the tax share does not increase, government spending will hugely outstrip revenues.

Deficits would beget higher interest rates, which would push up interest payments, which would beget still higher deficits and mushrooming debt.

The principal deficit-generating force is healthcare spending, which is assumed to grow faster than income. In addition, the ratio of workers to non-workers is expected to fall. Under this scenario, annual deficits of 10 per cent of gross domestic product would emerge by mid-century. The gap could be still larger unless growth of healthcare spending slows. The fiscal problems confronting Europe - the UK excepted - and Japan are worse. Their birth rates are lower and their pension systems more generous than those of the US.

Calls to action should be welcomed. In fact, analysts have been writing about these problems for years - too often, alas, in grey prose. But most elected officials still display symptoms of a malady that Robert Reischauer, the former Congressional Budget Office director, has labelled "deficit attention disorder". Indeed, George W. Bush and the US Congress have made the problem worse over the past three years by enacting two big tax cuts and increasing health benefits.

Laurence Kotlikoff, a professor of economics, and Scott Burns, a financial journalist, have decided to try to grab people's attention by turning up the rhetorical amplifier as far as it will go. As with conventional sound systems, this results in serious distortion. In this case, alas, it also obscures an important message. Furthermore, the authors lay out the problem so as to support the changes in taxes and social insurance that they have been peddling for years with few buyers. And they make unfounded allegations that officials are conspiring to keep people in the dark.

When confronted with apocalyptic scenarios, the late US conservative economist Herbert Stein remarked with droll wisdom: "If something cannot possibly happen... it won't." The fiscal future that follows from mindless adherence to current policy portends a future that cannot possibly happen. So, it won't. The question is how.

One possibility is paralysis. Political leaders might just watch as the economy slides into fiscal catastrophe. But eventual action is the more probable outcome. At some point, policies in the US and other nations will probably be changed to encourage retirement at later ages. That will reduce pension costs. In the US, it will also lower public healthcare spending because most Americans receive health insurance through work, not the government. Public programmes will probably cover a decreasing share of healthcare spending, at least for the roughly two-thirds of retirees who can afford to pay more than they do now. Even in the tax-phobic US, revenues are likely to increase, possibly through some mix of a new value-added tax and increased energy taxes. It is even conceivable that the US might reform its health system to cut spending. Even with such steps, total US government spending would rise, but it would remain lower than current budgets in most European nations.

A rightwing government would do more budget balancing through spending cuts; a leftwing government, more through tax rises. How and when the US deals with this fiscal challenge is profoundly important - for its economic future and its social and political character. Unfortunately, The Coming Generational Storm presents the issues in a way that is both biased and obscure.

A simple example illustrates the bias. Under current law, tax collections will increase as a share of national income because income growth pushes people into higher tax brackets, and pension costs will rise because of an ageing population. The tax increase would solve most of the projected deficit problem. Yet the authors not only ignore this solution, but dismiss as a "political non-starter" the smaller step of allowing some of the temporary tax cuts passed in the past three years to expire. At the same time, they embrace cuts in social security and health benefits as "the only real hope". Why? The authors trot out a scheme for changing old-age pension and health benefits that one of them has been hawking unsuccessfully for years, and claim that it is "the only reform that could possibly make sense". Really?

The obscurity derives from the authors' insistence on casting the budget problem in terms of "generational accounts". This framework entails estimates of economic growth and government revenues and spending in perpetuity, discounted to present value. This procedure is exquisitely sensitive to assumptions regarding variables that no one can forecast. What is the right discount rate? At what rate should one assume that per-capita healthcare spending grows 50, 100, or 200 years hence? The elaborate arithmetic of generational accounts diverts attention from the demonstrable budget deficits that emerge over the next few decades. It is like travelling from London to Bristol via Timbuktu.

Mixed in with all of this is a bewildering melange of financial advice - buy gold; don't mortgage your house; one spouse only should work; save, but not in tax-sheltered accounts - that makes one's head spin.

The US, most of Western Europe and Japan face a fiscal challenge they have not yet addressed. Early action is important. The book that lays out this problem clearly, together with a plausible agenda for action, remains to be written.

Henry J. Aaron is senior fellow, Brookings Institution, Washington DC, US.