This paper shall critique and analyze the strengths and weakness of the generational accounting assumptions and conclusions made in the research done by Jablonowski, Muller, and Raffelhuschen (2010) regarding Poland’s future fiscal scenario. The aim of the paper is to look into the current methodology and frameworks used in the analysis of generational accounts in certain countries. We explain why generational accounting measures may not sufficiently capture future fiscal situations. This paper shows that while generational accounts may be useful for policy-making purposes, current theoretical models still need some further fine tuning to ensure that the results of such analysis are reliable and credible. The limitation and future extensions of the said research are also briefly discussed and analyzed.
Table of Contents
Many developed countries have experienced steady decline in their population and fertility growth rates. This phenomenon can significantly affect the fiscal situation of many economies as the public sector scrambles to finance health care costs of its ageing population amidst the declining labor force. Moreover, current government policies especially on taxation and social security spending have the potential to shift current tax burden from one generation to the next. Fiscal policy, especially in relation to taxation, is a very sensitive issue especially among politicians and voters. Basically all types of people, regardless of class and nationality, would prefer lower taxes, better benefits, and more safety nets. Politicians are aware of this and are thus wary about raising taxes or cutting down on social security budget for fear of facing public backlash and loss of electoral support (The Economist, 2011).However, the current debt debacle in the US and the ageing population in many developing countries such as Japan have highlighted the risk of an economy going into default due to failure of the government to consider the impact of their policies on future economic sustainability.
Central banks and policy makers often use conventional budget measures such as deficits and national debt as primary indicator of the current economic health of the country (Gokhale, 2008). Very rarely do they go beyond and incorporate future impact of policies in the presentation of country statistics.
Economists and social scientists are now debating whether current macroeconomic accounting is enough to measure the country’s deficit or should this measure be more comprehensive and show how the future would look like given the current policies and population scenario (CBO, 2011).
The research done by Jablonowski, Muller, and Raffelhuschen (2010) attempt to picture Poland’s future fiscal situation using generational accounting techniques. Generational accounting is a word coined by Auerbach, Gokhale, and Kotlikoff (1991) to describe a framework for measuring “fiscal burdens facing current and future generations”. The intention is to create a meaningful statistics that will enable policymakers to determine whether existing policies are sustainable or not. At the same time, it offers an insight on how much a person is likely to pay in taxes in the future given his/her age (O’Neill, 1995).
The paper under review shows a distressing picture for the future of Poland. The country’s future fiscal situation is said to contain substantial imbalances that can hurt future generations. Moreover, the authors extended the use of generational accounting theory and analyzed the sustainability of existing social structures on health care and other government benefit plans. The authors conclude that many of these programs will be unable to meet future demands given the ageing population and the decreasing labor force of the economy if not sufficient measures are undertaken today to correct such weakness.
The goal of this critical reviewis to look deeper into the assumptions made by the author in coming up with the generational account output for Poland. The frameworks used and the robustness of data employed shall be the main focus of this writer’s critique.
This review shall be organizes as follows: Chapter 1 shall contain the review’s introduction. Current literature regarding generational accounting shall then be discussed in the next section. Chapter 3, on the other hand, shall contain the critical analysis of the paper and possible extensions of the said research. Finally, the conclusions of the critical review are presented in the last chapter.
- Literature Review
The idea that current fiscal policies have impact on future generations is not a new concept. Feldstein (1974) was the first pointed out the likelihood of generational debt transfers under the assumption of a balanced government budgets in his paper “Social Security, induced retirement, and aggregate capital accumulation”. However, it was only when Auerbach, Gokhale, and Kotlikoff (1991) developed the generational accounting terminology when such framework for measuring fiscal condition gained widespread attention.
Since then, several researches were conducted featuring some of the most developed nations in the world today. Raffelhuschen, Walliser, and Leibfritz (1999) applied generational accounting principles in analyzing future situation of Germany. Their findings suggest that the country is severely imbalanced and will require substantial corrective measure to ensure the sustainability of its social security system. The same conclusions were reached by Sartor, Kotlikoff, and Leibfritz (1999) who studied the generational impact of current macroeconomic policies of Italy.
In the case of Canada, Oreopoulos, Kotlikoff, and Leibfritz (1999)found current fiscal situation to have neutral effects on future generations. Other countries such as Thailand, New Zealand, and Sweden, meanwhile registered negative generational imbalances. This suggests that their current policies are enough to sustain current programs and changes in demographic population and at the same time, lead to lower tax obligations for future generations.
The researches above and most of the existing literature on generational account measurement uses the framework and formula developed by Auerbach, Gokhale, and Kotlikoff (1991) which uses net present value concepts under zero-sum constraints. The model computes for the present discounted value of future government purchases which is paid out by current net financial stock, future payments by current population and payments contributed by future generations. The model also assumes prospective population profile in the computation for the present value of tax payments of current and future generations.
However, the model used presents some critical challenges. Computation of net financial stock, for example, ignores the effect of real assets to isolate the effect of the need to include rental payments into the equation and limit the analysis solely on the impact of tax collection. However, in the real world, contributions of these real assets can significantly affect the fiscal situation of a particular economy.
While some countries have already adopted the use of generational accounting, the methodology still receives some criticisms. Gokhale (2008), for example notes that current generational framework does not consider the economic benefits derived from current government purchases which may be able to offset future fiscal imbalance. Another criticism is the current model’s disregard for policy adjustments that the public sector can implement in the future. These adjustments may change altogether the data assumptions and results derived.
In response to these criticisms, Gokhale and Smetters (2003) devised a new model which eliminates the need to involve hypothetical assumptions regarding future policies. In their paper, they cited certain desirable characteristics that will help guide future researches regarding generational accounting methodology. According to the two, generational models should be forward looking and incorporate future policy adjustments in its assumption. Data sets must be calculated in its entirety, preferably in terms of perpetuity and should encompass the entire operations of the government and not just parcel of it. Finally, the data to be used needs to be conceptually straightforward and easy to understand and communicate.
Some economists, on the other hand, criticize the uniform discount rates applied in the model. As different time periods feature changing profile and risks, applicable rates of discounts should therefore vary as Klumpes and Liyan pointed out (2010). Uniform rates cannot be applied for current and future generations as they face different risks and economic situations during their time.
Moreover, projections of future costs of social services are also based on a lot of uncertain assumptions which tends to weaken the result of the model (Urban Institute, 2010). Changes in the assumptions in the real world may render the analysis useless.
The current paper under review uses much of the theoretical model developed by Auerbach, Gokhale, and Kotlikoff (1991) in analyzing the generational effects of current fiscal policy. The authors extended the framework further and developed an isolated sub-system model to analyze the sustainability of selected sectors in Poland specifically in the areas of pension, health care, social security, and education.
- Critical analysis
The research content is analyzed based on the robustness of the data used and the overall strength of the analysis derived from the result of the generational accounts devised by the authors.
- Two Model Analysis
The paper analyzed the generational accounts of Poland in two ways. First, it looks into the generational impact of current policies and population on selected sub-systems (i.e. NDC pensions, other types of social insurance provided by Social Insurance Institution (ZUS), social insurance scheme for farmers, civil servants’ social benefits system, health care system and education). After doing a separate sub-system review, the authors went on to summarize the generational effect on the whole system. The conclusions for both frameworks are the same but it was more mixed on the first method than in the second. While the paper notes that education budgets are likely to be sustainable, pension programs, disability funds, insurance and health care were found to be not.
One good thing about the paper is that it provided sufficient explanation as to the assumptions used in the two analyses. However, it is quite hard to reconcile at one glance the relationship between the two methodological frameworks. While both theoretical models lead to practically the same conclusion, that Poland’s fiscal situation is not sustainable, introducing two frameworks to analyze the same topic only adds confusion. The graph below taken from the paper further explains this point.
Figure 1. Isolated Sub-System Approach for Pension and Disability Fund
Figure 2. Generational Accounts analysis of the whole system
The graph above for example both shows that Poland’s whole fiscal system and pension and disability plan are unsustainable in the long-term. However, their shape is very much different from each other. The paper did not provide sufficient explanation why such may be the case.
Moreover, the sub-system approach, in particular, suffer from too much rigidity since it does not factor external inflows which are characteristic of many social schemes such as pension, insurance, health care and education.
- Growth and discount rates used
The research applied RCG15 standard growth rate of 1.5% and real long-term interest rate of 3.0%. This is significantly different from the figures published by CSO (2009) reflecting the per capita GDP growth rates from 1998-2008 of 1.9% and discount rate as indicated by the yield of Poland’s ten-year government bond which was 3.4% at the time the paper was written. This could have a significant implication on the outcome of the model especially if we are considering the magnitude of imbalances at the long-end of the curve (Geske, 2007). As seen in the research by Gopalakrishnan and Sugrue (1995), Piana (2002), and Harper (2010), changes in the assumption in yield curve can lead to different conclusions.
There is also again the question regarding the correctness of using a standard return and discount rate in projecting generational income and expenses. As stated in other literature, a single discount rate tends to distort the results of the GA analysis since each time period is subject to different risk scenarios and fiscal considerations.
The authors attempted to portray the sustainability of selected sub-systems in the Polish economy. Most of the existing literature focused only in analyzing the whole sector. Future research especially those focusing on a specific sub-system can benefit from the methodology developed by the authors.
While there is a good attempt at analyzing generational accounts of isolated system, the result of such analyses were not sufficiently tied together with the system-wide results. It would have been good had the author linked and explain why such variations exists between the sub-system model and the whole system outcomes.
Moreover, future generational account analysis could also benefit from incorporating some sensitivity analysis. Most of the literature reviewed pretty much used one rate in their analysis. Doing a sensitivity analysis will help reduce the opposition being raised regarding the use of one rate in discount and growth rate projections and at the same time, give policy makers a working range to guide their decisions (Asian Development Bank, 2008).
Generational accounting is a growing discipline that is likely to prosper more in the coming years. The problem on population ageing and increasing budget deficit is something that does not only concern today’s population but other generations as well. Using generational accounting indeed has its benefits as it help policy makers picture out how much tax burden future citizens will likely shoulder given today’s fiscal policies. However, the overall theoretical model still needs some further fine tuning to ensure that the results of such analyses are reliable and credible.
Jablonowski, Janusz, Muller, Cristoph, and Raffelhuschen, Bernd (2010). “A fiscal outlook for Poland using Generational Accounts”. Forschungszentrum Generationenverträge No.47 – October 2010
Gokhale, Jagadeesh (2008). “The new Palgrave dictionary of Economics”, Second Edition. Palgrave Macmillan
The Economist (2011). “Generational accounting definition”. Retrieved from: http://www.economist.com/economics-a-to-z/g#node-21529945
US Congressional Budget Office (2011). “Who pays and when? An assessment of generational accounting”. Retrieved from: http://www.cato.org/pubs/articles/gokhale-
Auerbach, Alan J., Jagadeesh Gokhale, and Laurence J. Kotlikoff (1991). “Generational accounts: A meaningful alternative to deficit accounting iIn Tax policy and the economy”. MIT Press, Cambridge, Ma.
Geske, Teri (2007). “Back to basics: Key Rate Durations”. On the Edge Interatctive Date Fixed Income Analytics NewspaperQrt. 3
O’Neill, June (1995). “Who pays and when? An assessment of generational accounting”. Central Budget Office November 1995
Feldstein, M. (1974). “Social Security, induced retirement, and aggregate capital Accumulation”. Journal of Political Economy 82
Raffelhuschen, Bernd, Jan Walliser, and Willi Leibfritz (1999). “Unification and Aging in Germany: Who Pays and When?” National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA
Asian Development Bank (2008). “Chapter 7: Sensitivity and Risk Analysis”. Handbook for the economic analysis of water supply projects. Asian Development Bank, Manila.
Sartor, Nicola, Laurence J. Kotlikoff, and Willi Leibfritz (1999). “Generational Accounts for Italy” (p. 299 – 324) National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA
Oreopoulos , Philip, Laurence J. Kotlikoff, and Willi Leibfritz Canada (1999). “On the Road to Fiscal Balance” National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA
Gokhale, Jagadeesh (2011). “Who pays and when? An assessment of generational accounting”. Retrieved from: http://www.cato.org/pubs/articles/gokhale-
Gokhale, J. and Smetters, K. (2003). “Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities”. American Enterprise Institute, Washington, DC
Klumpes, Paul and Tang, Liyan (2010). “Shortcomings of government financial management: a generational accounting critique”. International Journal on Government Financial Management
Piana, Valentino (2002). “Interest Rates Analysis”. Retrieved from: http://www.economicswebinstitute.org/glossary/interest.htm
Harper, David (2010). “Financial Statements: Pension Plans”. Retrieved from: http://www.investopedia.com/university/financialstatements/financialstatements9.asp#axzz1Yjomjrtd
Gopalakrishnan, V. and Timothy Sugrue (1995). “The determinants of actuarial assumptions under pension accounting disclosures”. Journal of Financial and Strategic Decisions Vol.8, No.1 Spring 1995
Urban Institute (2010). “Taxes and the Budget: What is Generational Accounting?”. Retrieved from: http://www.taxpolicycenter.org/briefing-book/background/taxes-budget/generational-accounting.cfm