Fiscal Child Abuse

We are on course to tax our children every penny they earn.

Economics Matters -- Blog/Podcast/Financial Riddler/MaxiFi Puzzler

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Deficit Accounting — Driving in NY With a Map of LA

When it comes to fiscal policy, Congress is driving in NY with a map of LA — and heading straight for the East River. None of the 535 members of Congress seems to realize that their fiscal north star— the federal debt — has no fundamental connection to our nation’s underlying fiscal condition. Consequently, none of the people making fiscal policy appear to truly understand the depth of our insolvency.

The reason is strange, but true. Federal debt is not a well-defined economic concept. Yet this number is front and center in all fiscal policy debates, including the current debate over the President’s “big, beautiful tax-cut bill.”

We’re familiar with things that seem crystal clear but are anything but. The equations of physics don’t pin down time or distance. Their measurement depends on your frame of reference — how fast you are moving through space and in what direction. Since there are infinite many such frames, there are an infinite number of equally valid and, thus, equally useless measures of “absolute” time and distance.

Next time you meet an astronomer, ask them what time it is. Their response will likely be, “How many answers do you want?”

As I wrote in Science in 1988, economics has its own relativity problem. But you don’t have to be an Einstein to see it. Nothing in the equations of economics models — the corpus of economics science — tells us how to talk about our equations. We can discuss them in any of the world’s 7000 plus languages (frames of reference) and we’ll always reach the same conclusions about what’s really going on in the economy. An example is how much bread will be produced in county i in year t under circumstances j. But if you ask for the size of the economy’s debt in country i in year t under circumstances j, it’s “How many answers do you want?” The reason is you’ll be asking a linguistic, not an economics question.

Fiscal Relativity – the Simplest Example

Suppose Uncle Sam takes $X from Jack this year and gives him $X(1+r) a year from now, where r is the prevailing interest rate. Is Sam borrowing $X from Jack this year and returning principle plus interest (P&I) to Jack next year? Or is Sam taxing Jack $X this year and making an $X(1+r) transfer payment to Jack next year?

Using the first set of words makes this year’s deficit $X larger compared with using the second set. In using the first set, Uncle Sam puts his obligation to next year’s $X(1+r) payment to Frank on the books. In using the second set of words, he keeps it off the books.

More generally, is Sam borrowing N times $X from Jack this year, making Jack an (N-1) times $X transfer payment this year and replaying Jack N times $X(1+r) in P&I next year as well as taxing Jack (N-1) times $X(1+r) next year?

Compared to our first description (“Sam borrows $X), Sam’s runs an (N-1) times $X larger deficit this year. By setting N at a very large value, Sam can run, i.e., report, a massive deficit this year. Alternatively, Sam can run, i.e., report, a massive surplus by making N a very large negative number. But regardless of the choice of N, Sam is always treating Jack identically — taking $X from him this year, on net, and handing him $X(1+r) next year, on net.

If Jack was otherwise going to save $X and earn interest of r, Sam is simply saving for Jack what he’d otherwise save for himself. In this case, Sam is running no policy whatsoever if you look through the words. But Sam might actually be doing something real in the background. Sam might, for example be using this year’s $X to buy lunch for the President and having Jack’s grandkids fork over next year’s $X(1+r) to cover next year’s net payment to Jack. That’s real policy — making the President better off, making Jack’s kids worse off, while leaving Jack unaffected.

In short, regardless of the true underlying path of government policy, including doing nothing fundamental except engage in a word game, the government can announce any course of deficits and associated debts it wants. Stated differently, Uncle Sam is free to put on the books and leave off the books whatever he wishes.

Social Security’s $63 trillion unfunded liability, hidden as deep as possible in the appendix of Social Security’s 2024 Annual Trustees Report, illustrates how Congress uses fiscal labeling to hide the bacon. The $63 trillion off-the-books liability is, by the way, more than twice the size of official debt. In 2020, Social Security’s hidden obligation was $53 trillion. The ensuing $10 trillion Social Security deficit exceeded the concomitant official deficit.

Caution! When you read the above sentence, you were likely unwittingly persuaded that Social Security’s red ink, as measured by its Office of the Actuary, is a meaningful measure of something economic. Unfortunately, like official debt, it’s not well defined. Its size reflects our choice of words. Off-the-books debt is no better measured than on-the-books debt. Both are piecemeal, fundamentally meaningless numbers whose values are fully dependent on how their receipts and outlays as well as those of all other fiscal programs are jointly, if internally consistently (whenever the words “borrowing” are used, the future repayment of P&I on that borrowing is used), labeled.

This Message Is Not New

I’ve been writing and co-writing about deficit delusion for almost four decades. In the process, I’ve become deeply blue in the face. Check out the list of single and co-authored papers and books below. All are available at www.kotlikoff.net. (The books are either free or available on Amazon for peanuts.)

My manuscript, “Generational Policy,” show, via examples, that the deficit is ill defined regardless of the nature of the economic environment and fiscal policy. In particular, the economy can feature incomplete information, asymmetric information, uncertainty, missing markets, and credit constraints. This includes the subtle case in which Joe seems not to be saving enough to lend $X to Uncle Sam when, in fact, his credit constraint will relax once private financial markets see that Joe will have the wherewithal to repay an additional $X private loan. (See Fumio Hayashi’s brilliant analysis of this case.)

The Deficit Delusion problem is also unrelated to policy. Policy can be uncertain, time-inconsistent, distortionary, non-linear — you name it. As long as economic outcomes don’t depend on the economy’s choice of language — the economic equations at play don’t depend on what language people speak, which would reflect irrationality, any course of fiscal policy can be conducted while also “running” i.e., proclaiming, any course of government debt.

“On the General Relativity of Fiscal Language,” my paper with Harvard economist, Jerry Green, makes the deficit delusion argument in mathematical terms. If you’re a math geek, check it out at kotlikoff.net/articles. Jerry, by the way, is co-author of the microeconomic theory textbook read by every PhD economics graduate student in their first year of grad school. We choose the provocative title not to compare ourselves with Einstein. We did it to provoke a response — Are these guys possibly comparing themselves to Einstein? Are they out of their minds? — and, thereby, ensure the paper would be read and reread by economists — almost all of whom had studied with Jerry, either directly or indirectly. It wasn’t and isn’t read and reread by economists, at least in the U.S.

Too many mostly American economists were and are getting too much attention and earning too much money by marching in the Emperor’s parade to even notice their own nudity. Just go to the amazon.com and search for government debt. You’ll find one book after the next chock full of meaningless numbers, including This Time is Different, co-authored by one of the world’s truly top economists, Harvard’s Kenneth Rogoff. When I called Ken to raise the problem, he telephonically shrugged and suggested the importance of using numbers people understood.

What Ken didn’t appreciate is that he and everyone else on the planet is free to relabel every past and future transaction with Uncle Sam differently from the way Uncle Sam has labeled and will label those transactions. The same holds for all the debt time series — past and future — in all other countries. Hence, he and his co-author, Carmine Reinhart, could have written an infinite number of versions of the same book, reaching an infinite number of different conclusions.

As I write this Substack column, which I hope you’ll share with your members of Congress, the blue in my face is turning to red. I’m frankly beyond pissed off that the current fiscal policy debate is yet just one more chapter in The Emperor’s New Clothes. Or is it the key chapter in the history of Emperor Nero — the one where he fiddles while Rome burns?

It’s Our Children’s Lifetime Net Tax Bills, Stupid

Since federal debt is a number in search of a concept, what is the underlying concern of those who want to limit federal debt, not by changing words but by changing policy? The answer is the fiscal burden we are imposing on our kids. This is the question all 535 members of Congress should be asking rather than arguing over what will happen to a truly meaningless number over just the next decade.

The key question is whether we are on a course to tax, on net, young and future generations most of what they are projected to earn or, indeed, more than what they are projected to earn. That spells their personal and our national economic demise.

The lifetime net tax rate – the present value of projected future taxes net of projected future benefits facing today’s and tomorrow’s newborns divided by their projected lifetime earnings, also measured in present value, is a well-defined economic measure. Any choice of fiscal labels will deliver the same answer.

Producing this measure is called Generational Accounting — a methodology I developed together with Berkeley economist, Alan Auerbach, and CATO economist, Jagadeesh Gokhale, starting in 1989. Over the years, its been done for every large advanced and emerging economy and by a long list of U.S. and foreign economists.

The Fiscal Gap and Generational Accounting

Measuring the lifetime net tax rates facing today’s and tomorrow’s newborns starts with another label-free measure called the Fiscal Gap. It calculates, as a constant share of current and future GDP, the amount of extra resources the government needs to extract through time, either in the form of lower outlays or higher receipts, to achieve fiscal balance also know as intertemporal government budget balance.

Like generational accounting, the fiscal gap is label free because it doesn’t care which receipts and payments are called official and which are called unofficial — it includes them all.

Fiscal balance — having a zero fiscal gap — references a course of policy in which the path of all future government receipts equals the path of all future outlays — regardless of their “official” status. Yes, calling an obligation “official” may make it seem safer, but defaulting on unofficial Social Security benefits is much less likely politically than defaulting on official debt — something the Mar-a-Lago Accord, written by my former Boston University undergraduate student, Stephen Miran (Chair of the President’s Council of Economic Advisers) infamously contemplates. Hence, “official” conveys nothing economic. In particular, it doesn’t mean safe.

I’ve lobbied Congress and the heads of the Congressional Budget Office for years to at least supplement their ridiculous deficit accounting with fiscal gap accounting. There was no interest with one exception. Senator Thune, who is now the Republican Senate Majority Leader, joined forces with Democratic Senator Kaine in 2013 to sponsor a bill that would have required the CBO, the General Accounting Office, and the Office of Management and Budget to do fiscal gap and generational accounting on a routine basis and, certainly, for every major fiscal initiative.

Thune and Kaine asked their Senate colleagues to co-sponsor the bill — the Intergenerational Financial Obligations Information Act — The INFORM Act. A paltry three Republicans and three Democrats agreed to do so – this despite a full-page ad in the NY Times, urging the bill’s adoption.

The ad contained signatures of 1000+ economists including 15 Nobel Laureates in Economics, former Secretary of State, Defense, and Treasury as well as former OMB Director, George Schultz, and many other former top government officials. Frankly, George Schultz’s signature, by itself, is all the endorsement anyone should care about. When I met with George in his office to ask for his endorsement, it took me three minutes to explain the issue and one second for him to agree.

That was 2013. The situation facing our kids today is far worse. I invite Senators Thune and Kaine to reintroduce and oversee passage of the INFORM ACT. In invite the brilliant economist, Elon Musk, to read the bill.

Other Countries/Regions Have Adopted Fiscal Gap and Generational Accounting

The European Union has published its Fiscal Sustainability Report every three years, for all 27 member nations, since 2006. The S2 Indicator is the fiscal gap measure just mentioned, i.e., it’s the share of annual GDP needed to achieve fiscal balance. In 2021 (page 228), its value ranged from 0.7 in Latvia to 12.1 in Slovenia. Italy’s fiscal gap was 2.1 percent of GDP forever. France’s was 1.8 percent; Germany’s was 2.6 percent.

How could and can Italy’s fiscal gap be so low when its official debt-to-GDP ratio was and is so high? The answer is that Italy’s off-the-books debt is remarkably low thanks to several major government pension reforms as well as that country’s much lower (relative to GDP) government healthcare outlays.

My 1993 study of Norway’s fiscal gap, co-authored with Alan Auerbach, Jagadeesh Gokhale, and Erling Steigum appears, as I’ve been told by Erling, to have led to the establishment of Norway’s close to $2 trillion Sovereign Wealth Fund. As we pointed out in 1993, although Norway’s official debt was a huge negative number, the country was in major fiscal trouble. This reflected the country’s finite reserves of North Sea oil and its extremely high level of public spending relative to GDP, which was projected to continue forever.

When I landed in Bergen to present our paper, together with Erling, to the Bergen School of Economics, I was immediately rushed to Bergen’s main hospital by the main Norwegian TV station. Erling had arranged to have me present Norway’s generational accounting bill to the latest Norwegian newborn. A half hour later it was being shown on Norwegian TV and an hour later the Prime Minister, Brundtland, was being questioned about the study, which she’d not seen. The Prime Minister and her successors took the study and its updates seriously, moved Norwegian fiscal gap and generational accounting in-house into the Norwegian Finance Ministry and, after a few years, initiated the Norwegian Sovereign Fund (also known as the Pension Fund).

Norway’s Sovereign Wealth Fund is the world’s largest. The U.S., whose GDP is 99 times larger, also has a Sovereign Wealth Fund. That’s what we can label as a putative electronic account at the U.S. Treasury, albeit with precisely zero assets.

Our Country Is Beyond Broke – The U.S. Fiscal Gap

The table below is based on a forthcoming study by myself, Emanuele DiCarlo of the Bank of Italy, Mauro Maré of LUISS University and the Mercato Fondi Pensione, and Marco Olivari of Boston University. The study will compare fiscal solvency in the U.S. and Italy. The Italian results are forthcoming. But the U.S. fiscal gap and generational accountings are complete. Both incorporate state and local as well as federal government policy based on data and forecasts from both the Bureau of Economic Analysis forecasts, which considers the entire government sector, as well as the CBO, which considers simply the federal government sector.

The U.S. fiscal gap is calculated as of 2023, i.e., it uses actual 2023 and 2024 data. But it incorporates the Congressional Budget Office’s extended budget forecast, which anticipated the “big and beautiful” budget bill recently passed by the House and likely to be passed by the Senate. It also includes the CBO’s estimate of future tariff revenue. Hence, it provides our best picture of the prevailing U.S. fiscal gap as of today.

The fiscal gap is sensitive to the choice of discount rates. Conceptually, the proper discount rate equals the projected real return to U.S. national wealth. This value has averaged 6 percent real in the postwar period. Based on a 6 percent real discount rate, the U.S. fiscal gap is 7.8 percent of GDP. That’s a massive figure. By comparison, all of federal discretionary spending – federal purchases of goods and services – totals roughly 6 percent of GDP.

Hence, one way to achieve close to fiscal sustainability – a situation in which policy is adjusted immediately and then fixed forever — is to eliminate all federal government discretionary spending. This is miles higher than the 22.6 percent discretionary spending cut proposed in the President’s budget. It’s also light years above the 8 percent of discretionary spending that DOGE’s brilliant economist, Elon Musk, has buzz sawed.

As the table indicates, the U.S. fiscal gap ranges from 7 to 9.2 percent of annual GDP as the discount rate rises from 4 percent to 8 percent. Yes, the fiscal gap is sensitive to this assumption. But even the lowest value — a 7 percent fiscal gap — is astronomical. Eliminating a 7 percent fiscal gap requires an immediate and permanent 21.8 percent cut in all federal spending apart from interest on official debt. This figure jumps to 26.0 percent and 31.7 percent assuming 6 percent and 8 percent discount rates, respectively. As for immediate and permanent increases in taxes, the requisite hikes are 25.3 percent, 29.4 percent, and 35.1 percent assuming 4 percent, 6 percent, and 8 percent discount rates, respectively.

The Cost of Delay

Consider, for the 6 percent real discount-rate case, what happens to the requisite 26.0 percent permanent spending cut or the 29.4 percent permanent tax hike if no adjustments are made until 2035. The requisite spending hike starting from that date is 40.4 percent and the requisite tax hike is 39.5 percent.

Bankrupting Our Children — U.S. Generational Accounting

Finally, consider the lifetime net tax rate that all generations born in 2024 and thereafter will face if we achieve fiscal balance without raising remaining lifetime net taxes on anyone alive in 2023. The rate is 103.1 percent!

Hence, we’re on a path to tax, on net, today’s and tomorrow’s newborns more than every penny they earn. Every media outlet in the country should be screaming FISCAL FIRE! And every member of Congress should be asking whether they love their jobs more than their kids.

How can this be? It’s easy when you can focus on your self-made numbers and disregard the rest. To quote Simon and Garfinkle’s,

I am just a poor boy
Though my story's seldom told
I have squandered—I have squandered my resistance
For a pocketful of mumbles such are promises
All lies and jest
Still, a man hears
What he wants to hear
And disregards the rest, mmhm-hmm, mm, mm-mm, mmm

Democratic and Republican Administrations and Congresses alike have spent the postwar engaged in a singular policy — taking from younger generations and giving to older generations. This was the thesis of my 2004 book, co-authored with Scott Burns —The Coming Generational Storm. And it was the thesis of our 2012 book, The Clash of Generations. The situation in 2012 was far worse than in 2004 and the situation today is far worse than it was in 2012.

The gravity of the problem and the failure of economists, let alone politicians, to take notice was what led me in 2012 and, again, in 2016 to run for President. My policy platform, You’re Hired, which offers radical, but simple (generally 10 bullets each) reforms to our tax, benefit, healthcare, and Social Security systems can yet save the day. This is the playbook that DOGE’s brilliant economist, Elon Musk, needed to read and follow, not engage in the heartless and mindless destruction of essential federal government services, which he’s overseen to his master’s delight and our nation’s lasting damage. How can this man sleep at night?

But Can’t the U.S. Borrow for Free Given Its Growth Rate Is Higher, on Average, than Its T-Bill Rate?

Some economists, notably former IMF Chief Economist, current Professor of Economics at the Paris School of Economics and Senior Fellow of the Peterson Institute, Olivier Blanchard, believe the historic excess of the GDP growth rate over the federal government’s Treasury Bill rate means that Uncle Sam can borrow for free, i.e., that we can run an indefinite Ponzi scheme with our children and never have to raise any generation’s lifetime net tax rate. Blanchard’s most recent book, Fiscal Policy Under Low Interest Rates, makes this case. It’s, unfortunately, deeply flawed.

To be clear, fiscal gap and generational accounting are simple calculations that ignore uncertainty, which explains why the real return on T-Bills generally lies below the growth rate, which generally lies far below the real return on national wealth. Unfortunately, as these two co-authored (with economists Johannes Brumm, Xiangyu Feng, and Felix Kuber) papers — Are Deficits Free? and When Interest Rates Go Low Should Public Debt Go High — show, the only free lunch associated with the observed historic excess of the growth rate over the borrowing rate is improving risk sharing across generations and countries.

Such potential improvements demand bidirectional, not unidirectional intergenerational and international transfers. I.e., in some states of the world, the old should share their good fortune with the young and vice versa in other states of the world. The same holds for any two countries. In short, there is no basis for further ripping off our children to the benefit of ourselves once you get economic theory straight.

Beyond Fiscal Gap and Generational Accounting

Economic computation has moved on since Alan Auerbach and Jagadeesh Gokhale and I presented our first fiscal gap and generational accounting analysis in a January 1991 NBER paper entitled Generational Accounts: A Meaningful Alternative to Deficit Accounting. In particular, we can now simulate large scale, life-cycle models (models in which current generations are happy to expropriate their progeny) with realistic macroeconomic shocks. Blanchard examined a toy version of his model in his 2019 American Economic Association Presidential Address in which he all but proclaimed that deficits are free. Unfortunately, he misread his toy model.

This 2024 paper, co-authored with Jasmina Hasanhodzic, entitled Studying Generational Risk in a Large-Scale Life-Cycle Model, goes beyond refuting Blanchard’s conjecture based on a correct theoretical analysis of his and related toy models. It does so by building a large scale, realistic version of his toy model.

To quote from our abstract, "We find no support for the view that intergenerational policy can deliver Pareto improvements when safe interest rates run below the average growth rate. In our model, such policies entail welfare losses from crowding out that swamp oblique risk-mitigation schemes.” (Pareto improvements are situations in which policy changes are free — they help at least some and hurt none. And intergenerational policy is code for deficit finance.)

The future of fiscal sustainability analysis no longer lies in getting a rough, but telling picture using fiscal gap and generational accounting. Yes, these are infinitely better ways to assess fiscal policy than by obsessing over inherently meaningless, intentionally manipulated, and incredibly short-term federal deficit numbers. But we now have the ability, thanks to computational advances, to simulate the range of potental impacts on future generations if we continue to run fiscal policies that no responsible parent would remotely entertain.

References (Note: Most Books and Papers are Co-Authored, But I Have Reached my Word Limit So Can’t Specify Them.)

1. “Deficit Delusion,” The Public Interest, 1986.

2. “Dynamic Fiscal Policy,” Cambridge University Press, 1987 (Note, see chapter 7).

3. “The Deficit Is Not a Well-Defined Measure of Fiscal Policy,” Science, 1988.

4. “Deficit Thinking,” The Sciences, 1989

5. “Generational Accounting,” The Free Press, 1992

6. “Generational Accounting - a New Approach to Understanding Fiscal Policy,” Scandinavian Journal of Economics,1992

7. “Generational Accounting: A Meaningful Way to Evaluate Fiscal Policy,” The Journal of Economic Perspectives, 1994.

8. “Generational Accounting Around the Globe,” The American Economic Review, 1999

9. “Generational Accounting Around the World,” The University of Chicago Press, 1999

10. “Generational Policy,” MIT Press, 2003

11. “The Coming Generational Storm,” MIT Press, 2004

12. “On the General Relativity of Fiscal Language,“ Institutional Foundations of Public Finance, Harvard University Press, 2008.

13. “The Clash of Generations,” MIT Press, 2012

14. “Are Deficits Free,” The Journal of Public Economics, 2022.

15. “When Interest Rates Go Low, Should Public Debt Go High?" The American Economic Journal: Macro, 2024.

16. “Studying Generational Risk in a Large-Scale Life-Cycle Model,” forthcoming, The Journal of Money, Banking, and Credit, 2025.