Unprecedented Fiscal Stress in a Perpetual Youth Model

by Alexander W. Richter, Indiana University

The Congressional Budget Office (CBO) projects that federal debt as a share of output will explode. After incorporating fiscal adjustments that are widely expected to be enacted, they contend that by 2035 federal debt held by the public will reach 185 percent of GDP. Nearly all of these projected increases in government debt are the result of increases in the growth of spending on the largest three entitlement programs − Medicare, Medicaid, and Social Security. By 2035, CBO projections indicate that total spending on entitlement programs will rise from 10.1 to 16 percent of GDP, of which roughly three-quarters can be attributed to increases in Medicare spending. For historical context, debt has exceeded 100 percent of GDP only for a short period during World War II, peaking at 113 percent of GDP in 1945. However, unlike the period following the War, when debt relative to GDP fell sharply over the following two decades, budget shortfalls are projected to continue widening for the foreseeable future (Congressional Budget Office 2010). The literature emphasizes examining the distributional and aggregate implications of various fiscal policies. The conventional models are two-period and, more recently, sophisticated 55-period overlapping generations (OLG) models that incorporate inter- and intra-generational heterogeneity, life-cycle and population dynamics, bequest motives, stochastic income levels, and several program-specific components. These features assess distributional and generational effects, but do not deal with the degree of uncertainty that actually surrounds the policies. In models with forward-looking agents, ignoring uncertainty pushes the effects of policy adjustments toward the present.

This paper takes a stand on how future policy must adjust. Reaching the fiscal limit, the point at which increases in taxes are no longer feasible, is an unavoidable reality when political gridlock prevents the passage of sweeping entitlement reform. At this point, regardless of whether it is due to political or economic reasons, either the monetary authority is forced to forego its inflation target or the fiscal authority is forced to reduce its promised entitlement benefits. My research examines how expectational forces impact both aggregate and distributional outcomes, whether reductions to entitlement benefits are inevitable, and how the presence of long-term debt impacts these outcomes.

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