The Method of Generational Accounting

This section draws heavily on Auerbach and Kotlikoff (1999) in summarizing the standard method of generational accounting. This methodology was first developed in Auerbach, Gokhale and Kotlikoff (1991).

Generational accounting is based on the government’s intertemporal budget constraint, which given in equation (1). This constraint requires that the remaining lifetime net tax payments of current generations and the lifetime net tax payments of future generations suffice, in present value, to cover the government’s bills – the present value of its future spending on goods and services as well as its official net indebtedness.
The first term on the left side of (1) sums the generational accounts — the present value of the remaining lifetime net payments — of existing generations. The term Ngc stands for the account of the generation bom in year k. The index к in this summation runs from t-D (those age D, the maximum length of life, in year 0) to t (those bom in year 0).

This constraint doesn’t imply that the government ever retire its debt, only that it service at each point in time all debt that remains outstanding.

The second summation on the left side of (1) adds together the present values of the generational accounts of future generations, with к again representing the year of birth. To measure the value of these prospective future generational accounts as of time t, we need to discount these accounts to time t. We do so using the economy’s real before-tax rate of return, r.

The first term on the right hand side of (1) expresses the present value of government consumption. In this summation the values of government consumption in year s, given by Gs, are also discounted to year t. The remaining term on the right-hand side, Df, denotes the government’s net debt in year t — its explicit debt minus its assets, which consist of its financial assets plus the market value of state enterprises and extractable resources. credit

Equation (1) indicates the zero-sum nature of intergenerational fiscal policy. Holding the present value of government consumption fixed, a reduction in the present value of net taxes extracted from current generations (a decline in the first summation on the left side of (1)) necessitates an increase in the present value of net tax payments of future generations.