3  Projecting primary balances

When the terminal date T in equation (8) is set at less than infinity the fiscal gap is solving to ensure that the debt-to-GDP ratio returns to the initial ratio in the specified terminal year. Taxes and/or spending are adjusted to generate a path of primary balances that returns the debt ratio to the initial value. (It is possible to specify alternative debt targets.) Although an infinite time horizon seems the most relevant for government, it raises questions about the appropriate “current policy” projection of the primary balance given the uncertainty behind the parameters affecting taxes and spending. Shorter-term, finite horizons are often used to provide a “consistency check”.

The US Congressional Budget Office (CBO, 2000) calculates fiscal gaps over a 75-year time horizon (the same time period used by the US Social Security trustees in their projections). In the context of population ageing, Blanchard suggests the application of a “long-term tax gap” for a 50-year period that, at a minimum, should include major transfer programmes and use simple assumptions about other spending programs. In calculating ENW, Wells (1996) sets the time horizon H (analogous to T above) to match the lifetime applicable to the youngest existing generation (i.e., the generation born in the initial year, which gives H = 75 years).

In his application of the fiscal gap to the long-term US fiscal position, Auerbach (1994) considers terminal dates of 2031, 2071 and ∞. Auerbach (1994, 1997) and Auerbach and Gale (1999a) argue that terminal dates set at less than infinity are arbitrary and understate the magnitude of the US fiscal balance because the primary balance is projected to be in deficit in the years approaching 2070 and those that follow.[6] Ongoing primary deficits result from their assumption that taxes to GDP are constant, and Social Security and Medicare maintain their 2070 expenditure shares of GDP in subsequent years as the population structure stabilises. These assumptions allow for the calculation of a “permanent” time horizon measure of the fiscal gap. For the US this will be greater than the fiscal gap calculated for a finite horizon T. This is because the primary deficits projected after 2070, which are included in the permanent measure, are larger than those in a typical year up to 2070.

Table 1 summarises a selection of US fiscal gap estimates generated by the CBO and Auerbach and Gale to provide a sense of how estimated fiscal gaps vary according to the choice of T and how they change with updated projections of primary balances. Table 1 indicates that including years after 2070 has a considerable impact on the calculation of the size of the US fiscal gap and the calculations of the fiscal gap change through time.

According to the CBO (1997), around two-thirds of the improvement in the fiscal gap from 5.4% in May 1996, to 4.1% in March 1997 comes from changes in their 10-year projections of taxes and spending.

Note: The Auerbach and Gale results are not directly comparable to those of the CBO even over a similar time horizon because of methodological differences. These relate mainly to the exclusion of feedback effects in the Auerbach and Gale calculations. The CBO projections include feedbacks between the fiscal position, national saving and investment, and real interest rates. The effect of the fiscal deficit on investment is assumed to be partially offset by increased private saving and foreign borrowing. There are no economic feedbacks from tax rates to labour supply or private saving, or between government investment and private sector output.

Tax and spending assumptions also influence the size of the US fiscal gap. Beyond the first 10-years the CBO projections use “simple rules” reflecting historical patterns. For example, discretionary spending is held constant as a share of GDP so that discretionary programs rise with inflation and real economic growth. If discretionary spending after 2009 is increased only at the rate of inflation (i.e., there is no real growth in spending and so, with real GDP growing this will involve a falling share of GDP), the 75-year CBO fiscal gap falls from 0.5% to minus 0.7%.

Auerbach and Gale (1999b) note that the baseline assumption for discretionary spending in the first 10 years sees its share-to-GDP fall from 6.6% in 1998 to 5% in 2009. As a result, more than half of the 10-year surplus is based on this assumption. If discretionary spending were held at its 1999 share of GDP, Auerbach and Gale’s estimate of the (permanent horizon) fiscal gap increases from 1.3% to 3.17%.

The CBO baseline projections assume that tax receipts remain constant as a share of GDP after the first 10-years. Auerbach and Gale (1999b) estimate that somewhere between 79% and 96% of the recent surge in revenue is assumed to be permanent in the 10-year projections.

The CBO (1999) acknowledge that the tax-to-GDP share at the end of the 10-year baseline projection is higher than in any year during the post-WWII period, except 1998. If receipts are assumed to return to the level in the decade preceding 1994 (19.5% of GDP), the fiscal gap increases from 0.5% to 1.6% of GDP.

The assumptions around revenues and expenses in the Treasury’s projections are discussed in Section 5.