Characterizing the Effects of Entitlement Reform in a Perpetual Youth Model∗ (Preliminary and Incomplete)

The U.S. federal government is facing the prospect of exponentially rising entitlement obligations that are threatening to push the debt-to-GDP ratio to historically unparalleled levels. In an effort to understand the economic consequences of these projected debt run-ups, this paper takes a stand on how future policy must adjust and examines its implications for the aggregate economy. Assuming the monetary authority never relents on its policy to aggressively fight inflation, delaying reform forces taxes continuously higher and increases the probability of the economy reaching the fiscal limit, the point at which increases in taxes are no longer feasible. Recognizing the potential economic consequences of reaching the fiscal limit, this model places the fiscal authority in a horse race to pass reform prior to the economy hitting the fiscal limit. If reform is passed prior to reaching the fiscal limit, tax policy is able to remain passive, as transfers switch to a stable process that holds indefinitely. If, on the other hand, the fiscal limit is reached, taxes become active and, assuming government default is not possible, the monetary authority is forced to passively adjust the nominal interest to rising inflation. Although this policy adjustment helps to stabilize debt, it fails to address the underlying problem. Without reform, transfers continue to follow an unstable path, and, without a clear direction from Congress or the aid of monetary policy, inflation begins to pose a significant challenge for the aggregate economy.