Don't Let Class Warfare Turn Into Generational Warfare

Whether you call it "class warfare" or not, income and wealth were dividing lines in the 2012 election.

President Barack Obama campaigned to raise taxes on the top 2 percent of earners. Mitt Romney called the 47 percent of Americans who didn't pay federal income taxes in 2009 "entitled" and "dependent upon government." And income was a strong predictor of voting preferences, too, with richer voters casting ballots for Romney and poorer ones for Obama.

A new division may emerge in future, based not on income but on age.

The coming generation of retirees hasn't paid nearly enough in taxes to cover the costs of the pensions and medical care it has promised itself. The generation of Americans between ages 60 and 65 in 2010, for instance, has underpaid by some $292 billion, according to the International Monetary Fund.

That means young Americans -- and those yet to be born -- will face an ugly decision. Either they can cover their parents' and grandparents' bills by raising their own taxes, or they can cut their elderly relatives' benefits.

How much would taxes have to rise? Substantially, if not to impossibly high levels, though the exact amount depends on future policy, demographics and discount rates.

The IMF thinks it could take an additional 57 percent in tax revenue for the government to make good on its promises, if it was to close the gap with taxes alone. A 2001 study by a pair of economists, Jagadeesh Gokhale and Laurence J. Kotlikoff, also projected that net tax rates would have to rise from 36 percent of total income for individuals born in 2001 to 73 percent for those born in 2026. Your descendants surely won't appreciate that inheritance.

What about cutting benefits, then? Social Security would require a 27 percent cut to square scheduled benefits with forecasted tax receipts, and Medicare a 33 percent cut, according to the trustees of both social-insurance programs.

It's worth remembering that while a spending cut and a tax increase might be equivalent from the perspective of balancing the budget, they're opposites when it comes to equity among generations. Tax increases raise net lifetime transfers of wealth; cuts in spending lower them.

Here's a prediction: What to do won't be an easy choice for the U.S. An open political struggle will break out between an elderly generation of beneficiaries and a younger generation of taxpayers. The young are unlikely to surrender an extra 10 percent or more of their lifetime income to cover the expenses of the elderly without a fight.

It's not that the young don't believe in a social safety net that includes old-age and health insurance. Most of them do, though polls show they are open to ideas like privatization. It's that the young will be right to insist that a safety net can only work on the basis of an intergenerational compact -- one which asks every generation to pay its own way. The older generation has violated that compact.

Elders should make a good-faith effort to permanently fix the system according to principles of generational equity. It's too late for them to fully square up to their obligations -- but at least they can leave a more just system.

My recommendation is for a tax penalty on Social Security benefits, levied proportional to the rate of underfunding by each birth-year cohort, with revenue returning to the trust fund. The Social Security Administration already maintains such estimates of unfunded liabilities.

Suppose those born in 1950 paid enough in lifetime Social Security taxes to cover 70 percent of their scheduled benefits, leaving the other 30 percent an unfunded liability. When their Social Security benefits are paid out, the federal government could raise a tax on those benefits to reduce the unfunded liability, either fully or by some fraction of the total amount.

If the fraction was half, the cost of unfunded liabilities would be evenly split between each generation and its successors. In this example, the tax would be 15 percent of benefits.

Any such tax would have to be phased in gradually. It could rise 2 percent each year for 25 years, say, until it reached the half-and-half penalty. (Penalty surtaxes could be levied on estates according to birth year, too.) Medicare would need a similar arrangement, though the details would differ because it isn't a cash transfer. The offsets could be elevated Medicare premiums, deductibles and coinsurance payments.

Insisting on greater generational equity would lessen the incentive for voters to award themselves bigger benefits than they're willing to pay for. That would be progress. What each generation owes the next is a complicated question, though: There's more to it than balancing cash flows.

Every generation inherits institutions, knowledge, technology and private wealth, and with that, you could argue, some obligation to its forebears. Still, young people shouldn't also inherit fiscal obligations so huge as to absorb much of their own effort. Using public borrowing to underwrite a huge transfer of wealth from the young and unborn to the old breaches that basic notion of fairness.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.