The Coming Generational Storm

This paper extends the Auerbach-Kotlikoff life-cycle simulation model by incorporating demographic change, including lifespan extension, and multiple earnings groups within each cohort. The model is used to study the U.S. demographic transition. To ensure a realistic pattern of fertility by age, the model assumes that each agent gives birth to fractions of children during his child-bearing ages. The new model can also initiate transitions from arbitary initial conditions. The baseline simulation, which assumes a continuation of social security pay-as-you-go finance, exhibits sharp increases over time in the payroll tax rate. This increase siphons away so much saving that capital shallowing, rather than capital deepening, occurs over time. Hence, general equilibrium feedback effects exacerbate, rather than mitigate, the problems arising from population aging. The paper also simulates a range of policy reforms, including privatizing social security with different finance mechanisms. The simulations indicate that, compared with a continuation of current policy, privating social security would generate very major long-run welfare gains, particularly for the poorest members of society.