On Wednesday, March 15 at noon, the Golub Center for Finance and Policy hosted Professor Jasmina Hasanhodzic of Babson College in a special research seminar. Professor Hasanhodzic presented her paper “Valuing Government Obligations When Markets are Incomplete” (joint work with Laurence Kotlikoff).
Valuing future government spending commitments and tax receipts, whether they are sure or risky, is critical to assessing the sustainability of fiscal policy. If markets were complete it would be an easy matter to determine if the present value of projected spending exceeded the present value of projected receipts. But such markets don’t exist for numerous reasons including the inability of the living to trade with the unborn. The approach taken here posits and simulates a ten-period overlapping generations model and uses it to determine the immediate payments—the compensating variations—agents would require to forego promised government future net payments. “Agents” include future generations who are assumed to discount their utility while alive for the number of years it will take for them to be born. Our metric for pricing the compensating variations is agents’ expected utility functions. The sum total of compensating differentials represents a risk-adjusted fiscal gap—the present value of what the government has promised to pay current and future generations in transfer payments net of what it has promised to take from them in taxes. We find that the appropriate fiscal discount rates to be applied to promises of sure future payments depend on the agent’s age (which, as indicated, can be negative) and the state of the economy. They also depend on the size of the payments and whether the promises incorporate the general equilibrium effects of the promised payments. For infinitesimal payments, which have no general equilibrium feedback effects, the discount rates are, surprisingly, remarkably close to the economy’s prevailing safe short-term rate of return. This finding provides some support for standard government practice of discounting firmly promised future benefits and taxes, such as those associated with the U.S. Social Security system, at a fixed rate.