This is related to the so-called OECD approach which also relies on the
intertemporal budget constraint but which for a finite horizon solves for the
needed adjustment given an assumed level of debt at the end of the period
(Blanchard(1990)). The latter property of the method introduces a large ele-
ment of arbitrariness in the analysis since the results are very sensitive to the
imposed time horizon and the stipulated debt level3 .
From the abovementioned forward looking approaches it possible to calcu-
late the level at which e.g. taxes need to be to ensure that the intertemporal
budget constraint is fulfilled4 . The latter is often motivated by reference to tax
smoothing arguments.
One shortcoming of these approaches is that they neglect general equilibrium
effects of say changes in taxes. This is a serious shortcoming in evaluating both
the order of magnitude of the needed changes to ensure fiscal sustainability and
the implications of various types of reforms. The second generation approach5
to which the present paper belongs is thus based on an explicit intertemporal
general equilibrium model (here: an OLG model for Denmark, cf below). The
main attraction is that this approach is formulated in such a way that it can be
used directly in the process of formulating and assessing policy proposals.
3 A forward looking method using an OLG model
The purpose is to develop indicators making it possible to assess the sustain-
ability of current policies, and in the case of sustainability problems the order of
magnitude of the required reforms. The following outlines the basic mechanisms.
A simple model in the appendix illustrates the calculation of the indicators and
their relation, while later sections present applications for Denmark.
Denote the primary budget deficit - revenues less expenditures - (relative to
GDP) by
b(xt, yt, zt) (2)
where x denotes a vector of endogenous variables, y a vector of policies, and z a
vector of exogenous variables (including foreign variables, demographics, shocks
etc.). The endogenous variables are determined by some model left unspecified
here for simplicity, but the endogenous response of various variables and how
they impinge on the public budget is of course central to the whole approach,
cf below.
Policies are given by
3 However, for a sufficiently far-sighted horizon the sensitivity wrt. the debt level may be
very limited.
4 Frederiksen (2001) proposes a method to calculate the sustainable budget balance given
the intertemporal budget constraint and assuming a exponential form for the deterioration
in net tax receipts. A disadvantage of this approach is that the sustainable budget balance
under a sustainable policy is not time invariant.
5 Heide et.al. (2005) make an assessment of fiscal sustainability for Norway using a CGE-
model and solving for the PAYG value of the pay-roll tax. See also Fehr, Jokisch and Kotlikoff
(2004) and McMorrow and Roeger(2004).