Oil price risk, prudent fiscal policy, and generational accounting

Oil price risk, prudent fiscal policy, and generational accounting Erling Steigum This paper proposes a new method for adjusting generational accounts for risk. Generational accounting is a tool that has proven very useful in addressing fiscal policy sustainability issues, particularly in welfare states with complex tax-transfer systems and population aging. In the case of Norway, an additional problem for fiscal planning is the government's considerable exposure to oil price risk. Up till now, adjustment of generational accounts for this source of risk has been ad hoc and not transparent. The analytical framework is an overlapping generations model of a small open economy with an exhaustible resource (petroleum) wealth owned by the government. We assume that the oil price risk cannot be diversified in international capital markets. The optimal policy of the government is derived from expected social welfare maximization. Adopting a CRRA welfare function, the optimal tax policy involves intergenerational risk sharing and fiscal prudence in terms of precautionary public saving. It is the optimality of fiscal prudence that warrants a risk adjustment of the petroleum wealth. The risk adjustment factor is derived from a quadratic approximation of the first-order condition for social welfare maximization. We show how future resource revenues can be adjusted for risk such that a zero generational account deficit corresponds to the optimal policy. The method can be applied even if the actual policy does not imply generational balance in a real world application. The proposed method shows how such a risk adjustment could be related to parameters characterizing the probability distribution of future petroleum revenues and to the coefficient of relative risk aversion. The method is illustrated using stylised facts about the Norwegian economy. More information about the stochastic properties of the petroleum wealth is however needed before more reliable assessments of the quantitative importance of the risk adjustment can be made.