It is now almost two decades since the development of the prototype of the Auerbach-Kotlikoff dynamic life-cycle simulation model (the A-К Model). The model has been used to examine a host of policies, including tax reform, tax cuts, investment incentives, tax progressivity, expansion of social security, government spending, monetary policy, endogenous growth, the size of the informal sector, human capital accumulation, and educational policy. It has also been used to study demographic change, the timing of policy impacts, the efficiency gains from fiscal reforms, and the effects of fiscal policies on both the intra- and intergenerational distributions of economic welfare.
Although much of the research on the model has been conducted by Auerbach and Kotlikoff and their co-authors, economists around the world in academia, government, and multilateral lending institutions have developed and studied their own versions of the model.
This paper describes, in the next section, the origins of the A-К Model and the economics profession’s reaction to it. Section III considers some of the general lessons that have been learned in using in the model. Section IV illustrates the model’s current capacities by considering tax reform and social security privatization. Section V discusses outstanding research questions and the need for additional improvements to the model. The Appendix, reproduced from Kotlikoff, et. al. (1997), lays out the model’s current structure and describes its method of solution.
Origins of the A-К Model
The 1970s was a period of tremendous intellectual ferment in academic economics, in general, and public finance, in particular. In macroeconomics, Lucas and Sargent were dismantling the foundations of postwar Keynesian economic analysis. Their critique focused on shortcomings in Keynesian econometric practice. But in forming their critique, they stressed the importance of connecting macroeconomic outcomes to microeconomic fundamentals and that the current economic decisions of rational economic agents depend as much on their expectations about the future as they do on their immediate circumstances.