Behind the Numbers: The Great Surplus Debate



Save It

Alicia H. Munnell

A
booming economy, surging tax revenues, and three budget deals (1990,
1993, and 1997) have allowed the administration's Office of Management and
Budget (OMB) to project budget balance this year and surpluses thereafter. The
Congressional Budget Office (CBO) also projects surpluses, beginning in 2001. No
sooner did surpluses appear on budgeteers' spreadsheets than tax cutters,
highway builders, and a host of others attempted to claim them. President
Clinton countered with his State of the Union call to "Save Social Security
First." Although the President flagged the right priority, he missed a striking
opportunity. He should have called for separating Social Security from the rest
of the budget. The surpluses belong to Social Security; there are no surpluses
in the rest of the budget. Taking Social Security out of the unified budget
allows Social Security to increase the national savings rate and politically
shores up the program

ARE THE SURPLUSES FOR REAL?

The challenge of balancing the unified budget went very quickly from hard
to easy, thanks to strong economic performance and a related but not yet fully
understood jump in federal revenues. Future surpluses depend on a continuation
of this strong economic performance. Continued economic health depends, in turn,
on both continued good luck—for example, the Asian crisis has only minimal
impact on the U.S. economy—and the monetary policy decisions of the Federal
Reserve. The Fed remains the only game in town, since the march toward surpluses
means fiscal policy will be restrictive for the foreseeable future. The economy
is in unknown and unexpected territory. No one five years ago would have
predicted that unemployment could hover around 4.7 percent while inflation
remained around 2 percent. The Fed deserves credit for its willingness to
experiment in this new economic environment, and its continued flexibility will
be key to a prolonged expansion and budget surpluses.

The 1997 budget deal cut the deficit by $118 billion over 1998-2002 and
pushed the budget from red ink into black. The legislation made significant cuts
both in the so-called mandatory side of the budget via detailed programmatic
changes to Medicare and in the discretionary outlays that include defense and
other domestic programs. The budget deal, however, did not spell out how these
discretionary programs were to be cut but rather imposed a complicated series of
caps. These limit discretionary spending in 2002 to the level of nominal
spending in 1999; inflation will pare the purchasing power of that spending by
about 12 percent from today's levels. Even if Congress and the administration
balk when they see the particulars and trim the discretionary spending cuts to 6
percent, the budget will still be in surplus through 2008, the end of the
projection period.

How those short-term changes translate to the long run, however, is more art
than science. For example, OMB projections show a "current services" budget in
surplus almost through 2060. But these projections are very sensitive to
assumptions about the growth in discretionary spending—it grows in line with
inflation, grows in line with population, or remains a constant share of GDP—and
the future of health care costs. My view is that deficits
will probably reemerge as the baby boom retires. The question is what to do with
the surpluses in the meantime.

DON'T GIVE THE SURPLUSES AWAY

The biggest threat is that the surpluses will be given away either
through an assault on the tax code or simply as tax cuts. Although critics
bemoan the complexity of the tax code, to date it has been relatively simple for
most American taxpayers. Roughly 75 percent of filers use the standard
deduction, and most of the remaining 25 percent claim deductions simply for
mortgage interest, state and local taxes, and charitable contributions. But this
will change. The legislation passed in August 1997 that cut taxes on families
with children, small-business owners, and investors required more than 800
changes to the code. Capital gains tax cuts and confusing individual retirement
account choices will further complicate the top end of the income scale. For
middle-income families the complexity will come from education and child
credits, which will require separate calculations and involve complex phase-outs.
This increased complexity may increase taxpayer frustration.

H
earings before the Senate Finance Committee in late 1997 created the
impression that the Internal Revenue Service commonly abuses taxpayers. This is
most probably not true. The bipartisan Kerrey-Portman IRS commission recently
concluded that there was no systematic abuse of taxpayers. Instead the
commission's report noted, "The agency spends significant resources educating
personnel to treat taxpayers fairly, and the commission found very few examples
of the IRS personnel abusing power."

The four witnesses, who really did have horrible stories, were culled from
approximately 1,500 people who had contacted the committee. It's impossible to
know how many of them had legitimate complaints, but assume they all did. That's
1,500 compared to 200 million tax returns filed each year and roughly 2 million
audits. That's abuse at the rate of .00075 percent—not acceptable, but hardly
widespread.

Regardless of the facts, the attack on the IRS has helped fuel the attack on
the tax code. Louisiana Republican Representative W. J. (Billy) Tauzin, who
joined Texas Republican Dick Armey in an antitax road show last fall, said that
the IRS is "drunk with power." He went on to say that "If you've got any agency
that's drunk with power, the first and most important thing you do is take the
liquor away—the IRS code itself."

Scrapping the Internal Revenue Code has little to recommend it. Moving from
progressive rates to a flat rate raises the tax burden drastically on low-income
families and reduces it sharply on the rich. [See Joshua Marshall, "A Liberal
Tax Revolt
."] At the same time, the pressure to return some part of the
unified budget surplus in tax cuts will be almost irresistible. Since the budget
rules constrain outlays, lawmakers are always tempted to achieve spending
objectives through the tax system. Several critics have also been bemoaning the
inequities created by the so-called marriage tax. The only hope of permanently
protecting the surpluses is to clarify that they belong to the Social Security
program and make them unavailable for alternative purposes.



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REMOVE SOCIAL SECURITY FROM THE BUDGET

Until now, separating Social Security from the unified budget has been
politically impossible—despite numerous formal attempts—because it would have
made the federal deficit look even bigger than it was. With the rosier budget
picture, OMB projects that even the non-Social Security part of the budget will
be in balance by 2007. Removing all Social Security revenues and expenditures
from the budget documents and the annual budget process would focus public
discussion, analyses, and budget-balancing efforts thereafter on the non-Social
Security section of the budget.

With this change, the Social Security system would become a vehicle to
increase national saving and capital accumulation without resorting to the risky
and expensive option of individual, private accounts. More saving is not an end
in itself but rather a means of achieving more investment, increased
productivity growth, and higher levels of income in the future.

To date, increasing saving through accumulations in the Social Security trust
funds has produced ambiguous results. Including Social Security in the unified
budget has meant that Social Security surpluses have been available to finance
deficits in the rest of the budget. Critics contend that the existence of Social
Security surpluses encourages either taxes to be lower or non-Social Security spending to be higher than it would have been otherwise. Although little
evidence exists to support this contention, an accounting treatment that
separates Social Security from the rest of the budget will clarify the extent to
which the system is adding to national capital accumulation.

We have tried other means of increasing saving, and they have not worked.
When American saving rates dropped dramatically in the 1980s, Congress responded
with the development of special tax-favored saving and pension accounts, such as
individual retirement accounts, 401 (k) plans, and Keogh plans. A lot of money
was accumulated in these accounts, but personal saving declined. My reading of
the evidence is that individuals have shifted their saving toward the tax-favored
vehicles, but have not increased the total amount of saving. The result
has been a loss of federal tax revenues without any compensating response from
individuals. Economists agree that reducing budget deficits or accumulating
budget surpluses is the most direct and effective way to increase the nation's
saving rate.

Social Security has been part of the budget since 1969, when the Commission
on Budget Reform advocated the unified budget concept to better measure the
effect of budget policy on the economy. But fiscal policy has diminished in
importance since the late 1960s, reflecting the observed inability of Congress
to make timely decisions, a changed perception of the importance of fiscal
policy for stabilization in a world with increasingly integrated capital
markets, and the intense focus on balancing the budget.

To politicians who have labored hard during the 1990s to eliminate deficits
in the unified budget, shifting Social Security out of the budget will seem to
be moving the goalposts. As soon as they declare victory on balancing one
budget, they will be faced with a deficit in another budget. Therefore,
postponing the shift, perhaps until 2007 or so, would soften resistance. It
would also prevent undue pressure to further cut discretionary spending, which
has already taken more than its share of hits.

Would it work? Comparisons of the federal government with the states are
always tricky, but states have been successful in this endeavor. They accumulate
reserves to fund their pension obligations but generally balance their budgets
excluding the retirement systems. Their nonretirement budget balance has
remained positive, while annual surpluses in their retirement funds have been
hovering recently around 1 percent of GDP. Thus, states appear to be adding to
national saving through the accumulation of pension reserves. With a commitment
to balance the non-Social Security portion of the budget the same should be
achievable at the federal level.

The best way to protect the surpluses from unwise tax cuts and to protect the
Social Security program from those who want to privatize it is to take Social
Security out of the unified budget. In the short run, this move would make clear
that there are no surpluses in the non-Social Security part of the budget and
would mute calls for tax cuts and unfunded spending increases. For the long run,
the accounting change would eliminate the possibility of using surpluses in
Social Security to mask deficits in the rest of the budget. Documenting that the
Social Security trust funds were an effective saving vehicle would remove a
major argument from those who want to privatize Social Security into a system of
individual accounts.



Invest It

Dean Baker

W
ith the federal budget deficit under control, we can at last focus on
the other rising deficit—of public investment. There is a proven correlation
between public outlay on physical and human capital and a country's productive
capacity. Yet over the last two decades in the United States, public investment
in almost all areas has declined precipitously. Since peaking in the late 1970s,
federal spending on public investment, measured as a share of total economic
output, has fallen by more than a third. If current budget trends hold, it will
fall another 35 percent over the next ten years. These investment declines could
significantly impede economic growth in the next century.

In orthodox thinking, deficit reduction reduces interest rates and thereby
allows for more private-sector investment. This in turn boosts productivity
growth and long-term economic growth. The current rosy economy is often
attributed to deficit reduction. Certainly, one can cheer aspects of the current
economic situation. The unemployment rate has fallen to its lowest level since
the early 1970s, and real wages have begun to rise. But while the economy's
growth rate has been respectable, it is virtually identical to the path
projected before the President's deficit reduction plan was implemented in 1993.

And while the deficit has fallen faster than anyone had anticipated, the
impact on real interest rates has been limited. The average real (inflation-adjusted)
rate over this period has been 3.9 percent, only slightly higher than
the 3.8 percent projected by the Congressional Budget Office (CBO) prior to the
passage of the Clinton budget.

Contrary to widespread belief, the investment share of GDP in 1997 was the
same as in the last business cycle peak in 1989—10.4 percent, which is far below
its 1979 peak. Thus the decline in the deficit did not increase investment share
or productivity growth. The rate of productivity growth over the current cycle
is nearly the same as the 1980s rate and considerably lower than the rates in
both the 1960s and 1970s. While there was strong productivity growth in the
first three quarters of 1997, this more rapid growth would have to continue for
a considerable time to offset the slow growth earlier in the decade. So deficit
reduction has not met expectations in terms of spurring overall growth, private-sector
investment, or productivity growth.

INVESTING LESS AND LESS

Economists agree that what has contributed significantly to
economic growth over the last half century is public investment. Some studies
suggest that expenditures on public investment actually affect productivity more
than private investments do. But even if the impact of public and private
investment on productivity is roughly comparable, recent trends are alarming
because the decline in public investment has not been offset by increases in the
private sector.

This decline in total investment bodes ill for our future. As we enter the
twenty-first century, we need to educate and train our workers, upgrade our
infrastructure to support new technologies, and give basic science the means to
sustain innovation and technological advance. But we may not be able to make
these crucial investments.

Human capital. Outlays on education, training, and early childhood
needs are sound investments because they increase the economy's productive
capacity in the future. But spending on education and training, after rising
throughout the 1960s and 1970s, has fallen by about 50 percent since 1976.
Spending fell steeply in the early Reagan years, increased slightly under the
Bush administration, and then continued to decline under Clinton. This area of
spending is projected to experience further cutbacks over the next ten
years.

Physical capital. Public expenditures on physical capital provide the
basic infrastructure that the economy needs to sustain itself—the roads,
bridges, highways, and airports that support the transportation of people and
goods. They also include facilities such as water purification systems, which
provide clean drinking water to most cities, and sewage treatment facilities,
which protect the nation's lakes and rivers. A well-planned system of
infrastructure can lead to better use of existing urban areas and nearby
suburbs, thereby reducing sprawl and the resulting pollution. Construction of
efficient mass transit systems can also provide people with an attractive
alternative to driving.

Here, too, spending has fallen. After federal outlay on physical capital
peaked at just over 0.8 percent of GDP in 1980, it has since fallen to 0.5
percent of GDP and, if budget constraints on discretionary spending remain in
place, may fall to less than 0.3 percent of GDP by 2007. Pollution-control
facilities, such as waste-water treatment plants and urban mass transit [see J.
W. Mason, "The Buses Don't Stop Here Anymore," TAP, March-April 1998],
have suffered the most severe cuts in recent years.

Research and development. In each of the major industries in which the
United States is the recognized world leader—aerospace, computers, agriculture,
and pharmaceuticals—federal expenditures on research and development have been
essential to growth. In the case of both aerospace and computers, research
financed by the Defense Department or NASA led to major technological
breakthroughs. The research supported by the Department of Agriculture and the
system of land grant universities established to promote the spread of modern
agricultural practices have been critical to establishing the United States as
the world's leading agricultural producer. The government's support for research
conducted through the National Institutes of Health has stimulated the
pharmaceutical and biotechnical industries. Until recently, more than half of
the research and development in pharmaceuticals was paid for by the
government.









FEDERAL CIVILIAN INVESTMENT SHARE OF GDP

graph
Source: Office of Management, and Budget, General Accounting Office.

The government's role in supporting basic research is crucial because there
is a considerable time lag between scientific discovery and successful
commercial applications, and the private sector is generally reluctant to
support investments that require such a long payoff period. Furthermore, some
discoveries may lead to enormous gains to society but might not provide much
profit for an individual firm. Such research requires public support. But
federal support has dwindled considerably since the 1960s—and projections show
it falling further in the future. In 1966, federal spending on research and
development was nearly 1 percent of GDP. On its current trajectory, R&D
spending will fall to less than 0.25 percent by 2007.

T
he President's 1999 budget does include modest investment in creases:
an additional $6.3 billion in research subsidies; tax credits over five years to
promote energy conservation; an additional $7 billion to reduce the average
class size for young children; and $1 billion a year toward renovating the
nation's schools. Though worthwhile, these funding levels are woefully
insufficient. And even if all the President's proposals were passed into law,
total expenditures on public investment would still decline because of cuts in
other areas. The Office of Management and Budget (OMB) projects that, even when
the President's entire investment package is included, public investment will
increase at the rate of 1.6 percent a year from 1998 to 2003—which is more than
one-half of a percentage point less than the OMB's projected 2.2 percent rate of
inflation. When investment spending falls in inflation-adjusted dollars, it
falls even more rapidly as a share of GDP. Moreover, the President won't get all
the investment he has requested; Congress has its own agenda, and some of the
funding for the President's proposals depends on uncertain events such as the
tobacco settlement. The general trend for public investment is downward, and the
only question is how fast it will fall.

INVESTMENT WE NEED

To calculate the investment shortfall, we can use 1976, a typical year in
postwar fiscal policy, as a baseline. Using this comparison, the shortfall in
public investment for 1998 is a whopping $68.2 billion. The largest spending
deficit, $26.1 billion, occurs in education and training. The shortfall in
spending on physical capital is $21.9 billion, and $18.5 billion in R&D. If
projected spending paths hold, the shortfall will rise to $173.1 billion in
2007, at which point we will be spending $55.9 billion less in physical capital,
$52 billion less on education and training, and $45.5 billion less on R&D
than we were in 1976.

A
n even more dramatic shortfall emerges when we compile estimates from
government agencies and experts in various fields of the public expenditures
needed to meet basic goals, such as maintaining bridges at acceptable standards
or providing adequate school facilities for children. For example, an additional
$11 billion in annual federal spending will be needed to stabilize the physical
condition of the nation's schools. The unmet need for higher education, as
measured by the estimated cost of extending the Pell Grant program to all
eligible low-income students wanting to attend college, is $10.1 billion. The
shortfall in spending on training, as measured by comparing the level of U.S.
expenditures as a share of GDP with the average spent on training by the
Organization for Economic Cooperation and Development (OECD) countries, is $22.8
billion. (And if you compare U.S. spending on training with comparable spending
in Germany, the shortfall is even higher: $32.5 billion.) And to fully fund Head
Start, which currently enrolls only one-third of the low-income students who
qualify for it, would require an additional $8.6 billion.

The largest estimated needs in the area of physical capital are for
expenditures to maintain and improve the nation's highways and bridges and the
mass transit capital stock. To fill potholes and re-pave highways, as well as to
ensure the structural integrity of the nation's bridges, the government will
need to spend $11.4 billion. This is a question not just of basic safety, but of
sustaining projected levels of economic growth. Public investment can be used
not just to guide economic growth, but to counterbalance suburban sprawl.

The present level of U.S. spending on R&D, measured as a share of GDP, is
below the OECD average. To increase civilian research dollars as a share of GDP
to Germany's level, for example, the United States would need to invest $6
billion more in basic research; to match Japan's R&D spending relative to
GDP, we would need to spend $14 billion more.

Any means of estimating our unmet public investment needs are, by necessity,
crude. Even these rough estimations, however, suggest that a substantial
shortfall exists. In our deficit-cutting zealotry, we've skimped on public
investment for the better part of two decades—and we now find ourselves
confronted with a backlog of needs and an inadequate current level of spending
to address them. Failure to use the surplus to increase public investment will
slow the country's economic growth and jeopardize the health and safety of the
population.



Understand It

Robert Eisner

L
ast summer, the Wall Street Journal labeled as "Invincible
Ignorance" a Republican proposal to run federal budget surpluses. With the
surplus at last here, the label is now all too bipartisan, as President Clinton
recommends that we reserve every penny of the surplus for Social Security. As
tactics, this may be a clever way of heading off regressive Republican tax cuts,
but as strategy it just reinforces the conservative fiscal assumptions that
continue to paralyze many Democrats.

The government's running a surplus, whether "reserved" for Social Security or
anything else, means it takes more in taxes than it gives the public in outlays.
That helps neither liberals looking for more public investment nor conservatives
who want businesses and households to make their own private spending decisions.
Nor does it help the economy or the solvency of Social Security.

A budget surplus reduces the federal debt held by the public, currently
holding steady at some $3.8 trillion. The meaningful measure here is the ratio
of the debt to our national income or gross domestic product. Measured properly,
the federal debt is already declining rapidly relative to GDP. The debt was more
than 110 percent of GDP after World War II. It fell last year from 49.6 percent
to 47.3 percent. A balanced budget itself, without any surplus, will bring it
below 45 percent this year and keep reducing it year after year—just as rapid
growth and moderate deficits reduced the World War II debt to about 24 percent
at its postwar low in the 1970s.

T
he alleged Social Security crisis stems often from uncertain
forecasts that the Old Age and Survivors and Disability Insurance (OASDI) trust
funds will be running out of money by the year 2029. Using the surpluses to add
to the funds, if that is what any in the administration have in mind, would then
delay that still distant doom another ten years.

But Social Security checks do not come from the trust funds. They come
directly from the United States Treasury. With or without trust funds, our
future Social Security benefits are specified by law. They will be paid out of
taxes or borrowing, as long as the public supports the program. The OASDI funds
are actually no more than accounting entities. The accountants—or these days,
the computers—keep track of our payroll taxes and credit them to these accounts.
They charge payouts from the Treasury to them. They also credit the accounts
with an interest return on whatever positive balances the computers report—currently
about 6 percent on balances of some $700 billion.

If increasing balances in the fund accounts seems necessary to reassure the
baby boomers that Social Security will be there for them, we can do that easily
without budget surpluses. We could readily credit other tax receipts to the
OASDI trust funds, just as we do in the case of the Supplementary Medical
Insurance trust fund (Medicare part B). For example, we could add credits of
income taxes equal to 1.5 percent of taxable incomes to those 12.4 percent
payroll tax credits.

Crediting more revenues to the trust fund accounts, however, whether out of a
specific income tax credit or out of less certain budget surpluses, would have
no effect whatsoever on government spending, taxing, or the debt to the public.
Neither would it make any difference for the real issue for Social Security—an
aging population.

The bread eaten by those not working must be baked by those working. When the
numerous baby boomers retire and no longer produce for themselves, they will
require support from the smaller Generation X then working. So if we want to
bolster Social Security, the best solution is to increase economic growth rates
and increase the wages that finance OASDI payouts.

With even a modest 1 percent per year growth in worker productivity—and our
recent robust growth that has turned the deficit to surplus has been greater—we
will have some 36 percent more output per worker in the year 2029. That will be
enough, even with the predicted 10 percent increase in the burden on the working
population, to offer 24 percent additional real income per capita to everyone,
young and old. And this amount can be increased even more if we achieve and
maintain maximum employment and maximum investment in the skills and
productivity of the American people.

In that respect, holding budget surpluses for Social Security is perverse.
Not using the surplus means no direct spending or targeted tax credits for old
or new programs to invest in education, research, child care, health,
infrastructure, or the environment. It also means no general tax cut to offer
the public more to spend on its own.

Those advocating running a surplus and "paying down" the debt have one or
both of two motivations. Many simply want to reduce the role of government. They
fear the alternative of using the surplus for new government programs. Others
argue that maintaining a surplus and reducing the debt will increase saving and
investment. With less financial wealth and more to pay in taxes, the public will
be forced to consume less.

But will less consumption necessarily bring more saving, investment, and
growth? One can simply assume this, as did most pre-Keynesian economists as we
plunged into the Great Depression of the 1930s. If employment can be assumed to
be always full, along with total income and product, less consumption indeed
must mean more investment. But suppose lower consumption causes firms to reduce
production and lay off workers. Will our national saving rise then? If I do not
buy a new car will the automobile manufacturer invest more—or less?

We also hear that with the government buying back its own securities,
interest rates will be reduced and that will encourage investment. But
economists have found little evidence that the rate of change of the federal
debt has had much to do with interest rates. If we wish to stimulate investment
with lower interest rates, the path to this runs by Alan Greenspan and his
Federal Reserve. They clearly have the power to change interest rates, as
anybody in the financial markets can testify. Low interest rates and the
contributions of consumption to a prosperous economy are the way to maximize
investment.

T
he worst part of running surpluses to pay down the debt is its effect
on public investment. President Clinton's 1999 budget proposes some $65 billion
in new money for child care, Head Start, more teachers and classrooms, basic
research, health, infrastructure, the environment, and other programs. That
comes to just three-quarters of 1 percent of our projected gross domestic
product. For years we have been told we could not have more of this kind of
investment in our future because it would increase the deficit. With prospective
surpluses, should we not finally provide properly for our children, our
grandchildren, and ourselves?

Indeed, I would lay out a more ambitious program. Merely keep the ratio of
federal debt to GDP constant. With (nominal) GDP growing at even a modest 5
percent per year this would mean that our current $3.8 trillion debt held by the
public could grow by $190 billion. This would be "balance" in the relevant
economic sense of the debt staying in the same position relative to our national
income. But since the increase in the debt is the deficit, it would mean a
deficit of $190 billion—and one growing at that 5 percent per year. I would use
this deficit to finance public investment—in the human and physical capital
vital to productivity and growth.

This would be the way not merely to "save" Social Security, which is in
danger only from those who would nibble away at it or "privatize" it in the way
of "reform." It would offer more production and income in the years ahead to all
of us, young and old.



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