oversight

Budget Issues: Analysis of Long-Term Fiscal Outlook

Published by the Government Accountability Office on 1997-10-22.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                     United States General Accounting Office

GAO                  Report to Congressional Requesters




October 1997
                     BUDGET ISSUES
                     Analysis of Long-Term
                     Fiscal Outlook




GAO/AIMD/OCE-98-19
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Accounting and Information
      Management Division

      B-278394

      October 22, 1997

      The Honorable Pete V. Domenici
      Chairman, Committee on the Budget
      United States Senate

      The Honorable John R. Kasich
      Chairman, Committee on the Budget
      House of Representatives

      As you requested, this report updates our previous simulations of the
      long-term economic impact of federal budget policy. In 1992, we first used
      a macroeconomic model to simulate the effects of alternative fiscal policy
      paths in promoting or inhibiting long-term economic growth and the
      results supported the view that deficit reduction was key to our nation’s
      long-term economic health.1 In 1995, our updated simulations indicated
      that a path of “no action,” under which current policies remain unchanged,
      could not be sustained over the long run.2 We identified three forces
      driving the long-term growth of the budget deficit—health spending, Social
      Security, and interest costs. Since our 1995 report was issued, the
      Congress and the President have taken additional fiscal action to eliminate
      the annual deficit, culminating in the recent passage of the Balanced
      Budget Act of 1997 (BBA). The Congressional Budget Office (CBO) projects
      that these actions, along with the recent strong performance of the
      economy, will eliminate the deficit by 2002 and achieve several years of
      budget surpluses.

      In this report, we have updated our work to address the long-term budget
      outlook following passage of BBA to help the Congress assess the long-term
      consequences of current policies and alternatives. We used our long-term
      economic growth model to simulate the path resulting from the BBA
      through the year 2050 assuming no further policy changes (“no action”).
      For this path, we adopted CBO’s 10-year budgetary and economic
      projections, under which the federal government would run budget
      surpluses from 2002 through 2007, the end of CBO’s forecast period.3



      1
       Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the Economy
      (GAO/OCG-92-2, June 5, 1992).
      2
      The Deficit and The Economy: An Update of Long-Term Simulations (GAO/AIMD/OCE-95-119,
      April 26, 1995).
      3
      CBO’s budget projections, and thus our simulations using CBO data, reflect the net effect of the
      Balanced Budget Act of 1997 as well as the Taxpayer Relief Act of 1997.



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             In addition to simulating the long-term results of current fiscal policy, we
             also developed several alternative fiscal policy paths to illustrate how
             overall fiscal policy changes can affect future budgetary and economic
             outcomes. While this report discusses the consequences of alternative
             fiscal paths, it does not suggest any particular course of action, since the
             choice of the most appropriate fiscal policy path is a policy decision to be
             made by the Congress and the President. As discussed with your office,
             three alternatives were chosen to represent different degrees of fiscal
             restraint. Two of these alternatives follow the “no action” path in the early
             years of the simulation period but then shift direction once deficits
             reemerge in the second decade of the 21st century by maintaining either a
             budget balance or modest deficits through the remainder of the simulation
             period. A third alternative path would run larger surpluses than the “no
             action” path in the near term and for a longer period of time.

             Simulations are useful for comparing the potential outcomes of alternative
             policies within a common economic framework but should not be
             interpreted as forecasts of the level of economic activity 50 years in the
             future given the range of uncertainty about future economic changes and
             the responses to those changes.4 Simulation results provide qualitative
             illustrations, not quantitative forecasts, of the budget or economic
             outcomes associated with alternative policy paths. In our simulations, we
             employed a model originally developed by economists at the Federal
             Reserve Bank of New York (FRBNY) that relates long-term gross domestic
             product (GDP) growth to economic and budget factors. All models require
             the use of assumptions to permit extrapolations to be made. For details of
             the model’s assumptions, see appendix I.


             Economic growth—which is central to many of our major concerns as a
Background   society—requires investment, which, over the longer term, depends on
             saving. The nation’s saving consists of the private saving of households
             and businesses and the saving or dissaving of all levels of government. In
             general, government budget deficits represent dissaving—they subtract
             from national saving by absorbing funds that otherwise could be used for
             investment. Conversely, government surpluses add to saving.

             Since the 1970s, private saving has declined while federal budget deficits
             have consumed a large share of these increasingly scarce savings. The

             4
              The impact of federal spending reduction on aggregate national saving and investment depends on
             how consumers respond to such reductions. For example, a reduction in federal Medicaid spending
             may result in greater private spending on nursing home care thereby diminishing the effect on total
             national saving.



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                                         result has been to decrease the amount of national saving potentially
                                         available for investment.5 Since we last reported on this issue in 1995,
                                         private saving has remained low. However, federal budget deficits have
                                         declined significantly from the levels of the 1980s and early 1990s, freeing
                                         up some additional funds for investment. (See figure 1.) Nevertheless, total
                                         national saving and investment remain significantly below the levels
                                         experienced in the 1960s and 1970s. Economists have noted that these low
                                         levels of saving and investment raise concerns for the nation’s future
                                         productive capacity and future generations’ standard of living. As we have
                                         said in our earlier reports, the surest way to increase the resources
                                         available for investment is to increase national saving, and the most direct
                                         way for the federal government to increase national saving is to achieve
                                         and maintain a balanced federal budget. Running budget surpluses would
                                         further increase saving and allow the government to reduce the level of
                                         federal debt held by the public.


Figure 1: Effect of the Federal Budget
Deficit on Net National Saving           Percent of net national product
(1970-96)
                                         12



                                         10



                                             8



                                             6



                                             4



                                             2



                                             0
                                                     1970-1979                1980-1989                   1990-1993                1994-1996
                                                                                              Years

                                                                 Available for capital formation      Absorbed by the federal deficit

                                         Note: Entire bar represents nonfederal saving net of capital depreciation. Shaded portion of bar
                                         represents net national saving. Nonfederal saving is comprised of private saving and the
                                         aggregate state and local government surplus/deficit.

                                         Source: GAO analysis of U.S. Department of Commerce data.

                                         5
                                          The depressing effect of deficits on growth might have been mitigated had they financed higher levels
                                         of public investment. However, as a share of GDP, federal investment spending has actually declined
                                         over the past two decades.



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                   Our earlier work concluded that without further policy action,
                   commitments in federal retirement and health programs would together
                   become progressively unaffordable for the nation over time, and the
                   economic consequences would force belated and painful policy choices.
                   Growing deficits and the resulting lower saving would lead to dwindling
                   investment, slower growth, and finally a decline in real GDP. Living
                   standards, in turn, would at first stagnate and then fall. These findings
                   supported our conclusion that action on the deficit might be postponed,
                   but it could not be avoided.

                   The results of our past work have been very similar to the conclusions
                   reached by other government entities and private analysts. Most notably,
                   CBO published analyses based on its long-term model work in 1996 and
                   1997 that corresponded with our main findings.6 Also, in 1994-95, the
                   Bipartisan Commission on Entitlement and Tax Reform reached similar
                   conclusions in its study of future fiscal trends.

                   Since our 1995 report, robust economic growth and policy action have
                   combined to sharply reduce the deficit and are projected by CBO to result
                   in budget surpluses in the near term. This report addresses the outlook for
                   the budget over the longer term. We will explore how recent progress
                   affects this outlook and the fiscal and economic impacts associated with
                   alternative long-term fiscal policy strategies.


                   Major progress has been made on deficit reduction in the past several
Results in Brief   years, culminating in the passage of the Balanced Budget Act of 1997. The
                   balanced budget or surpluses that are projected would represent an
                   enormous improvement in the federal government’s fiscal position
                   through the next 10 years. Moreover, the improvements in national saving
                   and reduced debt and interest costs can be expected to produce tangible
                   gains in economic growth and budgetary flexibility over the longer term as
                   well. As a result, the emergence of unsustainable deficits is substantially
                   delayed under recently enacted fiscal policy. While our 1995 simulations
                   showed deficits exceeding 20 percent of GDP by 2024 if current policies
                   were not changed, our updated model results show that this point would
                   not be reached until nearly 2050.

                   Notwithstanding this progress, if no further action were taken, (a “no
                   action” scenario), our simulations indicate that federal spending would

                   6
                    Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006, May 1996,
                   and Long-Term Budgetary Pressures and Policy Options, March 1997.



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                  grow faster than revenues soon after the baby boom generation begins to
                  retire in 2008. These higher spending levels would be driven by escalating
                  health and Social Security costs. Rising interest costs would compound
                  the deficit problem and take up an increasing share of the federal budget.
                  Our simulations show that growing deficits, left unchecked, would
                  eventually result in declining investment and capital stock and, inevitably,
                  falling living standards. Over the long term, the “no action” scenario is
                  unsustainable. Timely policy action can avoid these economic
                  consequences. While a “no action” simulation is not a forecast of what will
                  happen, it illustrates the nature of future fiscal challenges.

                  The alternative simulations illustrate the potential fiscal and economic
                  benefits of achieving a sustainable budget policy. According to our
                  simulations, a fiscal policy of balance through 2050 or extended periods of
                  surplus, for example, could shrink the burden of federal interest costs
                  considerably and also result in a larger economy over the long term. All of
                  these alternative policies would increase per capita GDP in 2050 by more
                  than 35 percent over a “no action” policy, but they would require
                  additional fiscal policy changes. Some of these changes may be difficult to
                  achieve, but over the long term they would strengthen the nation’s
                  economy and overall living standards. Early action would permit changes
                  to be phased in and so give those affected by changes in, for example,
                  Social Security or health care benefits, time to adjust.

                  In considering what fiscal adjustments to make, policymakers need to be
                  presented with more complete information on the costs of the
                  government’s existing long-term commitments. The budget’s current
                  structure and reporting mechanisms have not focused attention on such
                  commitments, nor has the budget process facilitated their explicit
                  consideration. Financial statements are beginning to provide some of this
                  information. Options to change budget reporting and process to improve
                  recognition of these commitments and prompt early action to address
                  potential problems warrant further exploration.


                  In recent years, the federal deficit has declined substantially from
Policy Action     $290 billion in fiscal year 1992—4.7 percent of GDP—to a CBO projected
Contributes to    level of $23 billion in fiscal year 1997—0.3 percent of GDP, which would be
Improved Fiscal   the lowest level since 1974. This improvement is due, in part, to deficit
                  reduction initiatives enacted in 1990 and 1993 as well as to subsequent
Outlook



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spending restraint.7 The Balanced Budget Act of 1997, coupled with the
strong recent performance of the economy,8 is expected to extend this
recent progress by achieving a balanced budget in 2002 followed by
several years of budget surpluses on a unified budget basis.9 The decline in
the deficit has significantly slowed growth in the federal debt held by the
public. As a share of GDP, this commonly used measure of federal debt is
projected by CBO to decline from about 50 percent in fiscal year 1993 to
30 percent in 2007.

The improving fiscal outlook over the near term carries longer term
benefits as well, as illustrated by comparing our current “no action”
simulation with our 1992 and 1995 modeling results. (See figure 2.) Our
initial modeling work in 1992 indicated that even in the short term,
prospective deficits would fuel a rapidly rising debt burden. Intervening
economic and policy developments led to some improvement by the time
we issued our 1995 report, as shown by a modest shift outward of the “no
action” deficit path. Nonetheless, both our 1992 and 1995 “no action”
simulations indicated that deficits would have reached 20 percent of GDP in
the 2020s. In contrast, the 1997 “no action” path—which follows CBO’s
10-year forecast—indicates small and shrinking deficits over the next few
years, followed by a decade of surpluses. Following the enactment of the
BBA in 1997, our simulation indicates that deficits would not reach the
20-percent level until nearly 2050. For purposes of comparison, the highest
deficit level reached since World War II was 6.1 percent of GDP in 1983.
Figure 3 illustrates the improvement in the long-term outlook for the
federal debt as a share of GDP stemming from recent policy actions and
economic developments.




7
 Recent legislation attempting to control the deficit included the Omnibus Budget Reconciliation Act
of 1990, the Budget Enforcement Act of 1990, and the Omnibus Budget Reconciliation Act of 1993.
8
 Policy action accounted for about 25 percent of the recent improvement in CBO’s budget estimates.
The remainder of the improvement was due primarily to economic factors.
9
 The unified budget includes annual Social Security trust fund surpluses. These surpluses are expected
to be temporary, peaking at $140 billion (including interest) in 2009 before declining and eventually
turning to deficits in the following decade. For additional information, see Federal Debt and Interest
Costs, CBO, May 1993, and Federal Debt: Answers to Frequently Asked Questions (GAO/AIMD-97-12,
November 27, 1996).
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Figure 2: Deficit Paths Under GAO’s
Past and Present “No Action”
Simulations                           Percent of GDP
                                      25


                                      20


                                      15


                                      10


                                       5


                                       0


                                      -5
                                           1997   2002    2010           2020                2030             2040    2050
                                                                                Years

                                                             No action   No action      No action after BBA
                                                               1992        1995                1997




                                      These recent fiscal improvements represent substantial progress in the
Long-Term                             near term toward a more sustainable fiscal policy. However, longer term
Implications of                       problems remain. As in our earlier work, a “no action” policy remains
Current Fiscal Policy                 unsustainable over the long term. (See figure 2.) While the federal budget
                                      would be in surplus in the first decade of the 21st century, deficits would
Path                                  reemerge in 2012, soon after the baby boom generation begins to retire.
                                      These deficits would then escalate, exceeding 6 percent of GDP before 2030
                                      and exceeding 20 percent of GDP by 2050.

                                      A comparison of federal debt to the size of the economy tells a similar
                                      story—near-term improvement followed by potentially unsustainable
                                      growth as the baby boomers retire. (See figure 3.) In the early years of the
                                      simulation period, budget surpluses produce a substantial reduction in the
                                      absolute size of the debt as well as in the relationship of debt to GDP, from
                                      today’s level of around 50 percent to about 20 percent in 2015. However, at
                                      that point, the debt to GDP ratio begins to rise rapidly, returning to today’s
                                      levels in the late 2020s and growing to more than 200 percent by 2050.




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Figure 3: Debt-to-GDP Ratios Under
GAO’s Past and Present “No Action”
Simulations                          Percent of GDP
                                     250



                                     200



                                     150



                                     100



                                      50



                                       0
                                           1997          2010           2020                2030             2040   2050
                                                                               Years

                                                           No action   No action       No action after BBA
                                                             1992        1995                 1997




                                     Such levels of deficits and debt imply a substantial reduction in national
                                     saving, private investment, and the capital stock. Given our labor force
                                     and productivity growth assumptions, GDP would inevitably begin to
                                     decline. These negative effects of rapidly increasing deficits and debt on
                                     the economy would force action at some point before the end of the
                                     simulation period. Policymakers would likely act before facing probable
                                     consequences such as rising inflation, higher interest rates, and the
                                     unwillingness of foreign investors to invest in a weakening American
                                     economy. Therefore, as we have noted in our past work, the “no action”
                                     simulation is not a prediction of what will happen in the future. Rather, it
                                     underscores the need for additional action in the future to address the
                                     nation’s long-term fiscal challenges.

                                     The primary causes of the large deficits in the “no action” simulation are
                                     (1) the aging of the U.S. population, which corresponds to slower growth
                                     in the labor force and faster growth in entitlement program spending, and
                                     (2) the rising costs of providing federal health care benefits. In 2008, the
                                     first baby boomers will be eligible for early retirement benefits. As this
                                     relatively large generation retires, labor force growth is expected to slow




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considerably and, eventually, stop altogether. These demographic changes
mean fewer workers to support each retiree. Between 1997 and 2025, the
number of workers per Social Security beneficiary is projected to drop by
33 percent. Without a major increase in productivity, low labor force
growth will inevitably lead to slower growth in the economy and in federal
revenue. As slow growth in the labor force constrains revenue growth, the
large retired population will place major expenditure demands on Social
Security, Medicare, and Medicaid. In just 15 years, the Social Security
trustees estimate that the program’s tax revenue is expected to be
insufficient to cover current benefits. While the recent Balanced Budget
Act included some actions to restrain growth in Medicare spending and
increase income from beneficiary premiums, the program is still expected
to grow faster than the economy over the next several years. According to
CBO estimates, the Hospital Insurance Trust Fund portion of Medicare will
be depleted in 2007, even before retiring baby boomers begin to swell the
ranks of Medicare beneficiaries.10 Medicaid spending will also be under
increasing pressure as the population ages because a large share of
program spending goes to cover nursing home care.

In the “no action” simulation, Social Security spending as a share of GDP
increases by nearly 50 percent between now and 2030. By 2050, it
approaches twice today’s level. Health care spending, fueled by both an
increased number of beneficiaries and (in the early years of the simulation
period) rising per beneficiary costs, would grow even more
rapidly—doubling as a share of GDP by 2030 and tripling by 2050. As Social
Security and health spending rise, their share of federal spending grows
tremendously. (See figure 4.) By the mid-2040s, spending for these
programs alone would consume more than 100 percent of federal
revenues.




10
  Congress and the President have recognized the need for further changes in Medicare by establishing
a National Bipartisan Commission on the Future of Medicare as part of the BBA.



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Figure 4: Long-Term Change in
Composition of Spending as a
                                      Percent of GDP
Percentage of GDP Under “No Action”
Simulation                            50



                                      40

                                                              Revenue
                                      30



                                      20



                                      10



                                       0
                                                       1997                      2030 (BBA)                     2050 (BBA)
                                                                                   Years

                                                  Social Security   Medicare & Medicaid       Net interest   All other spending




                                      After initially declining, interest spending also increases significantly in
                                      the “no action” simulation. In the early years of the simulation period,
                                      budget surpluses reduce the burden of interest spending on the economy.
                                      However, when the surpluses give way to deficits, this decline is reversed.
                                      Growing deficits add substantially to the national debt. Rising debt, in
                                      turn, raises spending on interest, which compounds the deficit problem,
                                      resulting in a vicious circle. The effects of compound interest are clearly
                                      visible in figure 5, as interest spending rises from about 3 percent of GDP in
                                      1997 to over 12 percent in 2050.




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Figure 5: Net Interest as a Percentage
of GDP Under “No Action” Simulation
                                         Percent of GDP
                                         14


                                         12


                                         10


                                          8


                                          6


                                          4


                                          2


                                          0
                                              1997                2010             2020              2030             2040              2050
                                                                                          Years




                                         Alternatives to a “no action” policy illustrate the fiscal and economic
Alternative Fiscal                       benefits associated with maintaining a sustainable course. According to
Policies Would                           one definition, under a sustainable fiscal policy, existing government
Change Long-Term                         programs can be maintained without a continual rise in the debt as a share
                                         of GDP.11 Under an unsustainable policy, such as “no action,” the debt
Economic Outcomes                        continually rises as a share of GDP. As illustrated in our past reports and
                                         CBO’s work,12 a number of different policy paths could be sustained over
                                         the long term. In our current work, we tested three different long-term
                                         fiscal strategies, one that would allow for modest deficits, one that would
                                         maintain a balanced budget, and one that would include an extended
                                         period of surpluses. (See figure 6.)




                                         11
                                          For a detailed analysis of sustainability, see Olivier Blanchard, Jean-Claude Chouraqui, Robert P.
                                         Hagemann, and Nicola Sartor, “The Sustainability of Fiscal Policy: New Answers to an Old Question,”
                                         OECD Economic Studies, no. 15 (Autumn 1990). See also The Canadian Institute of Chartered
                                         Accountants, Indicators of Government Financial Condition, April 1997.
                                         12
                                           Congressional Budget Office, Long-Term Budgetary Pressures and Policy Options, March 1997.



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Figure 6: Alternate Deficit/Surplus
Paths                                 Percent of GDP
                                       8



                                       6



                                       4



                                       2



                                       0



                                      -2
                                           1997        2002                   2010                         2020                         2030
                                                                                        Years

                                                                No action      Constant         Maintain      Save SS
                                                                after BBA      debt burden*     balance       surplus**




                                      Note: Overlapping lines enhanced for clarity. As discussed in the text, these lines represent
                                      identical paths.

                                      *Debt-GDP ratio is maintained at lowest level reached in “no action.”

                                      **Social Security surpluses (including interest) are saved from 2000-2018, then balance is
                                      maintained.




                                      The “constant debt burden” simulation follows the “no action” path
                                      through 2015. From this point on, the debt is held constant as a share of
                                      GDP, rather than increasing as in the “no action” simulation.13 To prevent
                                      the debt burden from rising from its 2015 level of about 20 percent of GDP,
                                      the federal government would have to hold annual deficits to roughly
                                      1 percent of GDP. While not insignificant, this deficit level is relatively small
                                      compared to the federal deficits of recent years or to deficits in other
                                      industrial nations. For example, the European Union has established a
                                      deficit target of 3 percent of GDP for countries participating in the common
                                      currency arrangement.



                                      13
                                       Prior to 2016, the debt declines as a share of the economy due to the improved fiscal outlook for the
                                      near term.



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The “maintain balance” simulation also follows the “no action” path for the
early part of the simulation period. In 2012—the year that deficits
reemerge under “no action”—a balanced unified budget would be
achieved. Balance would then be sustained through the remainder of the
simulation period.

Going beyond balance by running larger budget surpluses for a longer
period of time than in the other simulations would yield additional
economic benefits by further raising saving and investment levels. For our
“surplus” simulation, we chose as a goal ensuring that annual Social
Security surpluses (including interest that is credited to the fund) add to
national saving. To achieve this goal, the federal government would run
unified budget surpluses equal in size to the annual Social Security
surpluses—which the Social Security Trustees estimate will peak at
$140 billion in 2009. Such a policy means that the rest of the federal
government’s budget would be in balance. Social Security’s surpluses
(including interest income) are projected to end in 2018. Beginning in
2019, our simulation follows a unified budget balance identical to the path
in our balance simulation.

Figure 7 shows the debt-to-GDP paths associated with the various
simulations. Under the “constant debt burden” simulation, the debt-GDP
ratio remains around 20 percent, which is the lowest point reached in “no
action.” Under both the “balance” and “surplus” simulations, the debt-GDP
measure would decline to less than 10 percent of GDP—levels that the
United States has not experienced since before World War I.




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Figure 7: Debt-to-GDP Ratios Under
GAO’s Four Fiscal Policy Simulations
                                       Percent of GDP
                                       70


                                       60


                                       50


                                       40


                                       30


                                       20


                                       10


                                        0
                                            1997                               2010                        2020                     2030
                                                                                        Years

                                                                 No action      Constant        Maintain       Save SS
                                                                 after BBA    debt burden*      balance        surplus**




                                       *Debt-GDP ratio is maintained at lowest level reached in “no action.”

                                       **Social Security surpluses (including interest) are saved from 2000-2018, then balance is
                                       maintained.




                                       Each of the alternative simulations would require some combination of
                                       policy or program changes that reduce spending and/or increase revenues.
                                       We make no assumptions about the mix of those changes in our analysis.
                                       We recognize that such actions would not be taken without difficulty.
                                       They would require difficult choices resulting in a greater share of national
                                       income devoted to saving. While consumption would be reduced in the
                                       short term, it would be increased over the long term. Early action would
                                       permit changes to be phased in and so give those affected by changes in,
                                       for example, Social Security or health care benefits, time to adjust.

                                       For both the federal government and the economy, any of the three
                                       alternative simulations indicates a vast improvement over the “no action”
                                       path. Sharply reduced interest costs provide the most striking budgetary
                                       benefit from following a sustainable policy. Currently, interest spending
                                       represents about 15 percent of federal spending, a relatively large share



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                                       that is a consequence of the deficits of the 1980s and early 1990s. As noted
                                       above, after shrinking in the early years of the “no action” simulation,
                                       interest costs increase sharply over the long term. In contrast, under the
                                       alternative simulations, the interest burden shrinks dramatically. (See
                                       figure 8.) By 2050, under either a balance or surplus policy, interest
                                       payments would represent 1 percent or less of total spending. Even under
                                       the less austere “constant debt burden” simulation, interest would account
                                       for only about 5 percent of spending.


Figure 8: Net Interest as a Share of
Total Spending in 2050 Under GAO’s     Percent of total spending
Four Fiscal Policy Simulations
                                       35


                                       30                                 28.8


                                       25


                                       20


                                       15


                                       10

                                                                                   4.8
                                        5

                                                                                               1.0          0.5
                                        0
                                                                                     Net interest

                                                                   No action     Constant            Maintain     Save SS
                                                                   after BBA     debt burden         balance      surplus*



                                       *Interest spending equals less than 1 percent of total spending.




                                       The economic benefits of a sustainable budget policy include increased
                                       saving and investment levels and faster economic growth, which results in
                                       higher living standards. For example, under any of our alternative
                                       simulations, per capita GDP would nearly double between 1996 and 2050. In
                                       contrast, under “no action,” growth in living standards would slow
                                       considerably and living standards themselves would actually begin to
                                       decline around 2040. By 2050, they would be nearly 40 percent lower than



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                                     under the balance simulation. This difference results from a wide gap in
                                     private investment. Under “no action,” large deficits eventually drive
                                     private investment spending down to zero while, for example, a balanced
                                     budget policy could produce a doubling of investment, as shown in table
                                     1.14 In the “no action” simulation, capital depreciation would outweigh
                                     investment, resulting in a diminishing capital stock and, eventually,
                                     contributing to a falling GDP.

Table 1: The Economy and Fiscal
Position in 1996 (Actual) and 2050   In per capita 1997 dollars
(Simulated)                                                                                                        Percent difference
                                                                               2050—               2050—         between “no action”
                                                                     1996 “No action”           “Balance”       and “balance” in 2050
                                     Real GDP                    $29,300          $40,900          $56,500                               38%
                                     Debt Held by the Public $14,500             $107,100            $2,400                            –98%
                                     Nonfarm business
                                     investment                   $3,000                 $0          $6,700                            N/A
                                     Nonfarm capital stock       $29,400          $17,400          $59,900                             244%
                                     Note: Based on Social Security Administration population projections.



                                     Figure 9 compares the path of per capita GDP under “no action” to a
                                     balanced budget policy. This difference graphically shows the emerging
                                     gap in long-term living standards that results from shifting fiscal policy
                                     paths. Although the “maintain balance” path would lead to higher living
                                     standards, the rate of growth would be significantly lower than that
                                     experienced over the past 50 years. Such a rate would be extremely
                                     difficult to attain given the slowdown in productivity growth that has
                                     occurred in recent decades.




                                     14
                                       Long-range simulations are quite sensitive to underlying assumptions and involve a large range of
                                     uncertainty. Hence, the amounts in table 1 should not be viewed as precise “point” estimates. Rather,
                                     they indicate the general magnitude of the differences that might result from different fiscal policy
                                     paths.



                                     Page 16                                         GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
                                      B-278394




Figure 9: GDP per Capita Projected
Under the “No Action” and “Balance”
Simulations                           Per capita 1997 dollars
                                      60,000


                                      50,000


                                      40,000


                                      30,000


                                      20,000


                                      10,000


                                           0
                                               1946   1955      1965   1975    1985      1997     2010       2020   2030   2040   2050
                                                                                         Years

                                                                        Historical    No action   Maintain
                                                                          data        after BBA   balance




                                      Source: GAO analysis of 1946-1996 historical data, GAO’s GDP simulations, and Social Security
                                      Administration population projections.



                                      Long-term economic simulations are a useful tool for examining the
Long-Term                             balance between the government’s future obligations and expected
Commitments Not                       resources. This longer term perspective is necessary to understand the
Adequately Reflected                  fiscal and spending implications of key government programs and
                                      commitments extending over a longer time horizon.15
in Budget Reporting
and Process                           The future implications of current policy decisions reflected in our
                                      simulations and in other financial reports are generally not captured in the
                                      budget process. The budget is generally a short-term, cash-based spending
                                      plan focusing on the short- to medium-term cash implications of
                                      government obligations and fiscal decisions. Accordingly, it does not
                                      provide all of the information on the longer term cost implications
                                      stemming from the government’s commitments when they are made. While
                                      the sustainability of the government’s fiscal policy is driven primarily by
                                      future spending for social security and health care commitments, the
                                      federal government’s commitments and responsibilities extend far beyond
                                      these programs. These commitments may, themselves, result in large costs


                                      15
                                        Budget Process: Evolution and Challenges (GAO/T-AIMD-96-129, July 11, 1996).



                                      Page 17                                            GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
B-278394




that can encumber future fiscal resources and unknowingly constrain the
government’s future financial flexibility to meet all its commitments as
well as any unanticipated or emerging needs.

Information about the cost of some of these commitments will be
increasingly available as agencies produce audited financial statements.
We anticipate that they will provide additional information on long-term
commitments, including such items as environmental cleanup and
insurance. For example, in its 1996 financial statements, the Department
of Energy reported a cost of $229 billion to clean up its existing
contaminated sites. The Department of Defense will also be developing
and reporting cleanup costs in financial statements. The Office of
Management and Budget has estimated that the government is likely to
have to pay $31 billion in future claims resulting from the federal
government’s insurance commitments. The first audited governmentwide
financial statements will be issued for fiscal year 1997. This represents a
key step in the government’s efforts to improve financial management and
provide greater transparency and accountability for the costs of
government commitments and programs.

The key challenge facing budget decisionmakers is to integrate this
information into the budget process. A range of options can be considered.
A logical first step would be to include understandable supplemental
financial information on the government’s long-term commitments and
responsibilities in the budget. For example, in a recent report we
concluded that supplemental reporting of accrual-based costs of insurance
programs would improve recognition of the government’s commitments.16
Other options to refine the budget process or budget reporting to improve
the focus on these commitments and prompt early action to address
potential problems can be explored. For example, long-term simulations of
current or proposed budget policies could be prepared periodically to help
the Congress and the public assess the future consequences of current
decisions. Another option, which would supplement the current practice
of tracking budget authority and outlays, would be to provide information
to permit tracking the estimated cost of all long-term commitments
created each year in the budget.




16
 See Budget Issues: Budgeting for Federal Insurance Programs (GAO/AIMD-97-16, September 30,
1997).



Page 18                                      GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
                        B-278394




                        In this report, the analysis of alternative fiscal policy paths relies in
Objectives, Scope and   substantial part on an economic growth model that we adapted from a
Methodology             model developed by economists at the FRBNY. The model reflects the
                        interrelationships between the budget and the economy over the long term
                        and does not capture their interaction during short-term business cycles.

                        The main influence of budget policy on long-term economic performance
                        is through the effect of the federal deficit on national saving. Conversely,
                        the rate of economic growth helps determine the overall federal deficit or
                        surplus through its effect on revenues and spending. Federal deficits
                        reduce national saving while federal surpluses increase national saving.
                        The level of saving affects investment and, in turn, GDP growth.

                        Budget assumptions in the model rely, to the extent practicable, upon the
                        baseline projections in CBO’s September 1997 report, The Economic and
                        Budget Outlook: An Update, through 2006, the last year for which CBO
                        projections are available in a format usable by our model. These estimates
                        are used in conjunction with our model’s simulated levels of GDP. For
                        Medicare, we assumed growth consistent with CBO’s projections and the
                        Health Care Financing Administration’s long-term intermediate
                        projections from the Medicare Trustees’ April 1997 report. For Medicaid
                        through 2006, we similarly assumed growth consistent with CBO’s budget
                        projections. For 2007 and thereafter, we used estimates of Medicaid
                        growth from CBO’s March 1997 report, Long-Term Budgetary Pressures and
                        Policy Options. For Social Security, we used the April 1997 intermediate
                        projections from the Social Security Trustees throughout the simulation
                        period. Other mandatory spending is held constant as a percentage of GDP
                        after 2006. Discretionary spending and revenues are held constant as a
                        share of GDP after 2006. Our interest rate assumptions are based on CBO
                        through 2006 and then move to a fixed rate. (See appendix I for a more
                        detailed description of the model and the assumptions we used.)

                        We conducted our work from September to October 1997 in accordance
                        with generally accepted government auditing standards. We received
                        comments from experts in fiscal and economic policy on a draft of this
                        report and have incorporated them as appropriate.


                        We are sending copies of this report to the Ranking Minority Members of
                        your Committees, interested congressional committees, the Director of the
                        Congressional Budget Office, and the Director of the Office of
                        Management and Budget. We will make copies available to others upon



                        Page 19                             GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
B-278394




request. The major contributors to this report are listed in appendix II. If
you have any questions concerning this report, please call me at
(202) 512-9573.




Paul L. Posner
Director, Budget Issues




Page 20                              GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Page 21   GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Contents



Letter                                                                                              1


Appendix I                                                                                         24

The Economic Model
and Assumptions
Appendix II                                                                                        28

Major Contributors to
This Report
Related GAO Products                                                                               32


Tables                  Table 1: The Economy and Fiscal Position in 1996 and 2050                  16
                        Table I.1: Key Assumptions                                                 26

Figures                 Figure 1: Effect of the Federal Budget Deficit on Net National              3
                          Saving
                        Figure 2: Deficit Paths Under GAO’s Past and Present “No                    7
                          Action” Simulations
                        Figure 3: Debt-to-GDP Ratios Under GAO’s Past and Present “No               8
                          Action” Simulations
                        Figure 4: Long-Term Change in Composition of Spending as a                 10
                          Percentage of GDP Under “No Action” Simulation
                        Figure 5: Net Interest as a Percentage of GDP Under “No Action”            11
                          Simulation
                        Figure 6: Alternate Deficit/Surplus Paths                                  12
                        Figure 7: Debt-to-GDP Ratios Under GAO’s Four Fiscal Policy                14
                          Simulations
                        Figure 8: Net Interest as a Share of Total Spending in 2050 Under          15
                          GAO’s Four Fiscal Policy Simulations
                        Figure 9: GDP per Capita Projected Under the “No Action” and               17
                          “Balance” Simulations




                        Page 22                            GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Contents




Abbreviations

CBO        Congressional Budget Office
FRBNY      Federal Reserve Bank of New York
GDP        gross domestic product
HCFA       Health Care Financing Administration
NIPA       National Income and Product Account
OASDI      Old Age Survivors’ and Disability Insurance
BBA        Balanced Budget Act of 1997


Page 23                            GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Appendix I

The Economic Model and Assumptions


             This update of GAO’s work1 on the long-term economic and budget outlook
             relies in large part on a model of economic growth developed by
             economists at the Federal Reserve Bank of New York (FRBNY). The major
             determinants of economic growth in the model include changes in the
             labor force, capital formation, and the growth in total factor productivity.
             To analyze the long-term effects of fiscal policy, we modified the FRBNY’s
             model to include a set of relationships that describe the federal budget and
             its links to the economy. The simulations generated using the model
             provide qualitative illustrations, not quantitative forecasts, of the budget or
             economic outcomes associated with alternative policy paths. The model
             depicts the links between the budget and the economy over the long term,
             and does not reflect their interrelationships during short-term business
             cycles.

             The main influence of budget policy on long-term economic performance
             in the model is through the effect of the federal deficit or surplus on
             national saving. Higher federal deficits reduce national saving while lower
             deficits or surpluses increase national saving. The level of saving affects
             investment and, hence, gross domestic product (GDP) growth.

             GDP is determined by the labor force, capital stock, and total factor
             productivity.2 GDP in turn influences nonfederal saving, which consists of
             the saving of the private sector and state and local government surpluses
             or deficits. Through its effects on federal revenues and spending, GDP also
             helps determine the federal budget deficit or surplus. Nonfederal and
             federal saving together constitute national saving, which influences private
             investment and the next period’s capital stock. Capital combines with
             labor and total factor productivity to determine GDP in the next period and
             the process continues.

             There are also important links between national saving and investment
             and the international sector. In an open economy such as the United
             States, a decrease in saving due to, for example, an increase in the federal
             budget deficit, does not require an equivalent decrease in investment.
             Instead, part of the saving shortfall may be filled by foreign capital inflows.
             A portion of the net income that results from such investments flows
             abroad. In this update, we retained the assumption in our prior work that

             1
              Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the Economy
             (GAO/OCG-92-2, June 5, 1992) and The Deficit and The Economy: An Update of Long-Term
             Simulations (GAO/AIMD/OCE-95-119, April 26, 1995).
             2
              Total factor productivity reflects sources of growth not captured in aggregate labor and capital
             measures, including technological change, labor quality improvements, and the reallocation of
             resources to more productive uses.



             Page 24                                          GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Appendix I
The Economic Model and Assumptions




net foreign capital inflows rise by one-third of any decrease in the national
saving rate.

Table I.1 lists the key assumptions incorporated in the model. The
assumptions used tend to provide conservative estimates of the benefit of
reducing deficits or running surpluses and of the harm of increasing
deficits. The interest rate on the national debt is held constant, for
example, even when deficits climb and the national saving rate plummets.
Under such conditions, the more likely result would be a rise in the rate of
interest and a more rapid increase in federal interest payments than our
results display. Another conservative assumption is that the rate of total
factor productivity growth is unaffected by the amount of investment.
Productivity is assumed to advance 1 percent each year even if investment
collapses. Such assumptions suggest that changes in deficits or surpluses
could have greater effects than our results suggest.




Page 25                              GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
                             Appendix I
                             The Economic Model and Assumptions




Table I.1: Key Assumptions
                             Model inputs                                         Assumptions
                             Saving rate: gross saving of the private             17.5% of GDP
                             sector and state and local government
                             sector
                             Labor: growth in hours worked                        Follows the Social Security Trustees’
                                                                                  Alternative II projections
                             Total factor productivity growth                     1%
                             Inflation rate                                       Follows CBO through 2007; 2.7% thereafter
                             Interest rate (average on the national debt)         Average effective rate implied by CBO’s
                                                                                  interest payment projections through 2006;
                                                                                  5.1% thereafter (CBO’s 2006 implied rate)
                             Surplus/deficit                                      Follows CBO’s budget surplus/deficit as a
                                                                                  percentage of GAO’s GDP through 2006;
                                                                                  GAO simulations thereafter
                             Discretionary spending                               CBO through 2006; increases at the rate of
                                                                                  economic growth thereafter
                             Medicare                                             CBO through 2006; increases at HCFA’s
                                                                                  projected rate thereafter
                             Medicaid                                             CBO’s projections
                             OASDI                                                Follows the Social Security Trustees’
                                                                                  Alternative II projections
                             Other mandatory spending                             CBO’s assumed levels through 2006;
                                                                                  increases at the rate of economic growth
                                                                                  thereafter
                             Receipts                                             CBO’s assumed levels through 2006; in
                                                                                  subsequent years, receipts equal 19.9% of
                                                                                  GDP (2006 ratio)
                             Note: In our work, all CBO budget projections were converted from a fiscal year to a calendar
                             year basis. The last year of CBO’s projection period is fiscal year 2007, permitting the calculation
                             of calendar year values through 2006.



                             We have made several modifications to the model, but the model’s
                             essential structure remains the same as in our previous work. We have
                             incorporated the change in the definition of government saving in the
                             National Income and Product Accounts (NIPA) adopted in late 1995 by
                             adding a set of relationships determining government investment, capital
                             stock, and the consumption of fixed capital.

                             The more recent data prompted several parameter changes. For example,
                             the long-term inflation rate is now assumed to be 2.7 percent, down from
                             3.4 percent in our 1995 report and 4.0 percent in our 1992 report. In this
                             update, the average federal borrowing rate steadily declines to 5.1 percent,
                             compared to our assumption of 7.2 percent in 1995 and 7.8 percent in 1992.




                             Page 26                                          GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Appendix I
The Economic Model and Assumptions




Our work also incorporates the marked improvement in the budget
outlook stemming from the Balanced Budget Act of 1997 reflected in the
10-year budget projections that CBO published in September 1997.

The distinction between the mandatory and discretionary components of
the budget remains important. We adopted CBO’s assumption from their
most recent 10-year forecast that discretionary spending equals the
statutory caps from fiscal years 1998 through 2002 and increases at the
rate of inflation from fiscal years 2003 through 2007. We assumed it would
keep pace with GDP growth thereafter.

Mandatory spending includes Health (Medicare and Medicaid), Old Age
Survivors’ and Disability Insurance (OASDI, or Social Security), and a
residual category covering other mandatory spending. Medicare reflects
CBO’s assumptions through 2006 and increases at HCFA’s projected rate in
subsequent years. Medicaid is based on CBO’s September 1997
assumptions; thereafter, it increases at the rates embodied in CBO’s
March 1997 report on the long-term budget outlook. OASDI reflects the
April 1997 Social Security Trustees’ Alternative II projections.

Other mandatory spending is a residual category consisting of all
nonhealth, non-Social Security mandatory spending. It equals CBO’s NIPA
projection for Transfers, Grants, and Subsidies less Health, OASDI, and
other discretionary spending. Through 2006, CBO assumptions are the main
determinant of other mandatory spending, after which its growth is linked
to that of GDP.

The interest rates for 1997 through 2006 are consistent with the average
effective rate implied by CBO’s interest payment projections. We assume
that the average rate remains at the 2006 rate of 5.1 percent for the rest of
the simulation period.

Receipts follow CBO’s dollar projections through 2006. Thereafter, they
continue at 19.9 percent of GAO’s simulated GDP, which is the rate projected
for 2006.

As these assumptions differ somewhat from those used in our earlier
reports, only general comparisons of the results can be made.




Page 27                              GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Appendix II

Major Contributors to This Report


                       Christine E. Bonham, Assistant Director
Accounting and         Andrew D. Eschtruth, Evaluator-in-Charge
Information            James R. McTigue, Jr., Senior Evaluator
Management Division,   MaryLynn Sergent, Senior Evaluator

Washington, D.C.
                       Richard S. Krashevski, Economist
Office of the Chief
Economist




                       Page 28                            GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Page 29   GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Page 30   GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Page 31   GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
Related GAO Products


              Budget Issues: Budgeting for Federal Insurance Programs (GAO/AIMD-97-16,
              September 30, 1997).

              Retirement Income: Implications of Demographic Trends for Social
              Security and Pension Reform (GAO/HEHS-97-81, July 11, 1997).

              Addressing the Deficit: Budgetary Implications of Selected GAO Work for
              Fiscal Year 1998 (GAO/OCG-97-2, March 14, 1997).

              Federal Debt: Answers to Frequently Asked Questions (GAO/AIMD-97-12,
              November 27, 1996).

              Budget Process: Evolution and Challenges (GAO/T-AIMD-96-129, July 11, 1996).

              Deficit Reduction: Opportunities to Address Long-standing Government
              Performance Issues (GAO/T-OCG-95-6, September 13, 1995).

              The Deficit and the Economy: An Update of Long-Term Simulations
              (GAO/AIMD/OCE-95-119, April 26, 1995).

              Deficit Reduction: Experiences of Other Nations (GAO/AIMD-95-30,
              December 13, 1994).

              Budget Issues: Incorporating an Investment Component in the Federal
              Budget (GAO/AIMD-94-40, November 9, 1993).

              Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to
              the Economy (GAO/OCG-92-2, June 5, 1992).

              The Budget Deficit: Outlook, Implications, and Choices (GAO/OCG-90-5,
              September 12, 1990).




(935248)      Page 32                             GAO/AIMD/OCE-98-19 Long-Term Fiscal Outlook
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