oversight

The Budget Deficit: Outlook, Implications, and Choices

Published by the Government Accountability Office on 1990-09-12.

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

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                                                                THE BUDGET
                                                                DEFICIT
                                                                Outlook, Implicati.ons,
                                                                and Choices



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Comptroller General
of the United States

B-240983

September 12,199O

The Honorable Charles E. Grassley
United States Senate

The Honorable J. James Exon
United States Senate

The Honorable Daniel P. Moynihan
United States Senate

The Honorable Bill Bradley
United States Senate

This report responds to your joint request that we provide our views on the dimensions of
the budget problem facing the nation, the implications of the deficit for the U.S. economy,
and some of the choices that must be made to attack the deficit problem.

The deficit has doubled as a percent of gross national product (GNP) every decade since the
1960s. This ominous trend has reflected a growing imbalance between revenues and outlays
in the general fund portion of the budget. The resulting deficits seriously depleted the
nation’s supply of savings in the 19809, which adversely affected our investment and long-
term growth. Rising deficits and borrowing have also meant that increasingly larger portions
of federal revenue are being used for debt service rather than for other more productive
purposes. We are recommending that this trend be reversed by a $300 billion fiscal policy
swing that would result in total budget surpluses of approximately 2 percent of GNP annually
by 1997-and close to a balance in the general fund.

We do not recommend specific program choices for reaching the fiscal policy goal, but
provide the Congress and the executive branch with scenarios and packages covering
defense and nondefense spending, as well as revenues, for achieving such a fiscal target. We
also discuss alternatives for enforcing budget agreements, basic budget reform initiatives,
and improved federal government stewardship over its resources.




Charles A. Bowsher
Comptroller General
of jhe United States
ECxecutiveSummary


                        This examination of the deficit was requested by Senators Exon and
                        Grassley, subsequently joined by Senators Moynihan and Bradley.

                        The deficit is a serious problem with ominous implications for the long-
                        term health of the economy. It is particularly disturbing to note that
                        each decade since World War II has witnessed a further deterioration of
                        fiscal policy. But only since 1981 have deficits been high enough to
                        increase dramatically the size of the debt relative to the economy. This
                        explosion of deficit spending has been accompanied by a decline in the
                        U.S. saving rate. Together they bode ill for future investment and eco-
                        nomic growth, and thus for the future standard of living of the Amer-
                        ican people.

                        There are many ways of reversing these trends. However, all involve
                        specific policy changes that are politically difficult, and the large
                        number of alternatives can lead to endless debate. The options examined
                        in this report are intended to provide a basis for constructive dialogue
                        leading to an agreement between the executive and legislative branches
                        on a long-term structural solution to the deficit problem. An agreed-
                        upon multiyear budget plan is the key to future fiscal responsibility.

                        The views expressed in this report are based on our many years of ana-
                        lyzing government programs, on our experience with financial manage-
                        ment, and on our involvement with the budget process since the
                        enactment of the Congressional Budget Act and the Gramm-Rudman-
                        Hollings legislation.



Nature of the Problem

Deficit                 Federal budget deficits are not new. By any measure, however, they are
                        getting worse. As figure 1 illustrates, the average deficit as a percent of
                        the gross national product (GNP) has doubled every 10 years for the past
                        40 years. Moreover, although the Gramm-Rudman-Hollings law required
                        steadily decreasing deficits, at present the deficit is out of control. In
                        January 1990, the Office of Management and Budget reported a baseline
                        deficit for fiscal year 1991 of $100.5 billion. As figure 2 shows, only a
                        few months later-partly       reflecting rising costs of the Resolution Trust
                        Corporation-that      office and the Congressional Budget Office posted
                        the current figure of over $230 billion -an estimate that is still rising.
                        Even this figure masks the true size of the general fund deficit because


                        Page 2                                           GAO/OCXXMM   The Budget De&it
                                          Executive               Summary




                                          it includes large surpluses in Social Security and other retirement trust
                                          funds. Excluding them, the current 1991 estimate is $372 billion. A
                                          recession could push it beyond $400 billion.


Figure   1:   Average Deficit by Decade
(1950.1989)
                                          6             Percent   of GNP




                                          4
                                                                                                  *



                                          3



                                          2                                            ‘\



                                          1




                                          0

                                                        196049      196049       1979-79     199089




Figure 2: Changing Estimates for 1991
Total Deficit
                                          250            Dollm     In Bllllonr




                                          200



                                          160



                                          199
                                                                                     GRH
                                                                                    Tmrgat
                                                -        -Mm--       -em-.       ---em-.

                                           60



                           Y
                                              0
                                                    t
                                                          OMS           cso                   OMS            CEO
                                                              January                                 July



                                          Page 3                                                                   GAO/OCG90-5   The Budget Deficit
                                    Executivesumuuuy                                                           ,T




Debt                                Deficits have to be financed, so they add to the debt. For the first
                                    36 years after World War II, however, debt held by the public did not
                                    grow as fast as the economy. As a result, debt as a percent of GNP
                                    declined steadily until 1974. The ever-larger deficits of the 1980s
                                    reversed this trend; currently debt as a percent of GNP is back to its 1963
                                    level, as shown in figure 3. More than $1.6 trillion has been added to the
                                    debt held by the public since 1980. But the total federal debt, including
                                    the amount held by Social Security and other trust funds, has increased
                                    even more, by $2.3 trillion. As a result, total debt now stands at over
                                    $3 trillion and is projected to reach $5 trillion in 1995. (See figure 4.)


Figure 3: Debt Held by the Public
(1960-1990)
                                    50      Percent of GNP

                                    45

                                    40

                                    35

                                    30

                                    25

                                    20

                                    15

                                    10

                                     5

                                     0

                                         1960            1965   1970     1975        1980         1985              1990
                                         Fiscal Year




                                    Page 4                                          GAO/OCG90-6   The Budget Deficit
                                        Executive              Summary




Figure 4: Qrorr Federal Debt and Debt
Held by the Public (1945-l 990)
                                        3666      Dollareln        BIllIon*


                                        3000


                                        2500


                                        2000


                                        1500


                                        1000
                                                                                                                             ,,-’
                                                                                                                     ‘*.’/          l -
                                         wo
                                                                                                             ..m=*
                                                               __-___
                                           0

                                               1945
                                               1945              1950                   1960
                                                                                        1960   1965   1970           1975                 1980   1985
                                                                                                                                                 1965   1990
                                                                                                                                                        1990
                                                                 1950         1955
                                               Flscal
                                               Flscal Year


                                                  -                Gross Federal Debt
                                                   n   n   n   - ’ Debt Held by the Public




Interest Costs                          The huge increases in the debt have been reflected in the rapid growth
                                        of interest payments. Gross interest, including interest payments for
                                        funds borrowed from Social Security and other trust funds, increased by
                                        222 percent from 1980 to 1989 and is the fastest growing expenditure in
                                        the budget. (See figure 5.) Current projections indicate that debt service
                                        costs will replace defense as the largest item in the budget by 1992.




                                        Page 6                                                                   GAO/OC!GBO-6 The Budget Deficit
                                       Executive   Summary




Flgure 5: lncrearerr in the Budget
Compared With Inflation (1980-l 989)   260    Percent Change

                                              -
                                       200



                                       160




                                       100




                                                               II
                                                                                                                                               Inflation
                                        50                      --__-----------_c--------------------------------




                                         0




Funding Sources                        A dramatic shift in the way federal programs are financed, as seen in
                                       figure 6, helps to explain the current underfunding of the government’s
                                       general operations. In 1990, general fund receipts covered only 67 per-
                                       cent of general fund outlays. This reflects the fact that excise taxes and
                                       corporation income taxes, which support general operations, have
                                       declined significantly as a source of federal revenue-from     25 percent
                                       of the total in 1970 to 13 percent in 1990. Individual income taxes,
                                       which also support general operations, have remained about the same,
                                       both as a percent of receipts and as a percent of GNP. Until the 198Os,
                                       the Social Security trust fund was kept in approximate balance, but it
                                       recently has begun running large surpluses. This has been possible
                                       despite large increases in benefit payments for a simple reason: the
                                       Social Security tax share has almost doubled, from 20 percent to 34 per-
                                       cent of federal revenues. In short, the trust fund part of the budget has
                                       operated on a pay-as-you-go basis, but the general fund has not.




                                       Page 6                                                                       GAO/OCGBO-5   The Budget     Deficit
                                         Executive               Summary




Flgure 6: C3eneral Fund and Trust Fund
Receipts(1950-1990)
                                         22      PercentofGNP

                                         20

                                         18

                                         16

                                         14

                                         12

                                         10
                                          a                                                                                                                                       .
                                                                                                                                                                l *--    1.11.
                                                                                                                                                      .**-•
                                          6                                                                                    l *
                                                                                                                                     .**.**==-
                                                                                                                        .L..
                                         4                                                                    ,mrnm*
                                                                                           .II.L-I.*
                                                                              .l.
                                                                            l .l.   .*
                                          2 * . I I I..             . l ’

                                         0

                                              1960                 1966             1960               1966            1970           1975       1980             1986           1990
                                              Flrcnl bar

                                                 -                 General Fund Receipts
                                                 n   n   n   n   1 Trust Fund Receipts
                                                 -                 Total Receipts




                                         These huge deficits are draining the pool of the nation’s savings, which
Consequences                             is already historically low. Net savings in the United States have
                                         declined from about 9 percent in the 1960s and 1970s to 3.7 percent
                                         from 1980 to 1987. The U.S. savings rate is 40 percent of Germany’s and
                                         only 20 percent of Japan’s As the correlations in figure 7 suggest, this
                                         has ominous implications for economic growth.




                                         Page 7                                                                                           GAO/W90-5           The Budget Deficit
                                       Executive      Summary                                                                              ,




Figure 7: Countries With High Net
Savings Experience High Productivity
Growth (1960-1987)                     6       Average Percentage Change In Productivity
                                                                                                                              Japan 0              L

                                       5


                                       4
                                                                                                              Italy 0
                                                                                                   France 0
                                                                                                  Germany 0
                                       3

                                                                  United Kingdom 0
                                                                           Australia 0     0 Canada

                                                             United States l



                                       0

                                           0                  4                  8                12                    16       20                24
                                           Average Net Savings as Percent of GDP




                                       Investment is financed from two sources, domestic savings and capital
                                       from abroad. With the decline in domestic savings and with the budget
                                       deficit absorbing a large portion of the savings that remain, the United
                                       States has come to depend increasingly on foreign capital. During the
                                       past decade, the United States has moved from a net creditor position to
                                       a net debtor position, transferring enormous wealth to foreign investors
                                       in the process. Investment financed overseas is better than none, but it
                                       results in foreign ownership of the assets. This means that future gener-
                                       ations must pay for these investments in dividends and interest to the
                                       foreign owners. If allowed to go unchecked, this practice will seriously
                                       erode the nation’s future standard of living.

                                       The ultimate consequences of the deficit, therefore, are lower economic
                                       growth and a weak competitive position in the world. Without the
                                       domestic savings needed to support investment, growth is bound to
                                       suffer. The lesson is clear: those who grow are those who save.




                                       Page 8                                                                    GAO/OCGW-5   The Budget Deficit
                          Executive   Summary




Solution

The Size of the Job       It is evident, then, that current fiscal policy involves high risks to our
                          nation’s competitive position and major long-term costs in the form of
                          low growth. The most desirable alternative, however, is less obvious, In
                          establishing that alternative, we were primarily concerned with the
                          need to restore the national savings rate over the next few years,
                          thereby restoring the potential for internally generated and financed
                          investment to levels the nation has achieved historically and that can
                          sustain the long-term growth it needs. Our analysis indicates that the
                          U.S. government should move the budget from its current 4 percent of
                          GNP deficit to a surplus of 2 percent of GNP over 6 years. If this shift in
                          fiscal policy is accomplished by 1997, it will yield an overall budget sur-
                          plus in that year of about $180 billion and would bring the general fund
                          close to balance.

                          In defining that goal, we considered the following:

                      l Current economic indicators suggest a weakening of the economy. This
                        suggests caution in the timing of short-term fiscal policy changes.
                      l The situation in the Middle East calls for prudence in shaping short-term
                        defense budget decisions while accentuating the need to reassess the
                        forces needed to meet future post-Cold War threats.
                      9 Achieving the significant shift in fiscal policy that we believe is essential
                        will require substantial changes in spending policies, revenue policies, or
                        both. Such changes should be carefully thought out and phased in over
                        long enough periods to avoid shocks and disruptions.
                      l Fiscal policy shifts should be limited in size and speed so that they will
                        not create unnecessary short-term risks to the economy.

                          We urge the administration and the Congress to consider alternatives
                          that take all of these factors into account but not to use them as an
                          excuse for postponing action. None of them changes the size or nature of
                          the long-term fundamental problem the country faces,

                          We recommend that the Congress and the President reach agreement on
                          a multiyear plan to move the general fund budget to approximate bal-
                          ance by 1997.

                          Our analysis indicates that a 6-year phased program that would begin to
                          reduce the deficit by $60 billion in the first year and by $300 billion in


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                                 Executive   Summary




                                 the final year represents an ambitious but practical attack on the
                                 problem. By 1997, this would consist of $240 billion in policy changes
                                 and $60 billion in savings from less borrowing. A sustained program of
                                 this magnitude should permit substantially lower interest rates; as a
                                 result, the lower costs of financing the federal debt might produce an
                                 interest rate “bonus” of another $60 billion by 1997.


The 1990 Budget Summit           As this report is being prepared for publication in late August 1990,
                                 budget summit negotiations are about to resume. Published reports indi-
                                 cate that the negotiators are seeking to reach agreement on a deficit
                                 reduction package of about $30 billion to $50 billion for fiscal year 1991,
                                 with a longer term cumulative goal of about $500 billion over the 5-year
                                 period from fiscal years 1991 through 1995. These goals are consider-
                                 ably more modest than we believe necessary. If achieved, they would be
                                 only a first step toward the more demanding goal recommended in this
                                 report, which would involve $1,050 billion in deficit reductions over a 6-
                                 year period. (On a fully comparable basis, our goal would be $500 billion
                                 by 1996, with another $250 billion in 1996 and $300 billion in 1997.)


Risks                            The risks of this program are short-term and low, but the benefits are
                                 long-term and substantial. Although we share the general concern about
                                 an economic slowdown, the fundamental change in fiscal policy dis-
                                 cussed here is not likely to impair seriously short-term growth. What
                                 these policies should do is yield lower interest rates, stronger invest-
                                 ment, higher exports, and a significantly higher rate of economic growth
                                 by the end of the century.


Role of Debt Financing and       There are three basic aspects to deficit reduction:
Interest Rates               l policy changes, that is, cuts in spending programs and increases in reve-
                               nues from changes in the tax code;
                             . interest savings due to the lower size of the debt; and
                             l interest savings due to lower interest rates that should accompany a
                               more restrictive fiscal policy.

                                 By 1997, we believe that $242 billion in program cuts or revenue
                                 increases will yield $120 billion in additional savings because of lower
                                 debt and interest rates, as shown in table 1.




                                 Page 10                                         GAO/OCG-W-5   The Budget Deficit
                                                                 Executive           Summary




Table 1: The Arithmetic of Deficit Reduction for 1992 Through 1997
Dollars in billions
      . .._                                 --- _-..-.--._              .--~--                 1992               1993     1994       1995     1996         1997           Total
Adiusted b&eke
  Total deficit                                  --_-. .-~----.~~.-._-- .._--.-.-!e!.--                          $-217    $-181      $-I85    S-186     $-180

Changes:

  Fiscal    oolicvg shift,
    ..I .I 1~                  -~.   ~~ _--...         .---.-~    ~-.      .~.-...   --.-..   . ..-.    .~..-.
       Policy changes.
                .*..                                                                                   48            93      135       173       209         242            900
      Debt servlce’sawngs    from policy change                                                         2             7       15        27        41          58            150
  Total flsc~i’policv   shift ‘--                                                                      50           100     150        200       250         300          1,050

  Interest rate “bonus”                                                                                12            22       35 -       48       55          62            234

  Total change from baseline                                                                           62           122      185        248      305         362          1,264

Baseline after policy change                                                                                              ___.__
Total Surplus or Deficit                                                                      $-I69               s-95       $4        $63     $116         $162
                                                                 Note: Totals may not add due to rounding



                                                                 Developing a package of $240 billion in policy changes, yielding total
Alternatives                                                     deficit reductions of about 1 percent of GNP per year, is a major political
                                                                 challenge. However, several advanced industrialized countries, such as
                                                                 Australia, Denmark, and Sweden, have achieved deficit reduction in
                                                                 excess of this goal. As a nation, we must make basic choices about how
                                                                 much to allocate to defense and domestic programs. We then need to
                                                                 balance that spending with adequate revenues to avoid draining the
                                                                 supply of domestic savings. With the economy operating near capacity,
                                                                 debt financing is not a lesser burden to the nation than taxes, only a less
                                                                 visible one. It is also much more costly. This is observable from the fact
                                                                 that 17 percent of federal taxes now goes for interest payments. Indi-
                                                                 rectly, it either forces a reduction of investment in the economy or
                                                                 requires borrowing abroad, or both.
                                                                 Each of these broad choices leads to a large number of more detailed
                                                                 ones. We do not advocate any one set of choices. Doing so would involve
                                                                 basic value judgments about the relative size of the public and private
                                                                 sectors and the role of government in our society, which should be made
                                                                 by elected officials. We, however, are suggesting options to be consid-
                                                                 ered, five of which are illustrated in figure 8. In very general terms,
                                                                 these options present combinations of defense cuts, domestic cuts, and
                                                                 revenue increases for consideration,


                                                                 Page 11                                                                      GAO/OCGBO-5    The Budget Deficit
                                             Executive     Summay




Finure 8: Illustrative Deficit Reduction Programs
                                              Package #I                                        Package #2                                     -
                                                   r                              Defense                                                 Defense




                                                                                                                                          Revenue


                                                                                  Non-Defense




                                             Revenue 0%                                           Non-Defense 0%




Defense reductions (See chapter 5)          $70 billion                                         $120 billion
                                            Force structure reduction of up to 25 percent.      Even greater force structure reduction.

Nondefense reductions (See chapter 6)       $170 billion                                        None

                                            Retain only core functions: law enforcement,
                                            tax collections, etc., plus low income support
                                            and activities funded with user char es and
                                            earmarked taxes. Tax 85 percent of 8 ocial
                                            Security benefits.
Revenue increases (See chapter 7)           None                                                $120 billion.
                                                                                                Large tax rate increases elimination of many
                                                                                                deductions and taxation of income now
                                                                                                exempt, or a new comprehensive
                                                                                                consumption tax (VAT).




                     Y




                                             Page 12                                                            GAO/occ-sCra   The Budget Deficit
                                                   Executive      Summary




Package #3                                         Package #4                                           Package #5

     I                               Revenue             I                                Revenue



                                                                                          Non-Defense                                          Non-D&me
                                     Non-Defense
                                                                                                                                               Defense



                                                                                          Defense
                                     Defenao




$70 billron                                        $100 billion                                         $120 billion

Force structure reduchon of up to 25 percent.      Force structure reduction of more than 25            Even greater force structure reduction.
 .I                                                percent.
$85 billion                                        $50 billion                                          $60 billion

User fees; program cuts; and devolution of         User fees; cuts in subsidies to business,            User fees; cut subsidies to business,
funchons to states with reduced federal            individuals, and farmers; health care cost           individuals, and Medicare; curtail foreign aid;
funding                                            containment; federal workforce efficiency            federal workforce efficiency measures.
                                                   measures.

$85 billron                                        $90 billion                                          $60 billion

Excuse taxes, plus gasoline or energy tax,         Excise taxes, plus gasoline or energy tax,           Gasoline or energy tax and excise taxes, or
plus increased income tax rates.                   plus increased income tax rates.                     increased income tax rates.


                                                   Note: Packages are illustrative only. Deficit reduction could be achieved in many ways. For example,
                                                   defense savings could be accomplished by slowing down modernization, or by making disproportionate
                                                   cuts in some forces to minimize reductions in others. Income tax rate increases can be minimized by
                                                   heavier reliance on gasoline or energy taxes, or by taxing income currently exempt.




                                                   Page 13                                                             GAO/-f)045    The Budget Deficit
                                                      Executive    Summary




                                                      In chapter 4, this analysis is expanded to 15 combinations, which are
                                                      summarized in table 2. Later chapters illustrate more specifically three
                                                      defense reduction packages, four packages of domestic spending cuts,
                                                      and three alternatives for increasing revenues.


Table 2: Basic Choices for Deficit Reduction (Changes From the 1997 Baseline)
Dollars in billions
                                                      Policy Changes                        Total policy    Debt service          Total fiscal
Policy sets                    Defense                  Nondefense               Revenues       change          savings           policy shift
Set1           --             _.    $70 .__-__-_----..-_
                                  _--.-                                $85            $85          $240              $60                  $300
                                      70                                 60           110           240               60                   300
                                      70                                110            60           240               60                   300
                             _________70
                                       .,.__
                                          - ...___-.-..-.---.----       170             0           240               60                   300
                                      70                                  0           170           240               60                   300
Set2                                 100
                                  .-- -.._.-..                     ..-___70 --         70           240               60
                                                                                                                      -_                   300
                                    100                          ____.   50            90           240               60            .-~--  300
                                    100                                  90            50           240               60                   300
                                     100                                140             0           240               60                   300
                                       100
                      ..---_~_.-- ..- _______-        .-                0             140           240               60                   300
Set3                                120                               60               60           240               60                   300
                                    120                               45               75           240               60                   300
                                    120                               75               45           240               60                   300
                                    120
                             -______---....--~~~                     120                0           240               60                   300
                                    120                                0              120           240               60                   300




                                                      The last three chapters of this report consider issues involving enforce-
Other Issues                                          ment of a budget agreement, recommend reforms in the budget process
                                                      that would move us beyond mechanistic approaches such as GRH, and
                                                      discuss the need to improve financial management so that the federal
                                                      government funds will be used prudently and effectively.


                                                      In the final analysis, a new fiscal policy is essential to the economic well-
Conclusion                                            being of the United States. Not only must the federal government find
                                                      the will and the way to confront the deficit crisis, it must also encourage
                                                      savings that will promote economic growth, ease and eventually end
                                                      U.S. dependence upon foreign capital, and provide the means to deal
                                                      with future needs as they arise.




                                                      Page 14                                              GAO/OCG90-6     The Budget Deficit
Executive   Summary




As this report shows, there are many possible alternatives available to
the Congress and the administration. Each of these alternatives involves
some short-term sacrifice, depending upon the choices that are selected
by elected officials. Such sacrifice, however, would be far outweighed by
the long-term benefits that would flow from a multiyear budget solution
agreed to on a bipartisan basis by both the Congress and the
administration.




Page 16                                       GAO/OCG-90-S   The Budget Deficit
Contents


Executive Summary                                                                                                 2

Chapter 1                                                                                                    22
Introduction                    Context of the Request                                                       22
                                Structure of the Report                                                      24
                                The 1990 Budget Summit                                                       25
                                Next Steps                                                                   25
                                Objectives, Scope, and Methodology                                           25
                                Note on Terminology                                                          26

Chapter 2                                                                                                    27
Background                      Recent Budget History                                                        27
                                Outlook for the Deficit and Debt                                             41

Chapter 3                                                                                                    46
Economic Policy                 Why Deficits Matter                                                          47
                                Historical Perspective on Investment                                         49
Considerations                  Setting Fiscal Policy Objectives                                             54

Chapter 4                                                                                                    57
Framework       for   Deficit   Overall Arithmetic of Deficit Reduction                                      57
                                Illustrative Strategies                                                      59
Reduction                       Illustrative Packages                                                        60

Chapter 5                                                                                                    65
DefenseAlternatives             Alternative Approaches to Restructuring                                      66
                                Summary of Options                                                           68
                                DOD’s 25 Percent Illustrative Force Reduction                                68
                                Option l-$70 Billion Reduction                                               70
                                Option 2-$100 Billion Reduction                                              71
                                Option 3-$120 Billion Reduction                                              72

Chapter 6                                                                                                    76
Nondefense                      Defining the Federal Role                                                    76
                                Structure of the Chapter                                                     77
Alternatives                    Ten Approaches to Spending Cuts                                              78
            *                   Illustrative Reduction Packages                                              89




                                Page I6                                         GAO/OCG-SO-6 The Budget Deficit
                       Contents




Chapter 7                                                                                               94
RevenueAlternatives    Mix of Taxes Has Shifted Over Time                                               94
                       The Aggregate Tax Burden on the U.S. Economy Is                                  96
                            Relatively Low by International Standards
                       Each Approach to Raising Revenue Has Limitations                                 97
                       Options for Raising Revenue                                                     102
                       Transition Issues Should Be Considered in Phasing in                            113
                            Changes

Chapter 8                                                                                              114
Enforcement of a       Increasing   the Effectiveness of All Approaches                                115
                       Enhanced     Executive Authority                                                115
Multiyear Budget       Improved     Congressional Processes                                            117
Agreement              Providing    Remedies                                                           117

Chapter 9                                                                                              120
Budget Reform          Move Beyond Automatic Budgeting                                                 120
                       Adopt a Joint Budget Resolution Procedure                                       122
                       Expedited Rescission                                                            122
                       Institute Meaningful Multiyear Budget Planning                                  123
                       Improve the Budget’s Numbers                                                    124
                       Change the Unified Budget                                                       126
                       Other Matters for a Budget Commission                                           130

Chapter 10                                                                                             131
Better Management of   Inattention to Management Controls Has Proven
                            Extremely Costly
                                                                                                       131
the Government Is      Approach to Decisionmaking Does Not Lead to Efficient                           132
Essential                   Use of Resources
                       Information Is a Key Factor                                                     133
                       Major Improvements in Federal Management Are Needed                             133

Appendix               Appendix: Letters From Congressional Requesters                                 136

                       Table 1: The Arithmetic of Deficit Reduction for 1992
                           Through 1997
           Y           Table 2: Basic Choices for Deficit Reduction (Changes                             14
                           From the 1997 Baseline)
                       Table 1.1: Changing Deficit Estimates for 1990 and 1991                          23
                       Table 2.1: GAO Adjusted Baseline Budget Projections                              42


                       Page 17                                            GAO/OCXHO-5   The Budget Deficit
Contents




Table 4.1: The Arithmetic of Deficit Reduction for 1992                     59
    Through 1997
Table 4.2: Basic Choices for Deficit Reduction (Changes                     60
    From the 1997 Baseline)
Table 4.3: $70 Billion Defense Restructuring-No     New                     61
    Revenues (Package 1)
Table 4.4: $120 Billion Defense Restructuring-No                            61
    Domestic Cuts (Package 2)
Table 4.6: Proportional Cuts (Package 3)                                    62
Table 4.6: $50 Billion in Domestic Cuts-Equal Shares                        63
    From Defense and Revenues (Package 4)
Table 4.7: $120 Billion Defense Restructuring-Equal                         64
    Shares From Nondefense and Revenues (Package 5)
Table 6.1: Relationship Between Funds Available and                         69
    Illustrative Budget Reductions in 1995
Table 5.2: DOD Illustrative Force Structure Reductions                      69
Table 5.3: Option l-$70 Billion Reduction                                   71
Table 5.4: Additional Reductions Under Option 2                             71
Table 5.5: Option 2-$100 Billion Reduction                                  72
Table 5.6: Additional Reductions Under Option 3                             73
Table 5.7: Option 3- $120 Billion Reduction                                 73
Table 5.8: Other Illustrative Defense Budget Reductions                     74
Table 6.1: Distribution of Baseline Nondefense Program                      77
    Outlays for 1997
Table 6.2: Domestic Deficit Reduction Strategies                            79
Table 6.3: Upper Range of Possible Health Care                              81
    Reductions
Table 6.4: Upper Range of Possible Business Subsidy                         84
    Reductions
Table 6.5: Upper Range of Possible Individual Subsidy                       a5
    Reductions
Table 6.6: Upper Range of Possible User Charge and Fee                      86
    Increases
Table 6.7: Upper Range of Possible Curtailment of                           87
    International Activities
Table 6.8: Upper Range of Possible Reductions in Selected                   87
    Scientific and Medical Research
Table 6.9: Option l-User Charge and Subsidy Emphasis                        90
Table 6.10: Option 2-Health Care, User Charge, Subsidy,                     91
    and State Grant Emphasis
Table 6.11: Option 3-Entitlement,    Health Care, User                      92
    Charge, Subsidy, and State Grant Emphasis



Page 18                                      GAO/OCG9O-5    The Budget Deficit
          Contents




          Table 6.12: Option 4-Minimal Federal Involvement                             93
              Except for Self-Financed Programs
          Table 7.1: Receipts, Outlays, and Deficits                                   95
          Table 7.2: Tax Revenues Relative to GDP for 23 OECD                          96
              Countries, 1988
          Table 7.3: Estimates of Largest Tax Expenditures-1996                       99
          Table 7.4: Revenue Effects of Capping or Eliminating                       106
              Certain Tax Expenditures
          Table 7.5: Illustration of Raising $115 Billion From                       112
              Selected Base Broadener
          Table 9.1: Restructured Federal Budget for Fiscal Year                     129
               1989

Figures   Figure 1: Average Deficit by Decade (1950-1989)
          Figure 2: Changing Estimates for 1991 Total Deficit
          Figure 3: Debt Held by the Public (1960-1990)
          Figure 4: Gross Federal Debt and Debt Held by the Public
               (1946-1990)
          Figure 5: Increases in the Budget Compared With                                  6
               Inflation (1980-1989)
          Figure 6: General Fund and Trust Fund Receipts (1960-                            7
               1990)
          Figure 7: Countries With High Net Savings Experience                             8
               High Productivity Growth (1960-1987)
          Figure 8: Illustrative Deficit Reduction Programs                            12
          Figure 1.1: Changing Estimates for Total Deficit                             23
          Figure 2.1: Total Budget Deficits (1947-1990)                                27
          Figure 2.2: Average Deficit by Decade (1950-1989)                            28
          Figure 2.3: Total Budget Deficits (1950-1990)                                29
          Figure 2.4: General Fund and Trust Fund Receipts (1950-                      30
               1990)
          Figure 2.5: General Fund and Trust Fund Outlays (1960-                       31
               1990)
          Figure 2.6: General Fund and Trust Fund Deficits/                            32
               Surpluses (1960-1990)
          Figure 2.7: Trust Fund Receipts and Outlays (1960-1990)                      33
          Figure 2.8: Trust Fund Surpluses (1960-1990)                                 36
          Figure 2.9: General Fund Spending Growth (1980-1989)                         38
          Figure 2.10: Gross Federal Debt and Debt Held by the                         39
               Public (1945-1990)
          Figure 2.11: Gross Interest on the Public Debt (1960-1990)                   39




          Page 19                                        GAO/oCG90-5   The Budget Defklt
Figure 2.12: Financing the Growth in General Fund                            40
     Spending (1980-1989)
Figure 2.13: Gross Interest vs. Defense Outlays (1960-                       43
     1997)
Figure 3.1: Countries With High Net Savings Experience                       47
     High Productivity Growth (1960-1987)
Figure 3.2: Effect of the Federal Budget Deficit on Net                      48
     Savings (1960-1989)
Figure 3.3: Gross Savings and Private Domestic                               50
     Investment (1980-1989)
Figure 3.4: U.S. Net International Investment Position                       51
     (1980-1988)
Figure 3.5: Average Hourly Earnings ( 1947- 1989)                            53
Figure 3.6: Real Short-Term Interest Rates (1950-1990)                       64
Figure 5.1: Alternative Defense Budget Levels (1991-                         66
     1997)




Abbreviations

AGI       adjusted gross income
CR0       Congressional Budget Office
CIW       chief financial officer
COLA      cost-of-living adjustment
DOD       Department of Defense
FSLIC     Federal Savings and Loan Insurance Corporation
GDP       gross domestic product
GNP       gross national product
GRII      Gramm-Rudman-Hollings
IRA       individual retirement account
IRS       Internal Revenue Service
JCT       Joint Committee on Taxation
NNP       net national product
OECD      Organization for Economic Cooperation and Development
OMU       Office of Management and Budget
RTC       Resolution Trust Corporation
VAT       value-added tax


Page 20                                       GAO/OCG!3O-6   The Budget Deficit
Page 21   GAO/OCG4JO-5 The Budget Deficit
Chapter 1

Introduction


                         This report responds to a request from Senators Exon and Grassley, who
                         were subsequently joined by Senators Moynihan and Bradley. The
                         request was stimulated by increasing concern about the budget deficit
                         and about the need for greater public understanding of the problem. The
                         requesters posed a broad ranging series of questions and asked us to
                         respond based on our experience with and knowledge of government
                         programs and finances. Their questions centered on

                     l   the outlook for the budget deficit and the public debt,
                     l   the selection of an appropriate fiscal policy for the nation, and
                     l   the budgetary choices that the Congress and the President must face if
                         that fiscal policy is to be achieved.

                         In response to these questions, we have set forth our views on the
                         dimensions of the budget problem faced by the nation, the implications
                         of the deficit for the performance of the U.S. economy, and the alterna-
                         tives that are available to solve the deficit problem.


                         The request grew out of the recognition, in the spring of 1990, that the
Context of the Request   federal budget deficit had gone out of control. Table 1.1 displays this
                         sudden explosion of the deficit as seen in re-estimates of the budget by
                         the Congressional Budget Office (CBO) and the Office of Management and
                         Budget (OMB) between January and July of 1990. The dimensions of that
                         growth are summarized in figure 1.1.

                         These revisions in the estimates reflected the escalating costs of the Res-
                         olution Trust Corporation (RTC), the agency responsible for resolving the
                         bankruptcy of the Federal Savings and Loan Insurance Corporation
                         (E'SLIC), and declining tax revenues from a softening economy.


                         Overruns had occurred before, though never on this scale. Still, the
                         events of the spring of 1990 followed several years in which optimistic
                         expectations for declining deficits, built on the assumption that Gramm-
                         Rudman-Hollings (GRH) deficit targets would be met, were often disap-
                         pointed when the actual financial results were unveiled. The resulting
                         doubts about the government’s ability to manage its financial affairs
                         were greatly intensified by the new explosion of the deficit in 1990. It
                         was in this environment that the requesters asked us to examine the
                         issues.




                         Page 22                                        GAO/OCG90-6   The Budget Deficit
                                            Chapter 1
                                            Iutroduction




Table 1.1: Changing Deficit Estimates for
lWOand1991                                  Dollars in billions
                                                                                                                Fiscal year
                                                                                                        1990                   1991
                                            Deficit estimate                                         CEO     OMB            CBO     OMB
                                            Januarv 1990                                             $138   $122.0            $138     $100.5

                                            Revisions:                                                                                  --
                                                Resolution Trust Corooration                          $22    $54.8             $65       $55.2
                                                Lower revenue                                          23     28.8              14         34.6
                                            ----Interest                                                2      5.8              11         21.3
                                                Other                                                  IO      7.1               4         19.8

                                            July 1990                                                $195   $218.5            $232      $231.4

                                            GRH taraet                                               $100   $100.0             $64       $64.0

                                            Excess deficit:
                                               January
                                            .___-. -..------                                          $38    $22.0             $74      $36.5
                                               Julv                                                   $95   $118.5            $168     $167.4



Figure 1.1: Changing Estimates for Total
Deticit



                                            200




                                            150




                                            100

                                                   -       ----        -m-m,

                                              SO




                                               0
                                                       t
                                                            OMB             CEO   OMB          CBO
                                                                  January               July




                                            Page 23                                                         GAO/OCG-90-B   The Budget Deficit
                   Chapter 1
                   Introduction




                   The report is structured around the questions that were posed to us.
Structure of the   Chapter 2 describes the background of the present deficit problem. It
Report             includes a recent history of the budget, an examination of the factors
                   that led to the explosion of deficits in the 1980s and a projection of the
                   future course of the deficit if nothing is done to contain it. Chapter 3
                   examines the economic implications of continued large deficits and of
                   efforts to reduce them. This analysis concludes that restoring the pros-
                   pects for long term economic growth requires a shift in fiscal policy of
                   about $300 billion by 1997, yielding a total budget surplus of about
                   $180 billion at that time, about 2 percent of gross national product
                   (GNP).


                   That shift in fiscal policy can be achieved in numerous ways. It was our
                   task to describe a representative range of the choices that are available.
                   Chapter 4 arrays the defense, nondefense, and revenue choices that
                   must be considered. We stress the key part in the arithmetic of deficit
                   reduction played by debt service costs, now the second largest spending
                   component in the budget and gaining rapidly on defense for the number
                   one position. We then describe various hypothetical packages of policy
                   changes, involving varying combinations of defense and nondefense
                   budget reductions and revenue increases. We take no position on which
                   would be preferable. That requires value judgments that must be made
                   by elected officials.

                   We then examine in greater detail the program choices within each cate-
                   gory: defense (chapter 5); nondefense (chapter 6); and revenues
                   (chapter 7). The program and revenue choices that are posed are
                   intended to define the range of options available to the Congress and the
                   President, not to indicate our position on the wisdom of choosing a par-
                   ticular course of action. Detailed data underlying the options portrayed
                   in these chapters, along with other technical and supporting material,
                   are being published in GAO/o%-90-m    which is a separate volume to this
                   report.

                   The final section of the report focuses on procedural and structural
                   questions. Chapter 8 discusses approaches to assuring that an agree-
                   ment to reduce the deficit by substantial amounts would be imple-
                   mented. In chapter 9 we suggest longer term changes in the budget
                   structure and process that would help prevent future explosions of defi-
                   cits such as those that occurred in the 1980s. The report concludes in
                   chapter 10 with a discussion of the need for a major strengthening of
                   the government’s management systems and controls as part of a
                   strategy for bringing government finances under control and for


                   Page 24                                         GAO/OCG-90-5   The Budget Deficit
                        Chapter 1
                        Introduction




                        assuring that whatever resources are allocated to the public sector are
                        used efficiently and effectively.


                        As this report is being prepared for publication, in late August of 1990,
The 1990 Budget         budget summit negotiations are about to resume. Because of the uncer-
Summit                  tainty surrounding the negotiations, we have not reflected their outcome
                        in the baseline for this report. Published reports indicate that the negoti-
                        ators are seeking to reach agreement on a deficit reduction package of
                        $30 billion to $50 billion for 1991, with a longer term goal of about
                        $500 billion over the 5-year period, 1991 to 1995.

                        If these reports are accurate, the current goals of the summit negotiators
                        are considerably more modest than we believe necessary. If achieved,
                        they would be only a first step toward the more demanding goal recom-
                        mended in this report, which would involve $1,050 billion in deficit
                        reduction over a g-year period, (On a fully comparable basis, our goal
                        would be $500 billion by 1995, with another $250 billion in 1996 and
                        $300 billion in 1997.)


                        We recommend that as the first order of business of the 102nd Congress
Next Steps              (or sooner, if possible), negotiations should resume between the Presi-
                        dent and the bipartisan leadership of the Congress with the objectives of

                        reaching agreement on a comprehensive package of policy changes that
                        will produce an overall budget surplus of about 2 percent of GNP (about
                        $180 billion) by 1997; and
                        enacting those changes into law in the form of a multiyear budget reso-
                        lution, along with the substantive legislation required to implement that
                        resolution, by the conclusion of the First Session of the 102nd Congress.

                        Chapter 4 provides a framework for developing that package of policy
                        changes, and chapters 5 through 7 provide a basis for examining the
                        choices that must be made.


                        The objective of this report is to respond to the questions posed by the
Objectives, Scope,and   requesters. The methodological approach varies from one section of the
Methodology I           report to another, depending on the issues being addressed. The histor-
                        ical background relies heavily on published data from OMB and CBO. The
                        outlook for the deficit and the debt begins with the baseline projections
                        for 1991 to 1995, which CBO published in July 1990. With assistance


                        Page 26                                         GAO/OCG90-6   The Budget Deficit
                      Chapter 1
                      Introduction




                      from CRO,we extended these projections to 1997, using standard CBO
                      methodology. We then adjusted the extended projections by assuming
                      that, in the absence of a deficit reduction program, interest rates would
                      remain at their present levels.

                      The economic analysis section of the report is grounded in standard eco-
                      nomic theory. The conclusions and recommendations with respect to
                      fiscal policy were tested using recognized econometric forecasting tech-
                      niques. The results of these simulations are presented in greater detail in
                      appendix I of a separate volume to this report, GAO/ocG80-SA.

                      The section of the report describing alternative policy choices for
                      accomplishing the needed shift in fiscal policy relies on various data
                      sources, including data published by OMB and CBO, and data we obtained
                      from the agencies whose programs are discussed. We selected particular
                      options to illustrate the range of choices available to the Congress and
                      the President based on our work in various program areas. The inclusion
                      of an item is only illustrative of the many choices that could be made,
                      not a recommendation that a particular choice should be made.

                      The section of the report dealing with needed changes in budget prac-
                      tices was developed by us from our previous work in this area and our
                      observation of the budget process over many years.

                      Drafts of this report were reviewed by a number of outside advisors
                      who were selected for this purpose on the basis of their expert knowl-
                      edge of particular issues. We sought a diversity of views on the various
                      issues and, as would be expected, received conflicting advice on many of
                      them. Time did not permit us to seek official agency views on these
                      issues.

                      The analysis in this report reflects data available in the period from
                      May through August of 1990.


                      Throughout this report, we use the term “general fund” in lieu of the
Note on Terminology   “federal funds” description found in most official budget documents. We
                      concluded that this would facilitate public understanding because “fed-
                      eral funds” is not a term often found in common usage.
         Y




                      Page 26                                         GAO/OCGO-5   The Budget Deficit
Chapter 2

Background


                                    This chapter provides a context in which to understand the nature of
                                    the deficit problem and a backdrop against which to consider the policy
                                    choices presented later in the report. We first review the recent history
                                    of budget performance. We then discuss the possible future course of the
                                    budget deficit and the public debt in the absence of an aggressive effort
                                    to control them.


                                    The pattern of budget deficits since World War II is displayed in figure
Recent Budget History               2.1, reflecting annual data in current dollars. Figures 2.2 and 2.3 are
                                    more revealing about underlying trends because they relate the deficits
                                    to a growing economy and avoid the distorting effects of price changes
                                    over long periods. These demonstrate that the annual deficits in the
                                     198Os, while dramatically larger than in earlier periods, are an exten-
                                    sion of a pattern that began much earlier. That pattern, as seen in figure
                                    2.2, shows the average deficit as a percent of GNP in each decade since
                                    the 1950s to be roughly double the average of the previous decade.


Figure 2.1: Total Budget Deficits
(1947-1990)
                                    240   Dollrrr   In Billlone
                                    220
                                    200
                                    180
                                    160
                                    140
                                    120
                                    100
                                     60
                                     60
                                    40
                                    20
                                     0
                                    -20
                                          T-
                                      1947 1950              1955   1960   1965   1970   1975     1980         1965       1990
                                      Fiscal Year




                                    Page 27                                              GAO/OCGSO-5     The Budget Deficit
                                        Chapter 2
                                        Background




Figure 2.2: Average Deficit by Decade
(1950-1989)
                                        4.9   Poreont of QNP

                                        4.0
                                                                 r-
                                        a.6




                                        2.0

                                        1.5

                                        1.0

                                        0.6

                                         0




                                        In figure 2.3, a long-term trend line has been fitted to the annual data,
                                        and that trend line shows a disturbingly steep upward slope since the
                                        1960s. The slope grew even steeper after 1970. It seems evident that
                                        some forces are at work that are not adequately explained by focusing
                                        exclusively on events in the 198Os, critical as those events are in under-
                                        standing our current problems.




                                        Page 28                                         GAO/O%-90-6   The Budget Deficit
                                    Chapter 2
                                    Background




Figure 2.3: Total Budget Deficltr
(1950.1990)
                                      Percent of GNP




                                    1960          1966         1960     1965   1970   1975      1960       1985        1990
                                    Fiscal Year

                                       -         Total Budget Deficit
                                       - - - - * Trend



Components of the                   To understand what has happened to the budget over the years, it is
Long-Term Trend                     necessary to focus on two major components of the budget. One is the
                                    general fund, which finances most of the general operations of govern-
                                    ment, primarily from unearmarked revenue sources such as the indi-
                                    vidual and corporate income tax. (In official budget documents, this is
                                    called the “federal funds” part of the budget. We use the label “general
                                    fund” because of its greater familiarity in common usage.) The other
                                    major component of the budget is the trust funds, in which certain pro-
                                    grams are financed from dedicated revenues. Social Security, financed
                                    by payroll taxes, dominates this component, along with Medicare and
                                    the Civil Service and Military Retirement funds.

                                    Each year’s budget deficit, of course, is simply the difference between
                                    revenues and outlays in that year. Thus, to find the source of the long-
                                    term trend toward larger and larger deficits, we must look at the trends
                                    in revenues and outlays. Figure 2.4 displays revenues, again in relation-
                                    ship to the total economy. Two things are of special significance. One is
                                    the long-term stability of total revenues in relation to the economy.
                                    While there is significant year-to-year variation, total revenues have
                                    remained consistently within a close range around 18 to 19 percent of


                                    Page 29                                              GAO/OCGBO-6   The Budget Deficit
                                          chapter 2
                                          Background




                                          GNP since 1960. Equally notable, however, is the shifting composition of
                                          those revenues, with a steadily declining share going to the general fund
                                          and a rising portion going to the trust funds, primarily to Social
                                          Security.


Flguro 2.4: Qeneral Fund and Trust Fund
Receipts (1950-l 990)
                                          22    Percent of GNP




                                           1950             1955        IQ60        1865   1970   1975      1980       1985        lQQ0
                                           Fiscal Year
                                           Flrcai

                                                -           General Fund Receipts
                                                9=n   n   1 Trust Fund Receipts
                                                -           Total Receipts




                 Y




                                          Page 30                                                    GAO/OCG90-6   The Budget Deficit
                                          Chapter 2
                                          Background




                                          Next we must look at what has happened on the outlay side of the
                                          budget, This is seen in figure 2.5, in which total outlays rise fairly
                                          steadily. Again, however, the composition is important. General fund
                                          outlays remained relatively stable at around 15 to 17 percent of GNP
                                          until recent years, when growing interest costs began to raise the trend
                                          line. Trust fund outlays, on the other hand, rose steadily in the earlier
                                          years, but have leveled off recently. From this brief examination, it is
                                          clear that the two major components of the budget-the general fund
                                          and the trust funds-have behaved very differently over the years.
                                          This is demonstrated in figure 2.6, which separates the deficits into
                                          their general and trust fund components. The long-term trend toward
                                          rising deficits is obviously centered in the growing structural imbalance
                                          in the general fund.


Figure 2.5: General Fund and Trust Fund
Outlays ( 1960-1990)
                                          26      Percent of GNP
                                          24
                                          22

                                          20
                                          18

                                          16

                                          14
                                          12
                                          10
                                           8

                                           6
                                           4

                                           2
                                           0

                                               IQ60                1965        1970   1975    lQ80          1985            1990
                                               Fiscal Year

                                                  -            Total Outlays
                                                  =l -   n   1 Trust Fund
                                                  -            General Fund




                                          Page 31                                            GAO/OCG90-6   The Budget Deficit
                                           Chapter 2
                                           Background




Figure 2.6: Qeneral Fund and Trust Fund
DefMs/Surpluees (1960-l 990)
                                          3       PercentofGNP




                                          -2

                                          -3

                                          -4

                                          -5

                                          .6

                                          -7

                                          -0

                                           1960                  1966      1970   1975     1980        1985            1990
                                               Fiscal Year

                                                  -         General Fund
                                                  - - - = 1 Trend
                                                  -         Trust Fund

                                           Thus we see that, over the years, trust fund outlays have risen, and a
                                           growing share of a relatively stable flow of total revenues has been allo-
                                           cated to the trust funds to finance those outlays. This is exemplified by
                                           legislation in the early 198Os, which increased the payroll tax to begin
                                           building substantial reserves in the Social Security trust fund while
                                           reducing individual and corporate income taxes. But the reduced flow of
                                           revenue to the general fund was not matched by a comparable reduction
                                           of claims on that revenue. Instead, total general fund outlays continued
                                           along the previous path and we borrowed the difference. To deal with
                                           this persistent deficit, we must either increase general fund revenues, or
                                           reduce general fund outlays, or both. Therefore, we need to focus on
                                           what has happened in recent years within the general fund part of the
                                           budget.


Recent Performance of                      Before turning to the general fund, however, we should look briefly at
Trust FundsI                               the trust funds, and especially at Social Security, which dominates the
                                           trust fund part of the budget. Until about 1980, the Social Security pro-
                                           gram was financed on a “pay-as-you-go” basis, under which payroll




                                           Page 32                                        GAO/OCG!W5   The Budget Deficit
                                      Chapter 2
                                      Background




                                      taxes were set at levels designed to finance current benefits and admin-
                                      istrative costs plus a small allowance for contingencies. Thus, as outlays
                                      rose over the years, revenues rose in lock step. This can be seen in figure
                                      2.7, showing the relationship between trust fund revenues and outlays.


F~QUMI 2.7: Trubt Fund Receipts and
Outlays (1960.1990)
                                      9      Percent of GNP
                                                                                               .+*‘L...
                                                                                              l+                  I-0. 41-h
                                      0
                                                                                        .**
                                      7




                                      2

                                      1


                                      0

                                          1950                   1965   1970   1975    1980                1995            1990
                                          Fled Year

                                             n   - - -   l   Receipts
                                             -               Outlays



                                      By the late 197Os, it was apparent that the prospective retirement of the
                                      “baby boom” generation, anticipated to begin by the second decade of
                                      the 2 1st century, combined with a dramatically lower birth rate since
                                      the 196Os, was pushing the Social Security fund into serious imbalance
                                      over the 76-year actuarial estimating period used for the program. In
                                      response, previously scheduled increases in the payroll tax were acceler-
                                      ated in order to restore reasonable actuarial balance. But the events that
                                      these taxes were intended to finance lay several decades in the future.
                                      Thus, the higher payroll taxes began quickly to produce revenues well in
                                      excess of the amounts needed to pay current Social Security benefits.
                                      Under current law, the resulting surpluses will continue accumulating
                                      for another 30 years or so, but will then be drawn down rapidly as the
                                      “baby boom” generation retires. The accumulated reserves will be
                                      exhausted by about 2050 under current actuarial projections.


                                      Page 33                                         GAO/OCG!N-5         The Budget Deficit
Chapter 2
Background




These surpluses in the Social Security fund began accumulating at the
same time the government started moving toward full funding of its
civilian and military retirement programs, producing surpluses in those
trust funds as well. The consequences are evident, as displayed in figure
2.8, which shows total trust fund surpluses that were more than 2 per-
cent of GNP in the late 1980s and continuing to grow. For the first time,
the trust funds’ performance became a major factor in the budget’s
overall performance and thus in the nation’s fiscal policy.

But these trust fund surpluses were matched by even larger general
fund deficits. Since trust fund surpluses are invested in the Treasury
bonds that finance the general fund deficit, the net result is that the
trust funds are financing a significant portion of that deficit.

This is the basis for a special concern with respect to Social Security.
The present situation, in which the trust fund surpluses are combined
with and partially offset a deficit in the general fund, means that the
payroll tax is being used, not to make provision for future retirement
benefits, but to pay for today’s general operations of government. The
rationale for increasing the payroll tax, however, was to enable Social
Security benefits to be paid to retirees in the next century without over-
burdening tomorrow’s workers. This can only be accomplished if Social
Security surpluses are accumulated as additions to the nation’s supply
of savings.




Page 24                                         GAO/OCGBO-6   The Budget Deficit
                                       Chapter 2
                                       Backgruund




FlQUrr3   2.8: Trust Fund Surplurer
(1960.1990)
                                       2.6 Percent of GNP
                                       2.4
                                       2.2
                                       2.0
                                       1.8
                                       1.6
                                       1.4
                                       1.2
                                       1.0
                                       0.0
                                      0.6
                                       0.4
                                      0.2
                                         0
                                      -0.2

                                             1966           1965   1970     1975        1990          1985            1990
                                             Fiscal Year




                                       Our earlier report on the Social Security trust fund, Social Security: The
                                       Trust Fund Reserve Accumulation, the Economy, and the Federal
                                       Budget (GAO/HRD-89-44, January 1989), pointed out that this addition to
                                       savings should lead to higher productivity and more rapid economic
                                       growth. With faster growth, retirement benefits can be maintained for
                                       the baby boom generation while also maintaining a higher standard of
                                       living for future workers. This, however, requires approximate balance
                                       in the rest of the budget, without which the trust fund surpluses will
                                       continue only to finance the other operations of government. Therefore,
                                       the changes to Social Security enacted in 1983 are not producing the
                                       desired result of lessening the burden of paying the retirement benefits
                                       of the baby boom generation. The budgetary reality is that part of the
                                       payroll taxes are being used to finance the current operations of govern-
                                       ment. The economic reality is that the trust fund reserves, because they
                                       are financing current consumption rather than productive investment,
                                       are illusory. They will remain so until the rest of the budget achieves
                                       approximate balance.

                                       As is apparent from this discussion, the problem of the budget deficit is
                                       centered in one part of the budget, the general fund, where a structural
                                       imbalance that began in the 1960s and 1970s grew to enormous propor-
                                       tions in the 1980s. This structural imbalance is not only a problem in


                                       Page 35                                        GAO/OCG-90-B   The Budget Deficit
                              Chapter 2
                              Background




                              itself, it raises legitimate questions about the appropriateness of the cur-
                              rent Social Security tax policy.


The General Fund in the       We actually started the 1960s with a general fund surplus of $800 mil-
1960s and 1970s               lion By 1970 that had shifted to a deficit of about $13 billion. That
                              understates the extent of the change, however, because it followed defi-
                              cits in the late 1960s that peaked at $28 billion, a huge amount by the
                              standards of the time. By 1980, the general fund deficit had reached
                              almost $83 billion, presaging the budgetary trauma of the next decade.

                              This secular trend reflects several factors, but the first key to the puzzle
                              lies on the income side of the budget, in the stagnation of revenues from
                              the corporate income tax and excise taxes. In 1960, these sources con-
                              tributed revenue equal to 6.5 percent of GNP. By 1970, that was down to
                              4.9 percent. By 1980, it was only 3.3 percent, barely half the 1960 level.
                              By contrast, individual income tax proceeds remained quite stable
                              throughout the period, at about 8 to 9 percent of GNP. The economy’s
                              performance also affected revenues, as we went from the steady growth
                              and low inflation of the 1960s to the tumultuous 1970s with that
                              decade’s oil price shocks, accelerating inflation, and periods of stag-
                              nating growth.

                              On the outlay side, changes took place in how the money was spent but,
                              as noted earlier, total general fund outlays remained in the range of 15
                              to 17 percent of GNP throughout the period. To examine these composi-
                              tional changes, we must look separately at the 1960s and 197Os, because
                              the explanations differ. In the 196Os, the dominant factor was rising
                              defense spending, accompanied by relatively slow growth in other parts
                              of the budget. This reflected the Kennedy administration’s defense
                              buildup, led by Defense Secretary McNamara, followed by the Vietnam
                              War.

                              Despite President Johnson’s commitment to social programs, the Great
                              Society made its presence felt in the 1970s not the 1960s. This can be
                              seen by looking at seven benefit programs financed through the general
                              fund

                          . Medicaid,
                          . the general fund subsidy for Medicare,
                          l the Food Stamp Program,
                          . the Special Supplemental Feeding Program,
                          l Supplemental Security Income,


                              Page 36                                         GAO/OCGQO-5   The Budget Deficit
                            Chapter 2
                            Background




                          . housing subsidies, and
                          . the Earned Income Tax Credit.

                            Of these, only the housing program existed in 1960, costing $140 million
                            in that year. Medicaid, Medicare, and the Food Stamp Program were cre-
                            ated in the 1960s but the four programs existing in 1970 still cost less
                            than $6 billion. By 1980, the other three programs had been established,
                            and the total cost of the seven had reached $42 billion. Meanwhile, the
                            defense budget was tightly constrained after the Vietnam War until the
                            Carter administration began a rebuilding effort in the last years of the
                            decade.

                            In one respect, the decision to allow some programs to expand (defense
                            in the 196Os, benefit programs in the 1970s) while others were held back
                            represented a lost opportunity to bring general fund spending in line
                            with the available revenues. Looking at the issue another way, once gov-
                            ernment decided to spend the money, it should have provided the rev-
                            enue to pay for that decision. Unfortunately, the failure to follow either
                            course was only a precursor to the budget policy errors of the 1980s.


The General Fund in the     To see why general fund spending continued to rise in the 1980s in rela-
1980s                       tion to GNP, notwithstanding the continuing downward trend in general
                            fund revenues, it is necessary to look at the components of that growth,
                            as shown in figure 2.9. Total general fund outlays rose by slightly over
                             100 percent from 1980 to 1989. Most of this growth can be found in
                            three key areas. Defense more than doubled, increasing almost $180 bil-
                            lion, reflecting the Reagan administration’s acceleration of the defense
                            buildup that began under President Carter. Spending for health pro-
                            grams grew even more rapidly, but from a smaller base, contributing
                            about $66 billion of the growth, mostly in Medicaid and in the general
                            fund subsidy for Medicare.




                            Page 37                                        GAO/OCGO-5   The Budget Deficit
                                    Chapter 2
                                    Background




Figure 2.9: General Fund Spending
Qrowth( 1980-1989)
                                    260       Percent
                                    240

                                    220
                                    200
                                    180
                                    160
                                    140
                                    120

                                    100
                                     80
                                     60

                                     40
                                     20
                                          -   -w-w      -----
                                                          -----
                                                        T 1              -----   -------L-------------------             Inflation




                                      0 -




                                    The fastest growing piece of the general fund budget was interest on the
                                    public debt, which more than tripled during the decade and added
                                    almost as much to spending as did the defense budget increases. In the
                                    mid-1970s, interest costs were only about 12 percent of general fund
                                    spending; today they are at 25 percent and continuing to rise, as the
                                    need to service the rapidly growing debt, as seen in figure 2.10, con-
                                    sumes resources that otherwise would be available for more productive
                                    use.




                                    Page 38                                       GAO/OCG90-6                  The Budget Deficit
                                            Chapter 2
                                            Background




Figure 2.10: Gross Federal Debt and
Debt Held by the Public (19451990)
                                            3500      Oollar* In Billlonn


                                            3000


                                            2500


                                            2000


                                            1500


                                            1000


                                             500
                                             500
                                                     m
                                                     m          ------I.m
                                                                ------I.m       -;.
                                                                                -;.   .. .. ..
                                                00

                                                   1945           1960        1955           1960   1965          1970    1975      1960          1985   1990
                                                   Fiscal Year

                                                       -             Total Debt
                                                       n   n   = n m Debt Held by the Public



Figure 2.11: Or088 Interest on the Public
Debt (1960-1990)
                                            5      PercentofGNP




                                            0

                                             1960                     1965                1970             1975           1960             1965          1990
                                             Fiscal Year




                                            Page 39                                                                      GAO/OCCMlO-6 The Budget Deficit
                                       Chapter 2
                                       Background




                                       As seen in figure 2.11, this growth of debt service costs, now rising
                                       again in relation to GNP, is the direct result of the deficits of the 1980s
                                       along with the high levels of interest rates that have accompanied those
                                       deficits. All the rest of the general fund spending programs, taken
                                       together, grew at a very modest pace, less than the rate of inflation.

                                       The performance of the revenue side of the general fund budget during
                                       the decade of the 1980s is shown in figure 2.12, displaying the gap
                                       between the growth of revenue and the growth of spending, a shortfall
                                       of almost $200 billion, that had to be financed by increased annual
                                       borrowing.


Figure 2.12: Financing the Growth in
General Fund Spending (1980-l 989)
                                       800   Dollrrr   In Bllllono




                                       400




                                       SW




                                       200




                                       la0




                                         0




                                                         lnaeami      Borrowing

                                                        All Other

                                                        Corporation     Income Taxes

                                                         Individual Income Taxes

                                                        Growth In Spending




                                       The composition of the general fund revenue base also changed signifi-
                                       cantly during the 1980s. The revenue from income taxes almost caught


                                       Page 40                                         GAO/O%-90-I   The Budget Deflclt
                          Chapter2
                          Background




                          up with the growth of the economy, despite the rate reductions in the
                          early 1980s. But other revenue sources fell well short of the rate of
                          growth of the economy, continuing trends begun in earlier decades. By
                          the end of the 198Os, the general fund was overwhelmingly dependent
                          on the individual income tax, the source of almost three-quarters of gen-
                          eral fund revenues. This is a marked contrast to the 196Os, for example,
                          when the individual income tax represented less than 60 percent of gen-
                          eral fund revenues.

                          The performance of the general fund in the 198Os, continuing in exag-
                          gerated fashion the trends starting in earlier decades, is cause for deep
                          concern about the ability of the federal government to manage its
                          finances. As the next section makes clear, the current outlook for the
                          future is not encouraging.


                          For fiscal year 1991, CBO estimates a baseline total deficit of $232 bil-
Outlook for the Deficit   lion, including the outlays of the Resolution Trust Corporation. That
and Debt                  total estimated deficit consists of a surplus of $73 billion in Social
                          Security, a surplus of $62 billion in the other trust funds, and a deficit of
                          $367 billion in the general fund. This estimate was developed according
                          to the estimating procedures used for the GRH deficit reduction process.
                          Those procedures are now used routinely by OMB and CBO in developing
                          baselines for the budget process. CBO has projected the estimates
                          through 1995, using the same procedures. With CBO’S assistance, we
                          extended those projections through 1997, to provide a baseline for the
                          policy choices discussed in later chapters.


Adjusting the Baseline    The CBO baseline assumed (as requested by the congressional members
                          of the budget summit negotiating group) that a major reduction in the
                          deficit would be implemented. Based on this assumption, CBO concluded
                          that interest rates would decline substantially and quickly from their
                          present levels. This yields significant savings in debt service costs, and
                          thus a deficit baseline significantly lower than would otherwise occur.
                          For reasons discussed in chapter 3, we agree that interest rates are
                          likely to decline significantly with the implementation of a substantial
                          deficit reduction plan. However, for purposes of this report, we con-
                          cluded that it would be preferable to portray the decline in rates as a
                          potential additional benefit of an attack on the deficit, rather than as
                          part of the baseline. Accordingly, we adjusted the CBO baseline to reflect
                          an assumption that interest rates would remain at approximately their



                          Page 41                                          GAO/oCG90-6   The Budget Deficit



                                                                                                          ‘I
                                                      Chapter 2
                                                      Background




                                                      present level in the absence of a major reduction in the deficit. The
                                                      adjusted baseline that we used for this report is displayed in table 2.1.


Table 2.1: QAO Adjusted Baseline Budget Projections
Dollars in billions
            _.      .-..----
                                                                                                   Fiscal year
Projection                                             1990         1991          1992            1993         1994      1995         1996          1997
                            ,-...-- .--.-...-
Genera; fund:-
  Revenue                                              $644         $689          $729            $774       $820        $869         $925          $985
  Oklays                                                 961        1,061        1,120            1,141      1,164       1,230        1,303         1,374
                                                        -
Deficit                                               $-317        $-372        $-391        S-367          $-344      $-361         S-378        $-388

Trust fund surpluses:
  Social Security
              _-      --..                               $59          $73          $83             $95        $109       $124          $140         $158
  Other                                                     64         62           57              55          54         52            52            50

   Subtotal                                            $123         $135          $140            $150        $163       $176          $192         $208

Total _deficit ..------. .--I.--                .--   $-195        $-237        $-251        $-217          $-161      $-165         $-166        $-160

Federal debt owed to:
  Social Security                                      $216         $289          $373            $467        $576       $700          $840         $998
  Other government accounts                              582          642          698             754         809        864           916          966

Subtotal                                               $799         $932        $1,070        $1,221        $1,385     $1,564        $1,756       $1,964

   The public                                         $2,378---    $2,612       $2,860        $3,077        $3,256     $3,442        $3,628       $3,809

Total Federal Debt                                    $3,177       $3,544       $3,930       $4,296         $4,641     $5,006        $5,364       $5,773
                                                      Note: Totals may not add due to rounding.

                                                      This baseline reflects some disturbing trends. The general fund deficit
                                                      rises with only a brief interruption toward $400 billion. Because of
                                                      growing Social Security surpluses, the total deficit stabilizes around
                                                       $200 billion. Total debt, reflecting the general fund deficits, crosses the
                                                       $6 trillion threshold late in 1996. In consequence, interest costs are pro-
                                                      jected to become the largest item in the general fund budget by 1992,
                                                       when they will exceed defense spending for the first time, as seen in
                                                       figure 2.13.




                                                      Page 42                                                         GAO/OCG-90-5    The Budget Deficit
                                          Chapter         2
                                          Background




Figure 2.13: Qrosr Interest vs. Defense
Outlays( 1960-1997)                       500          Oollsrr   In Billions

                                          450

                                          400

                                          350

                                          300
                                          250

                                          200

                                          150

                                          100

                                           50

                                            0

                                                1960               1965        1970   1975   1960     1965        1990        1995 1997
                                                Fiscal Year

                                                       -         Defense
                                                       I - - - - Gross Interest

                                          The budget summit negotiations that were in process as this report was
                                          being prepared for publication may lead to actions that would materi-
                                          ally affect the baseline. In view of the uncertainty surrounding those
                                          negotiations, however, we have not reflected their possible outcome in
                                          the baseline.


Limitations of the Baseline               A baseline is only an extrapolation of current policies and funding levels
                                          into the future. These projections are developed according to the very
                                          specific estimating procedures embodied in the GRH deficit reduction leg-
                                          islation (the Balanced Budget and Emergency Deficit Control Act of
                                          1985, as amended). Those procedures minimize the use of judgmental
                                          factors in estimating the deficit for purposes of implementing that legis-
                                          lation. One by-product of those procedures, however, is that known,
                                          unavoidable costs which were not funded in the base year, or for which
                                          legislation financing future spending has not been enacted, are usually
                                          excluded from the projections, potentially causing a misleading result.

                                          As a result, the adjusted baseline is not an estimate of future spending
                                          and revenue levels. Policies, priorities, and funding levels change from
                                          year to year, but in ways that are difficult to predict. Thus, our baseline


                                          Page 43                                                   GAO/OCG90-5   The Budget Deficit
Chapter2
Background




does not include all the cost items that some might wish or expect to see
covered in future budgets, such. as a more aggressive attack on AIDS,
homelessness, poverty among children, or the inadequacies of the
nation’s educational systems. Providing funds for new initiatives such
as these within the baseline would require offsetting savings elsewhere.

Even more to the point, the baseline does not include funds for the many
contingencies that will arise, including those about which the govern-
ment has no choice but to pay the bills when they come due. A recent
example of the potentially misleading nature of the baseline concept is
the spending for RTC. As the cost of resolving the bankruptcy of the Fed-
eral Savings and Loan Insurance Corporation rose beyond the funding
provided for that purpose, the official CBCIbaseline could not recognize
that additional spending because of the limitations specified in the esti-
mating procedures of the GRH legislation. But because that spending was
clearly unavoidable if the government was to make good on the full
faith and credit guarantee underlying the deposit insurance system, and
because of the magnitude of the distortion in the estimates that would
result from ignoring that spending, CBOmade an adjustment in the base-
line to reflect RTC spending from subsequent enactment of additional
funding. But this “adjusted” CBO baseline has no official status for the
GHH procedure until the additional funding is enacted.


We have concluded that there are other unavoidable costs that, because
of the required estimating procedures, have not been recognized in the
baseline. These include, for example, the cost of cleaning up and mod-
ernizing the nation’s nuclear weapons complex. Another example
involves the Medicaid program. Recent court decisions raise the possi-
bility that states will be forced to increase the fees they pay to those
providing services to Medicaid recipients. The federal government pays
a high percentage of those costs, so there is a significant potential for
major increases in Medicaid outlays. An even more recent example can
be seen in the additional costs of deploying and maintaining a large mili-
tary force in the Middle East.

Furthermore, the baseline excludes the cost of many projects which
have been approved, but for which actual construction funding has not
yet been provided. Prominent examples include the Space Station and
the Superconducting Super Collider. Consequently, terminating these
programs would not represent a savings from the baseline (except for
the early planning and design work currently being funded). Rather, it
would prevent an increase in outlays and the deficit above the baseline.
If any of these programs that are above the baseline, such as the Space


Page 44                                         GAO/ocG-soa   The Budget Deficit
        Chapter 2
        Background




        Station, are to be funded, they must not only compete with other pro-
        grams above the baseline, such as cleaning up the nuclear weapons com-
        plex, they must also compete against programs within the baseline.

         Budget Director Darman has recognized the threat posed by potentially
        costly items that are not reflected in budget estimates and baseline pro-
        jections. In his introductory essay for the 1991 budget, he referred to
        them as “Hidden Pacmen,” waiting to consume budget resources.

        In summary, the baseline is only a starting point for assessing the
        budget outlook and for adjusting priorities within the budget. In view of
        the potential magnitude of the items that are not reflected in the base-
        line, it is an optimistic starting point.

        In a report we issued in connection with the presidential and congres-
        sional transitions (The Budget Deficit, GAO/OCMWlTR,    November 1%38),
        we pointed out the budget threat posed by unrecognized costs, including
        those associated with the FSLIC insolvency. We remain very concerned
        about the potentially misleading nature of budget projections that fail to
        account for such threats and by the lack of systematic efforts to identify
        them, estimate their likely costs, and include them in official projections
        of the government’s financial outlook. If the costs represented by these
        known and unknown (and sometimes unknowable) additions to outlays
        are not offset by savings in other programs or increased revenues, the
        deficit will be considerably higher than our baseline would imply.

        We believe that better management, which is discussed at greater length
        in chapter 10, is critical to spotting future costs and in preventing them
        from developing. For example, better management can

    . provide government with the ability to detect problems in their early
      stages and take corrective action before they become extremely costly;
      for example, there is no doubt that better management systems would
,     have made it possible to deal with the savings and loan crisis at far less
      cost than is now the case; and
    l prevent or minimize future costs through such measures as better
      administration of loan portfolios, improved procurement procedures,
      and proper maintenance of facilities.




        Page 46                                         GAO/OCGBO-6   The Budget Deficit
Chapter 3

Economic Policy Considerations


                This chapter discusses the economic significance of large deficits and
                lays the economic policy foundation for deciding how much to reduce
                the deficit. Deficits matter primarily because they consume savings.
                Without adequate savings to finance investment, long-run economic
                growth suffers. In recent years, U.S. saving has been low compared both
                with historical norms and with other industrialized nations. This can be
                corrected by shifting the federal budget from deficit to surplus.

                To restore domestic savings to levels more consistent with higher
                growth periods of the postwar era would require (all other things being
                equal) a budget surplus equal to about 2 percent of GNP. Accordingly, we
                conclude that a shift in fiscal policy of about $300 billion, to an overall
                budget surplus of about $180 billion (about 2 percent of GNP), phased in
                over several years, is a reasonable goal under the present circumstances.
                While there are potential risks for the economy in such a policy, the
                transition to an overall budget surplus can be managed successfully if it
                is

              . phased in over a period of several years,
              . backed by a credible plan and a strong political consensus, and
              . supported by Federal Reserve action to facilitate lower interest rates.

                Opinion is currently divided about the likelihood that the US. economy
                is headed for a recession in the near future. In addition, there is concern
                that an oil price shock arising from conflict in the Middle East could
                increase risks for the U.S. economy. We believe that neither concern
                materially affects the fundamental issues we face. A major deficit
                reduction program should be undertaken as soon as possible in the
                manner just outlined. Under the circumstances, it is appropriate to be
                concerned about the timing of such a program, but it is vital that we
                deal with the deficit soon to avoid even more long-term damage to the
                economy.

                As this report is being prepared for publication, in late August 1990,
                budget summit negotiations are about to resume. Published reports indi-
                cate that the negotiators are seeking to reach agreement on a deficit
                reduction package of $30 billion to $50 billion for 1991 and $500 billion
                over the 5-year period, 1991 to 1995. If these reports are accurate, the
                goals of the summit negotiations are considerably more modest than we
                believe necessary. Achieving them would be only a first step toward the
                more demanding goal that we recommend, based on the analysis in this
                chapter.



                Page 46                                         GAO/OCG90-6   The Budget Deficit
                                           Chapter 3
                                           Econotnk Policy Comiderationc




                                           With the economy running close to full capacity, large and persistent
Why Deficits Matter                        budget deficits undermine the future well-being of the country by con-
                                           suming savings that would otherwise be available to finance investment
                                           supporting long-term economic growth. Numerous studies, statistical
                                           indicators, and everyday observations all strongly suggest that America
                                           has not been saving and investing enough to achieve the related goals of
                                           assuring future living standards and preserving a degree of influence in
                                           the world adequate for the protection of our basic interests. Long-term
                                           improvements in living standards and other aspects of economic
                                           strength depend on growth in productivity. A nation will likely suffer
                                           diminished productivity growth if it saves too little and is unable to
                                           invest adequately. The international comparisons shown in figure 3.1
                                           make this point dramatically; those who grow are those who save.


Figure 3.1: Countries With High Net
Savings Experlencs High Productivity
Growth (1960-1987)                         6       Average Percentage Change in Productivity
                                                                                                                                   Japan 0




                                           4
                                                                                                                 Italy a
                                                                                                       France0
                                                                                                      Germany0
                                           3

                                                                      United Kingdom 0
                                           2                                   Australia 0     0 Canada

                                                                 United States 0
                                           1




                                               0                  4                  8
                                               Avorago Not Saving8 as Pucenl ot GDP



                                           The effects of an investment shortfall are cumulative. An interruption
                                           of a few years in a generally high level of investment is no cause for
                                           alarm. But the implications for the future are increasingly ominous
                                           when, year after year, the nation

                                       l   skimps on investing in plant and equipment, education and training, and
                                           research and development;


                                           Page 47                                                                  GAO/OCG-30-B   The Budget Deficit
                                                Chapter 8
                                                Economic Policy Ckmideratious




                                           . allows environmental hazards to accumulate by declining to invest in
                                             preventive measures;
                                           . subjects highways, airports, and other public facilities to increasingly
                                             intensive use, but fails to make adequate provision for orderly mainte-
                                             nance and expansion; and
                                           l finances a major proportion of its domestic investment by borrowing
                                             abroad and selling off assets to foreign investors.

                                               The budget deficit is not the only reason for this underinvestment, but it
                                               has been a major contributor to the problem by absorbing between half
                                               and three-fourths of the net savings generated by the private sector and
                                               by the accumulating pension funds of state and local governments.
                                               Figure 3.2 displays the trend in net savings, recognizing that savings
                                               equal to depreciation is needed just to hold the total capital stock level.
                                               The federal deficit has absorbed half or more of the resources available
                                               to promote long-term growth.


Figure 3.2: Effect of the Federal Budget
Deficit on Net Savings (1950-l 989)
                                               15    Percent of NNP
                                               14
                                               13
                                               12
                                               11
                                               10
                                                                           I




                                                      196949    196049         1979-79   1969-99


                                                     1         Savings Absorbed by the Budget Deficit
                                                               Savings Available for New Capital Formation

                                               ‘Savings   of households,       net business savings, and state and local government   sutplus.




                                                Page 48                                                                GAO/OCGsOa        The Budget Deficit
                             Chapter 3
                             Economic Policy Considerations




                             But that is only part of the story. If the increased federal deficit had
                             been matched by increased individual savings, it would not have hurt
                             investment. This is not what happened. The deficit’s drain on savings
                             has come at a time when net business saving and personal saving were
                             markedly lower in relation to net national product (NNP) than in any pre-
                             vious decade since World War II. Thus, in the 198Os, the federal deficit
                             became-for the first time -a major offset to saving, while at the same
                             time saving in the rest of the economy was declining.

                             It would be desirable to increase private savings, but there is no federal
                             policy that can have the reliable and direct impact on the business or
                             personal component of savings that the federal budget deficit has on the
                             total. The contribution of state and local government pension fund accu-
                             mulations (the principal source of state and local surpluses) is relatively
                             small and is unlikely to increase. In this context, the federal budget def-
                             icit takes on even greater importance in the national savings picture,
                             precisely because saving trends in the other sectors are both unfavor-
                             able and less subject to policy control.


                             There is evidence of several types that the U.S. economy is suffering
Historical Perspective       from a syndrome of low savings, consequent low investment, and
on Investment                resulting low rates of growth. This evidence is discussed in greater
                             detail in appendix I of the companion volume to this report, GAO/
                             OCG-go-SA, which places the economic events of the recent past in a wider
                             historical perspective. In summary, not only has domestic investment
                             been low relative to GNP in recent years, but much of that investment
                             has been financed by foreign savings. In 1989, for example, fixed invest-
                             ment was the lowest share of GNP since 1975, and only slightly above the
                             lowest share of any year in the entire period since World War II. But
                             even this low level of investment was more than domestic savings alone
                             would have permitted, and this has been true in every year since 1982.
                             In 1986 and 1987, the difference was more than 25 percent. As an
                             accounting matter, this difference corresponds to negative American
                             investment abroad. That is, the portion of investment that could not be
                             financed from U.S. savings was financed by

                         . foreign direct investment here,
                         l sale of U.S. assets (at home or abroad) to foreign investors, and
                         . borrowing abroad.

                             During the 1980s the savings inflow represented by this negative U.S.
                             net investment abroad permitted domestic investment to remain above


                             Page 49                                         GAO/OCG!W6   The Budget Deficit
                                         Chapter 3
                                         Economic Policy Consideration




                                         the level that domestic savings alone would have permitted, as seen in
                                         figure 3.3.


Figure 3.3: Ch’oss Savings and Private
Domestic Investment (1980-l 989)
                                         20     Percent of GNP




                                         10

                                          a



                                          4

                                          2

                                          0

                                         1980          1961      1982      1983       1984       1965        1988    la87       1962      1989
                                         YOU

                                                -        Gross Private Domestic investment
                                                -9-1     Domestic Saving
                                                         Shaded Area Represents Investment Financed Abroad




                                         For the most part, the importation of foreign savings to finance our
                                         domestic investment reflected the fact that Americans bought more
                                         from the rest of the world than they sold there. To pay for the differ-
                                         ence, we sold US. assets to foreign investors and borrowed from them.
                                         Given the poor saving performance of the American economy, it is fortu-
                                         nate that there are willing foreign buyers for the assets Americans wish
                                         to sell, and enthusiastic foreign investors to seize opportunities in the
                                         U.S. Without them, investment in the U.S. would have been lower, the
                                         growth of output would have been slower, and fewer jobs would have
                                         been created.

                                         The willingness of foreign investors to invest here is a testimonial to
                                         American credit worthiness, but the increased reliance on foreign capital
                                         has obscured and postponed the consequences of the low domestic



                                         Page 50                                                             GAO/OCMKI-5    The Budget Deficit
                                      Chapter 3
                                      lkonomic  Policy Comiderations




                                      saving rate. Our shift from being a major creditor to being the world’s
                                      largest debtor nation has involved an enormous transfer of wealth from
                                      Americans to foreign investors. Because of that transfer of wealth,
                                      profits and interest payments will flow abroad in future years,
                                      depressing American living standards relative to what they would be if
                                      Americans owned those assets. We will probably not be able to continue
                                      borrowing and selling off assets abroad at the rate of recent years,
                                      because we have already dissipated our position as net creditor of the
                                      rest of the world and are running deeper into a net debtor position with
                                      every passing day, as can be seen in figure 3.4.


Figure 3.4: U.S. Net International
investment Position (1980-1988)
                                     300     Dollrro In Blllio~

                                     200
                                     ,oo /                          ----=-.___
                                                                                    ..




                                                                                                                   ", \
                                     -400                                                                                 \
                                                                                                                              ',
                                     -600                                                                                          '\



                                        1980          1981        1962           1993    1984   1995    1998     1907              1999
                                        Year



                                     There are other grounds for concern about this dependence that are less
                                     easily quantified. The U.S. economy is vulnerable in a variety of ways to
                                     adverse economic and political developments abroad, influences trans-
                                     mitted either directly through economic channels or indirectly through
                                     political pressures that limit our freedom of action in economic policy.
                                     Part of this vulnerability is the price we pay for the many benefits that
                                     come from global economic interdependence. But part of the growing
                                     vulnerability reflects the economic choices that the United States has
                                     made, particularly the federal deficit. Because of its low total savings,



                                     Page 61                                                       GAO/OCWHM   The Budget Deficit
             Chapter 3
             Economic Policy Comideratiom




             the United States has had to rely heavily on foreign savings and invest-
             ment. Accordingly, it must be more sensitive to the needs and views of
             the foreign investors who finance our debt and who own the factories
             that generate new jobs.

             It is sometimes said that the deficit will ultimately lead to a financial
             collapse and, conversely, that the absence of such a collapse is evidence
             that the deficit has no serious consequences. In fact, it is unlikely that
             the budget deficit by itself will produce a dramatic collapse. Continuing
             large deficits affect the economy seriously and fundamentally, but grad-
             ually. They have only limited potential for generating the discrete
             events that might trigger a collapse. However, the high real interest
             rates to which the deficit contributes are undeniably a source of strain.
             There is also the possibility that developments abroad might lead to a
             relatively abrupt disappearance of foreign investors from U.S. securities
             markets, such as the market for government securities. The resulting
             sharp rise in interest rates might precipitate a crisis. Thus, the deficit
             adds vulnerability to a financial and economic system that already has
             many other sources of vulnerability.


Real Wages   One consequence of lower domestic investment is that workers have less
             and older equipment with which to work. This means that productivity
             growth lags and wage increases may fail to keep up with inflation.
             Figure 3.5 shows that the peak in wages, adjusted for inflation, was
             reached in 1973. Toward the end of that year, the oil embargo ushered
             in the economic trouble of the 1970s. By 1989, real wages were below
             the level of 20 years earlier. Other data, using more comprehensive mea-
             sures of compensation, portray only a slightly better picture.




             Page 62                                        GAO/OCWWB    The Budget Deficit
                      chapter 3
                      Economic Policy Considerations




(1947-1989)
                      15      198Q Dollars
                      14
                      13
                      12
                      11
                      10
                                                                                                          \
                       Q
                       8
                       7
                       8
                       5
                      4
                       3
                       2
                       1
                       0

                       1947            1952   1957     1962   1987   1972        1977      1982       19671989
                       Year




Real Interest Rates   In a market economy suffering from inadequate savings, high interest
                      rates restrict investment to the level permitted by the available savings.
                      Figure 3.6 shows the historical pattern of short-term real interest rates,
                      defined as the rate on 3-month Treasury bills minus the rate of inflation.
                      Here again, history confirms the effects of low saving rates. Real rates
                      of interest were at historic highs in the mid-1980s. Both the low national
                      saving rate and the persistence of inflationary expectations from the
                      1979 through 1982 period probably contributed to those high rates.
                      Since 1986, there has been modest improvement in the overall saving
                      rate and inflation has remained under control. Real rates have fallen
                      significantly, but remain above historical norms.




                      Page 63                                               GAO/OCG90-5   The Budget Deficit
                                       Chapter 3
                                       Economic Policy Considerations




Figure 3.0: Real Short-Term Interest
Rates (1950-1990)
                                       6      Percent




                                           1950         1955    1960    1985   1970   1975       1980          1985      1990
                                           Year




                                       In sum, the official measures of saving and investment indicate that the
                                       past decade has been marked by a historically significant trend toward
                                       devoting a smaller share of current output to provision for the future.
                                       The results are evident in our deteriorating international investment
                                       position, high real interest rates, and low real wages, While some of
                                       these official statistics have shortcomings, there is no reason to question
                                       the general picture they paint. International comparisons corroborate
                                       that picture, consistently showing that the economies that have recently
                                       outperformed ours, especially the Japanese, devote much larger frac-
                                       tions of output to investment.


Setting Fiscal Policy                  choosing long-term budgetary objectives. We base our recommendation
Objectives                             on the need to restore total domestic savings to levels more consistent
                                       with higher growth periods of the postwar era, and to do so at a pace
                                       that would not create undue risks for the economy. After examining the
                                       data, we have concluded that this objective requires a shift in fiscal
                                       policy of about $300 billion toward surplus, to be fully phased in by
                                       fiscal year 1997. If this were accomplished, the budgetary results in
                                        1997 would be a total surplus of about $182 billion (as discussed in
                                       chapter 4), or about 2 percent of GNP.


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                        Chapter 3
                        Economic Policy Considerations




                        Neither accounting principles nor economic analysis can demonstrate
                        that any particular figure or schedule for reaching it are precisely cor-
                        rect. But we conclude that it is an appropriate and reasonable target
                        under the present circumstances. A significantly less ambitious goal
                        would not adequately serve the nation’s needs. An even more ambitious
                        goal would probably further accelerate the long-term growth of the
                        economy, leading to higher future standards of living and even greater
                        influence in world affairs. In our view, the risk is that we will do too
                        little, not too much.


Analysis of the         As a first step toward placing the proposed fiscal policy shift in perspec-
$300 Billion Goal       tive, we examined what it would have meant if an equivalent shift in
                        real terms had already been accomplished by 1989. It would have been
                        enough to halt the deterioration in the net international investment posi-
                        tion of the United States, though at a level more than half a trillion dol-
                        lars below the dead-even position of only 5 years previously. Gross
                        savings and fixed investment would rise significantly, but not to histori-
                        cally unprecedented levels.

                        This suggests that our proposal is a reasonable starting point, but it is
                        too simplistic to be adequately reassuring by itself. The fiscal policy
                        shift would cause other adjustments in economic behavior; the real
                        economy will not just stand still while major adjustments occur in a few
                        savings and investment accounts. Furthermore, the fact that the change
                        would be phased in gradually means that, as the last step was taken, the
                        economy would be substantially changed. For example, the public debt
                        will continue to rise, even as the deficit begins to fall, and the net inter-
                        national investment position will continue to deteriorate for years, even
                        as the trade balance improves. Thus a more sophisticated analysis is
                        needed to assess the implications of our proposal,


Analysis Using          We examined the effects of our deficit reduction recommendation using
Macroeconomic           macroeconomic forecasting techniques. The results of these simulations
                        are discussed in greater detail in appendix I of the companion volume to
Techniques              this report, GAO/OCGBO-SA. In summary, they support the conclusion that
                        an aggressive attack on the deficit

                    . does not seriously imperil continued economic growth in the short term;
                    l is likely to cause some temporary increase in unemployment;
                    l will yield lower interest rates, strengthened investment, and higher
                      exports; and


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    Chapter 3
    Economic Policy Ckumiderntions




. will generate a significantly higher rate of long-term economic growth
  by the turn of the century.

    The simulations show no sign that the postulated shift in fiscal policy
    would produce a recession. The simulations also support the conclusion
    that the effects on the economy do not change materially with different
    mixes of spending cuts and revenue increases.

    We considered carefully the plausibility of these simulation results. The
    degree of confidence to be placed in them is a key issue. Some argue
    that, because the economy is currently somewhat sluggish, now is not
    the time to attack the deficit. However, we conclude that the encour-
    aging results of the simulations can be accepted with reasonably high
    confidence, provided that

. the fiscal policy shift occurs over a period of several years,
. a credible deficit reduction plan is backed by a strong political con-
  sensus, and
l the Federal Reserve responds by facilitating lower interest rates.

    Most of the analysis leading to these conclusions was performed before
    Iraq’s invasion of Kuwait. Limited reanalysis suggests that price
    increases resulting from loss of Iraqi and Kuwaiti oil will probably
    reduce U.S. economic growth slightly in the near term, but this is largely
    independent of whether or not we undertake a deficit reduction pro-
    gram. Such a program, if undertaken in the fashion outlined above, need
    not materially increase the risks to the economy created by the current
    turmoil in the Middle East. However, the economy is currently showing
    some signs of softness and any weakness could be worsened by
    problems of energy supply. Nevertheless, we believe it is appropriate to
    begin action now. As will be seen in subsequent chapters of this report,
    the policy changes required to achieve the needed shift in fiscal policy
    are difficult, involving major, time-consuming legislative actions.
    Because the long-term damage to the economy from the deficit is cumu-
    lative, any delay only increases the problem. Thus, it is important to
    begin action promptly so that there can be assurance of major progress
    on the deficit as soon as possible. That is the premise on which we have
    based the deficit reduction strategies and choices set forth in the subse-
    quent chapters of this report.




    Page 56                                        GAO/OCG-90-6   The Budget Deficit
Chapter 4

F’ramework for Deficit Reduction


                          In chapter 3, we recommended a $300 billion shift in fiscal policy to be
                          achieved by 1997. But deciding on the total amount of deficit reduction
                          to be pursued is only the start. This chapter provides a planning frame-
                          work for deciding how to achieve that target. We review the arithmetic
                          of deficit reduction, stressing the reduction in debt service costs that
                          follows from policy changes to reduce the deficit. We then outline the
                          range of choices for policy actions that could achieve the needed change
                          in fiscal policy. Several possible combinations of defense and domestic
                          spending reductions and revenue increases are then discussed, illus-
                          trating the implications of choosing one approach rather than another.
                          These illustrations are supported by the expanded discussion of each
                          area in the subsequent chapters.

                          As this report is being prepared for publication, in late August 1990,
                          budget summit negotiations are about to resume. In chapter 3, we
                          explained why we believe the reported goals of those negotiations are
                          insufficient to meet the needs of the nation for increased saving, invest-
                          ment, and long-term growth. Accordingly, we recommend that as the
                          first order of business of the 102nd Congress (or sooner, if possible)
                          negotiations resume with the objectives of

                        . reaching agreement on a comprehensive package of policy changes that
                          will produce an overall budget surplus of about 2 percent of GNP (about
                          $180 billion) by 1997 and
                        . enacting those changes into law in the form of a multiyear budget reso-
                          lution, along with the substantive legislation required to implement that
                          resolution, by the conclusion of the First Session of the 102nd Congress.

                          This chapter, together with chapters 5 through 7, provides a basis for
                          examining the choices that must be made in developing that package of
                          policy changes.


                          Any reduction in the deficit will be comprised of cuts in programs,
Overall Arithmetic of     increases in receipts, and the interest savings that result from financing
Deficit Reduction         a smaller volume of debt. The $50 billion annual target indicated by the
                          analysis in chapter 3 would require program cuts or revenue increases
                          averaging about $40 billion annually from 1992 to 1997, with the
                          remaining $10 billion coming from reduced debt service charges. In
                          1997, the total policy change from the baseline would need to be about
                          $240 billion, yielding a further $60 billion in debt service savings. These
                          two amounts, taken together, represent the direct effects of a deficit
                          reduction program. Because this portion of the program is under the


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Framework   for Deficit   Reduction




direct control of the government, we call the total amount ($300 billion)
the “fiscal policy shift.” This shift, and the actions needed to achieve it,
are the primary focus of the remainder of the report.

However, a credible attack on the structural deficit of this magnitude
could yield a “bonus” in the form of reduced interest rates. This would
further reduce debt service costs in 1997 by as much as another $60
billion. Because these savings depend on the response of the financial
markets, which would be influenced by the policies of the Federal
Reserve System, we call it the “interest rate bonus.” But these savings
may be smaller than we now project if the financial markets are skep-
tical about the government’s commitment to deficit reduction. Further-
more, with the growing integration of U.S. and foreign financial
markets, interest rates here are much more influenced by developments
abroad than in past eras. The growing demand for capital elsewhere,
such as to meet the needs for reconstruction in Eastern Europe, could
well presage a worldwide secular rise in interest rates, from which the
United States would not be immune.

This arithmetic, showing the two components of the fiscal policy shift,
plus the monetary policy “bonus,” is displayed in table 4.1.




Page 58                                          GAO/OCG90-5   The Budget Deficit
                                              Chapter 4
                                              Framework    for Deficit    Reduction




Table 4.1: The Arithmetic of Deficit Reduction for 1992 Through 1997
Dollars in billions
----.-~                                                            1992          1993       1994     1995     1996         1997           Total
Adiusted baseline
   Total deficit
.--~_.----_--                                                    $-251         $-217       $-I81    $-I85    $-186     $-180

Chanoes:

    Fiscal policy
..--____-..          shift:
               __...--__---
       Policv chanaes                                                    48           93      135     173      209          242             900
~-- Debt service savings from policy change                               2            7       15      27       41           58             150
  Total fl8cal policy rhift                                              60       100         150     200      250          300           1,060

.“- interest
     --_._._   rate--..“bonus”
          III_IF.--.-l  “---                                             12           22       35       48       55          62             234

  Total change from baseline                                             62       122         185      248      305         362           1,264

Baseline after policy change

Total Surplur or Deficit                                        $-169           s-95           $4     $63     $116         $162
                                              Note: Totals may not add due to rounding




                                              The harsh reality is that $240 billion in policy changes over a period of 6
Illustrative Strategies                       years is a politically demanding target. It is clearly achievable, as the
                                              successful experience in making dramatic changes in budget policy in
                                              other democratic nations such as Australia demonstrates. But as our
                                              own experience over the past decade also demonstrates, assembling a
                                              package of policy changes that is politically acceptable and sustainable
                                              will be very difficult.

                                              As a framework for examining the choices that must be faced if a large
                                              deficit reduction program is to be implemented, we postulated a wide
                                              array of basic approaches, involving various combinations of defense
                                              and domestic spending reductions and revenue increases. These are dis-
                                              played in table 4.2.




                                              Page 59                                                        GAO/OCG90-5     The Budget Deficit
                                           Chapter 4
                                           Framework   for Deficit   Reduction




Table 4.2: Basic Choices for Deficit Reduction (Chanaes From the 1997 Baselinel
Dollars in billions   _.--
                                               Policy changes                          Total policy    Debt service          Total fiscal
Policy
 _     set8 .___ .-._ - ___.- Defense          Nondefense                   Revenue8       change           savings          policy shift
Set 1                        .~-     $70                $85                      $85          $240              $60                  $300
                                      70                 60                      110           240               60                   300
                                      70   -            110                       60           240               60                   306
                                      70                170                        0           240               60                   300
                                      70                  0                      170           240               60                   300
Set2                                 100                 70                       70           240               60                   300
                                     100                 50                       90           240               60                   300
                                     100
                               _~..____                  90                       50           240               60                   300
                                     100                140                        0           240               60                   300
 _,             . -     .-           100                  0                      140           240               60                   300
set 3                                120                 60                       60           240               60                   300
                                     120                 45                       75           240               60                   300
                                     120                 75                       45           240               60                   300
                                     120                120                        0           240               60                   300
                                     120                  0                      120           240               60                   300


                                           These basic alternatives only begin to illustrate the possible combina-
                                           tions of spending reductions and revenue increases that could yield the
                                           needed shift in fiscal policy. However, this list brackets the range of
                                           choices and provides a framework for the further development of those
                                           choices in subsequent chapters of the report.

                                           In each case, we assumed that there would be some significant defense
                                           spending reductions below the baseline. The debate in the summer of
                                           1990 was not on whether to cut back in this area, but rather on how to
                                           balance the need to deal with new problems, such as those in the Middle
                                           East, with the declining threat from the Soviet Union and Eastern
                                           Europe. We postulated long-run defense reductions below the 1997 base-
                                           line of $70 billion, $100 billion, or $120 billion, The balance of the
                                           required total policy change was then allocated in varying combinations
                                           of lower nondefense spending or additional revenue.


                                           The Congress has already cut the deficit where there is a broad con-
Illustrative ” Packages                    sensus for eliminating programs because of their intrinsic defects or for
                                           increasing taxes because of their intrinsic merits. The process of deficit
                                           reduction requires a new consensus, one that supports a package of



                                           Page 00                                                    GAO/OCG90-S     The Budget Deficit
                                      Chapter 4
                                      Framework     for Deficit   Reduction




                                      policy changes that is seen as fair and that considers the interest of
                                      future generations of Americans.

                                      The following discussion of the implications of various combinations is
                                      intended to illustrate the tradeoffs that must be faced in developing a
                                      politically acceptable package. It also demonstrates the consequences of
                                      refusing to consider all the possible sources of deficit reduction as part
                                      of a comprehensive program.

Table 4.3: $70 Billion Defense
Restructuring-No      New Revenues    Dollars in billions
(Package 1)                           Cateaorv                                                                Amount
                                      Defense Savings                                                               $70
                                      Nondefense Savings                                                            170
                                                                                                                   _-.--
                                      Revenue Increases                                                                0


                                      This package demonstrates the consequences of seeking to reach the
                                      fiscal policy target without additional revenue and with modest savings
                                      in defense, such as the 25 percent reduction in the force structure
                                      reflected in the Department of Defense (DOD) illustrative package
                                      presented to the budget summit negotiators. The required savings from
                                      domestic programs would still provide the resources to support core
                                      functions, such as revenue collection and law enforcement, and would
                                      finance most low income support programs. Other activities would have
                                      to be eliminated unless they could be financed from user charges or
                                      other dedicated receipts. Medicare, for example, would have to be
                                      financed by increases in monthly premiums or a substantial curtailment
                                      of services or of fees paid to providers.

Table 4.4: $120 Billion Defense
Restructuring-No      Domestic Cuts   Dollars in billions___-..
(Package 2)                           Category                                                                Amount
                                      -~       -__.-
                                      Defense Savings                                                          -- $120
                                      Nondefense_-.__
                                      ..~_        Savings
                                                      --                      -                                   .__ 0
                                      Revenue Increase                                                              120


                                      This package illustrates the consequences of seeking to achieve the
                                      fiscal policy target entirely through defense cuts and revenue increases
                                      without reducing the current role of the federal government in domestic
                                      programs. For defense (as discussed in chapter 5), it would entail as
                                      much as a 50 percent reduction in the military force structure, if the



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                                           Chapter 4
                                           Fnuuework     for Deficit   Reduction




                                           cuts were distributed in the same general fashion as those in   DOD'S   illus-
                                           trative force structure reduction.

                                           To raise $120 billion in revenue from any single source would require
                                           substantial changes in the current tax system including large rate
                                           increases, or major base broadening measures, or the introduction of a
                                           value-added or national retail sales tax. A blended approach would be
                                           preferable. Many combinations are possible, but one might be an income
                                           tax approach that combines rate increases and base broadeners.
                                           Another might be a consumption tax approach that includes excise tax
                                           increases and adjustments to the income tax to offset regressivity.

                                           Lower defense cuts in this package would require even more revenue.
                                           For example, if the defense savings were constrained to $70 billion,
                                           while still maintaining the nondefense portion of the budget, $170 bil-
                                           lion in additional revenue would need to be raised. The analysis in
                                           chapter 7 shows that raising $170 billion from any single revenue source
                                           would require a very substantial departure from the current system. For
                                           example, income tax rates would have to be raised from the current 15,
                                           28, and 33 percent levels to 18,34, and 40 percent, or entire categories
                                           of tax deductions or exempt income would have to be eliminated.
                                           Raising $170 billion from consumption taxes would require a value-
                                           added tax or a national retail sales tax. Accordingly, a mixed approach
                                           would seem more realistic.

Table 4.5: Proportional Cut8 (Package 3)
                                           Dollars in billions
                                           Category                                                                Amount
                                           Defense Savings             -.          __-                                  $70
                                           Nondefense Savings                                                            85
                                           Revenue Increases                                                             85



                                           This package shows the implications of allocating the burden of deficit
                                           reduction in proportional shares among defense cuts, nondefense cuts,
                                           and revenue increases. Important policy changes would be required in
                                           each area. In defense, this package implies approximately a 25 percent
                                           reduction in the force structure if distributed in the same general
                                           fashion as that illustrated by M)D. In nondefense programs, funding for
                                           popular programs would have to be reduced substantially or eliminated,
                                           others would have to be funded through user fees, and some functions
                                           would probably have to be devolved to the States with substantially
                                           reduced federal funding.



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                                     Framework    for Deficit   Reduction




                                     There are a number of ways to raise the needed $86 billion in additional
                                     revenue. One approach would be to combine increased excise taxes with
                                     broadening the income tax base and increasing rates slightly. If the
                                     excise taxes included a dramatic increase in the gasoline tax or the
                                     imposition of a new, broad-based energy tax, increases in income tax
                                     rates might be avoided but base broadeners would still be needed.
                                     Although the entire $85 billion could be raised through a value-added
                                     tax (VAT), it would hardly be worth the setup, administrative, and
                                     enforcement costs for this level of additional revenue.

Table 4.6: $50 Billion in Domestic
Cuts-Equal Shares From Defense and   Dollars in billions
Revenues (Package 4)                 Category                                                                    Amount
                                     Defense Savings                                          -.-_____             $100
                                     Nondefense Savings                          -___                    ____-       50
                                     Revenue Increases            -                                                  90


                                     This package illustrates the effects of limiting the nondefense program
                                     cuts and achieving the deficit reduction primarily in defense savings and
                                     revenue increases. The defense savings would require about a one-third
                                     reduction in the force structure if distributed in the fashion suggested
                                     by DOD’S illustrative program. Other approaches could achieve the same
                                     result. For example, it might be possible to eliminate selected weapons
                                     systems and otherwise slow the pace of modernization and reduce the
                                     cost of supporting functions such as the Defense Logistics Agency and
                                     the portion of the military hospital system located in the U.S. These
                                     would allow the needed savings to be achieved with somewhat smaller
                                     force structure reductions.

                                     Raising the needed revenues for this package would involve the same
                                     considerations as package 3.

                                     While the postulated nondefense savings in this package are somewhat
                                     more modest than in the others, they would still entail a significant
                                     departure from current priorities. Some activities could be maintained
                                     by financing them with user fees. A comprehensive program of user
                                     fees, applying commonly accepted principles of public finance, might
                                     provide $18 billion of the savings. The remaining $32 billion would have
                                     to come from the reduction or elimination of programs.




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                                      Chapter 4
                                      Framework    for Deficit   Reduction




Table 4.7: $120 Billion Defense
Restructuring-Equal     Shares From   Dollars in billions
Nondefense and Revenues (Package 5)   Cateaow                                                                Amount
                                      Defense Savings                                                            $120
                                      Nondefense Savings                                                           60
                                      Revenue Increases                                                            60


                                      This package illustrates the potential easing of the burden on
                                      nondefense programs and revenues that would accompany a substantial
                                      reduction in the cost of the military establishment. As noted previously,
                                      this level of defense cut could require a force structure reduction of up
                                      to 50 percent. As is discussed in chapter 5, however, this might not be
                                      the most appropriate way of achieving the reductions. Whatever the
                                      budget resources that can be made available for defense, they should be
                                      used to build a force that most effectively meets the security needs of
                                      the nation, That might imply a very different set of military priorities,
                                      force structure, and approach to modernization than was suited to the
                                      international situation of the past.

                                      The nondefense savings could start with a comprehensive program of
                                      user charges, but this would fall well short of what is needed. The
                                      remainder would have to come from the reduction or elimination of
                                      programs.

                                      Raising $60 billion in revenues could be accomplished in numerous
                                      ways: rate increases alone, eliminating a few “loopholes” completely or
                                      limiting more of them, substantial increases in excise taxes, or any com-
                                      bination of these approaches.

                                      These illustrative packages of policy changes are intended only to
                                      demonstrate the choices that must be made and the extent to which
                                      those choices are driven by the allocation of the deficit reduction burden
                                      among the major components of the budget. The implications for partic-
                                      ular programs are discussed in greater detail in chapters 5 and 6, and
                                      for revenues in chapter 7.




                                      Page 64                                        GAO/OCG90-6   The Budget Deficit
Chapter F>

Defense Alternatives


                Since shortly after the end of World War II, the US. defense budget has
                been driven overwhelmingly by the need to counter the military threat
                from the Soviet Union. This has entailed maintaining a peacetime mili-
                tary establishment which is extraordinarily large by historical stan-
                dards. This military force structure has been built around the principal
                mission of deterring both strategic nuclear war and large scale conven-
                tional war in Central Europe. Recent events in Eastern Europe and the
                Soviet Union permit a major reexamination of the defense posture of the
                nation and the budgetary resources required to support the defense
                establishment.

                The current U.S. military involvement in the Middle East makes it diffi-
                cult to focus attention on the comprehensive reassessment of the force
                structure that is needed to adapt that structure to the post-Cold War
                era. Nevertheless, that reexamination is essential and should be under-
                taken as soon as circumstances permit.

                The need to reduce the budget deficit lends added urgency to such a
                reexamination. The defense budget is such a dominant part of the
                overall federal budget, and particularly of the general fund where the
                structural imbalance is centered, that constraints on defense spending
                must inevitably be part of any aggressive attack on the deficit.

                The profiles of deficit reduction strategies outlined in chapter 4 involve
                defense budget reductions below the 1997 baseline of approximately
                $70 billion, $100 billion, or $120 billion, This chapter illustrates choices
                that might be made to achieve savings of those magnitudes which are
                shown in Figure 5.1. We emphasize that the purpose of this part of the
                report is to illustrate the implications of what might be required to
                achieve major reductions in the deficit.




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                                         Chapter 5
                                         Defense Alternatives




Figure 5,l: Alternative Defense Budget
Level8 (1991-1997)                       425      Dollsn   in Billions




                                         276


                                         259

                                           1991                 1992       1993   1994    1996         1999           1997

                                           Fiscal Year

                                                  -         CBO Baseline
                                                  -1-1      Scenario#l
                                                  m         Scenario #2
                                                  l mmm     Scmariott3




                                         The inclusion of particular items in an option does not imply that we
Alternative                              endorse that specific item or the level of spending reduction in that
Approaches to                            option. Indeed, the options illustrated in this chapter all involve reduc-
Restructuring                            tions that are spread in a relatively uniform fashion across the force
                                         structure. Thus, they all yield a force structure that looks much like the
                                         one existing today, but smaller. In developing a new force structure for
                                         the post-cold war era, however, proportional cuts in all parts of the
                                         force structure may not be the appropriate course of action. The new
                                         force structure should be built around a careful assessment of the likely
                                         future threats to our national security and vital interests and of the cir-
                                         cumstances in which the nation may need the capacity to apply military
                                         force.

                                         Approaching the task from this perspective, rather than as a matter of
                                         simply downsizing the present forces, might lead to a new structure that
                                         is very different from any of those to be illustrated here. Also, while an
                                         overall reduction in the defense budget would occur, there could be
                                         increases in some parts of the budget. One approach, for example, might



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Chapter   5
Defetw    Alt.ernativee




start with the assumption that the principal threat facing the United
States in the future is not a large scale conventional or nuclear conflict
that emerges with little warning, but rather threats to U.S. economic
interests and citizens in remote areas of the world, involving the appli-
cation of relatively low intensity military force. An option structured
around this thinking might make disproportionate reductions in forces
built to counter the previous Soviet threat of nuclear attack or of con-
ventional attack in Central Europe, while protecting forces that are rela-
tively more mobile and readily deployed to remote areas.

Another alternative might involve a fundamentally different approach
to modernization. For example, many new weapons systems might be
stopped after the research, development, and prototype stages. This
would ensure that the United States retained the capacity to produce
the most technologically advanced weapons, but the actual production
and fielding of new generations of weapons would take place at much
longer intervals than has been the pattern in the recent past. This
approach would also ensure that any new generation of weapons would
be thoroughly tested in the prototype stage before a decision was made
to begin production. Systems currently in development or procurement
that might be considered for termination or reduction are listed in table
5.8 appearing at the end of this chapter. Some of these are likely, of
course, to have been subject to reductions in association with the force
structure reductions under the illustrative options, so that the savings
available for realization under this option may be less than is indicated
if this approach is combined with one of those options.

Another approach might involve even deeper reductions in fully-staffed
active units than those proposed in the option discussed below. Those
retained would be maintained at a high state of readiness and coupled
with substantially greater investment in airlift and relatively high-speed
sealift capacity. This could significantly increase U.S. capability to
respond with effective military force in remote locations. Other units
might be retained in “cadre” status, ready for augmentation if threats
emerge that would require mobilization for large scale conventional
warfare.

In summary, the choices to be made in moving toward a smaller defense
establishment must depend heavily on judgments about the future
threats facing the United States and upon the circumstances in which
the nation may wish to be capable of applying military force, balanced
against the portion of the nation’s economic capacity it is prepared to
devote to the military establishment.


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                     With this perspective, our three illustrative options are discussed.
Summary of Options

Option 1             The $70 billion option was developed by pricing out an illustrative 25
                     percent force structure reduction set out by the Secretary of Defense,
                     but using notional unit costs estimated by us, rather than the appropria-
                     tion account estimates supplied by DOD. Our methodology for developing
                     the notional unit costs is discussed in appendix II of GAO/ocG-go-5A. Our
                     estimates were reviewed by DOD officials, who agreed with the logic of
                     the approach, but have not endorsed the specific estimates.


Option 2             The $100 billion option was developed by identifying additional force
                     structure reductions that would be consistent with a more aggressive
                     application of the approach embodied in the Secretary’s illustrative
                     package.


Option 3             The most severe option is a reduction of $120 billion from the 1997
                     baseline. It would entail a further extension of the force structure reduc-
                     tion reflected in the DOD illustration and in options 1 and 2.


                     At the request of those engaged in the budget summit negotiations, the
DOD’s 25 Percent     Secretary of Defense estimated the budget effects of an illustrative 25-
Illustrative Force   percent force structure reduction. The DOD material accompanying the
Reduction            Secretary’s illustrative force reduction identified the forces that would
                     be eliminated in terms of numbers of Air Force wings, Navy ships, and
                     Army divisions. The resulting budget reductions were expressed on the
                     basis of appropriation accounts, such as military personnel and procure-
                     ment. The DOD material does not provide a clear explanation of how the
                     force reductions were translated into budget reductions. As can be seen
                     in table 5.1, the approach used by DOD resulted in a disproportionate
                     reduction in funds for military personnel as compared to other compo-
                     nents of the DOD budget. Military personnel, making up about 27 percent
                     of the DOD budget, accounted for 48 percent of the presumed savings.




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                                        Chapter 5
                                        LMfenae Alternatives




Table 5.1: Relatlonshlp Between Fund8
Available and Illustrative Budget       Percent of totala
Reductions in 1995                      Amrowiatlon       accounts                              CBO baseline                     DOD reduction
                                        Military personnel                                                      27                           48
                                        Operations and maintenance                                              30                           25
                                        Procurement                                                             26                           26
                                        Research, development,       test, and evaluation                       12                            0
                                        Military construction                                                    2                            1
                                        Familv housina                                                           1                            1
                                        Other national defense                                                  3                                0
                                        aDoes not add to 100 due to rounding.
                                        Source: Calculated from DOD illustrative budget data.

                                        The DOD illustrative force structure reduction maintained on a propor-
                                        tional basis the current mix between active and reserve personnel. This
                                        is an important consideration for the budget because active forces are
                                        much more expensive than equivalent reserve units. For example, an
                                        active division or air wing costs three times as much as an equivalent
                                        reserve unit. Table 5.2 shows how DOD distributed the illustrative force
                                        reductions.

Table 5.2: DOD Illustrative Force
Structure Reductions                                                                              FY 1990                 DOD          FY 1995
                                        Service                                                      level           reduction            level
                                        General ouroose forces
                                        Army divisions                                                     18                6               12
                                        Navy
                                           Shies     -                                                    530             100              430
                                           Carrier battle aroups                                           14               2               12
                                        Marine brigades                                                     9               1                8
                                        Air force tactical wings
                                        ___--                                                              24               9               15
                                        Strateaic forces
                                        Navy ships (SSBN)                                                 36                11               25
                                        Air Force wings                                                   27               4.7             22.3
                                        Reserves
                                        Armv divisions                                                     10                4                   6
                                        Navy                                                         153.8"                2.5"           151.3"
                                        Air Force wings                                                    50              3.3             46.7

                                        Legend SSBN = ballistic missile submarine
                                        aPersons in thousands.
                                        Source: DOD illustrative budget data and other DOD information.




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                         Chapter 6
                         Defense Alternatives




                         DOD  estimates that the 25 percent force structure reduction results in a
                         budget reduction of $39.8 billion or 11 percent from the fiscal year 1996
                         CBO baseline. As discussed in previous chapters, we concluded that 1997
                         is a more appropriate point at which to plan on achieving the fiscal
                         policy goal suggested in chapter 3. Therefore, we extended the budget
                         effect of DOD'S illustrative force reductions to 1997, at which point it
                         yields a $66.8 billion, or 14 percent, reduction from the baseline.


                         This alternative involves repricing the DOD illustrative force structure
Option l-$70   Billion   reduction using notional unit cost estimates that we developed. These
Reduction                estimates spread most overhead, procurement, and support costs pro-
                         portionally among forces. This assumes that costs will be reduced in
                         proportion to any reduction in force structure. The development of these
                         notional unit costs is discussed in detail in appendix II of G~o/ocG-90-5~.
                         Applying these notional unit cost estimates to the force structure reduc-
                         tions in the DOD illustrative package would yield savings of $68.9 billion
                         or 17 percent from the 1997 baseline for defense spending. These results
                         are displayed in table 6.3.




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                                                          Defense Alternatives




Table 5.3: Option l-$70           Billion Reduction
Dollars in billions
            I -._- ._....
                                                                                                                            Percent
                                                                                                                          reduction         Savings
                                                                                 1S90POBr:t         Unit    Resulting    from base       from base-
General purpose forces                                         Unit costs         structure   reduction     structure      structure            line
Army division _- _        ..-___~-                                   $3.94              18              6          12             33          $23.64
Navy                 .~ ~~___
   Shies                                                               0.16            530            100         430             191I
   &rier.battle--  .. -.                                                                                                                        16.00
      groups                                                           6.14             14              2          12             14
t&line brigades_~.._ -.--. .--__I___                            -      1.17              9              1           8              11            1.17
Air Force tactical wings                                               1.82             24              9          15              38           16.38
Strategic forces                            -.-.-
Navy ships (SSBN)                                                      0.28             36             11          25             31             3.08
Air Force winas                                                        0.72             27              5          22             19             3.60
Reserve forces          .~ ~.---.___
Army division         ._ --~_..__.                                   1.13               10             4            6             40             4.52
N&y ..              -     _ .._.----.---                             0.03              154a            3          151a             2             0.09
Air Force wings~_. _-    ~. _.._.                   ---         -___ 0.13               50             3           47              6             0.39

DOD-wide agencies
            _ --- -.          ~-..-_-_-_.                           $32.40          $32.40                                          0

Total savinas In 1997                                                                                                                         $68.87
                                                          aPersons in thousands



                                                          This alternative carries the approach embodied in the DOD illustrative
Option 2-4 100                                            force structure reduction one step further by eliminating additional
Billion Reduction                                         forces beyond those reflected in the DOD illustration, as shown in table
                                                          6.4. This option results in a 26 percent budget reduction from the 1997
                                                          CBObaseline.

Table 5.4: Additional Reductions Under
Option 2                                                  Dollars in billions
                                                                                                                                          Estimated
                                                          Additional reductions                                                  additional savings
                                                          2 active Armv divisions                                                               $7.9
                                                          2 Navv carrier battle oroutx                                                           12.3
                                                          2 Marine brigades                                                                       2.3
                                                          25 percent reduction in DOD-wide agencies                                               8.1
                                                          Total additional aavinas in 1997                                                     $30.6




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                                                             Defense Alternatives




                                                             In addition to further reductions in forces, this option would include a
                                                             26 percent reduction in funding for non-wide agencies, such as the
                                                             Defense Logistics Agency, which had been protected under the original
                                                             DOD illustrative package. We believe that a 26 percent reduction in these
                                                             activities would be a reasonable component of this option in light of the
                                                             reduced force levels and the correspondingly reduced support needs.
                                                             The force structure that would remain if this option were selected, along
                                                             with the savings associated with the specific reductions, is shown in
                                                             table 5.6.


Table 5.5: Option 24100                  Billion Reduction
Dollars in billions
                                                                                                                                  Percent
                                                                                    1990 base                                  reduction        Savings
                                                                                         force            Unit   Resulting    from base      from base-
General purpose forces                                            Unit coat8         structure      reduction    structure      structure           line
Army
“,”     division
              .-.. -_      .-..._..-....                                 $3.94              18               8          10            44          $3152
Navy
    Ships                                                                 0.16             530            130          400            251
    Carrier battle                                                                                                                                  28.28
       groups -..-_          --_... ~-- .-....-___                        6.14              14               4          IO            29
Marine brigades                                                           1.17               9               3           6             33            3.51
Air
-..__Force
      -. - tactical
             ._._..     wings
                  -.- ~.~...
                         ..__._.                                          1.t32             24               9          15             38           16.30
Strategic forces
Navy ships (SSBN) -----.. ~.
                          --------
                             . .--                                        0.28              36              11          25            31             3.08
Air Force wings
           ._ I-- .-                                         -            0.72              27               5          22            19             3.60
R&&w          Forces
Army division                                                             1.13              10               4           6            40             4.52
Navy
._ _.-      . _.--” _.-..--. .---                                         0.03             154a              3         151a            2             0.09
Air_-..-.._
     Force wings
            ..-._-... .. ._-..-_---__                                     0.13              50               3          47             6             0.39

DOD-wide agencies
         ..__. .                 _..---~-----                           $32.40          $32.40            $8.1       $24.3             25            8.10

Total saving8 in 1997                                                                                                                             $99.47b
                                                             aPersons in thousands
                                                             bTotals may not add due to rounding.



                                                             This alternative would involve a further extension of the approach
Option 3-$120                                                embodied in the DOD illustrative package. Further reductions would be
Billion Reduction                                            made in most of the active forces, and there would be a further reduc-
                                                             tion in funding for the DOD-wide agencies. The additional reductions,
                                                             beyond those reflected in option 2, are set forth in table 5.6.


                                                             Page 7 2                                                   GAO/OCG4O-5   The Budget Deficit
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                                                             Defense Alternatives




Table 5.8: Additional Reductions Under
Option 3                                                     Dollars in billions
                                                                                                                                              Estimated
                                                             Additional reductions                                                   additional savings
                                                             1 active Army division                                                                 $3.9
                                                             2 Navv carrier battle arouos                                                            12.3
                                                             1 Air Force tactical wing                                                                1.8
                                                             7% reduction in DOD-wide agencies                                                        2.3
                                                             Total additional savings in 1997                                                      $20.3


                                                             The force structure that would remain after implementation of this
                                                             option is set forth in table 5.7.


Table 5.7: Option 3- $120 Billion Reduction
Dollars in billions_ ..-.-     .-.-.---
                                                                                                                                  Percent
                                                                                    1990 base                                   reduction       Savings
                                                                                         force            Unit   Resulting     from base     from base-
General    purpose
 . ._. ..lll_l. ..-...-.forces
                         - _---- __ .-..---.--                    Unit costs         structure      reduction    structure       structure          line
Army
..- __division
        ...~~_..- _-.__I..                                              $3.94               18               9           9              50        $35.46
NavyI. .^.         ..-.-_-.~
   Ships                                                                  0.16             530            160          370             30)           -
   Carrier battle                                                                                                                                  40.56
     groups                                                               6.14              14               6           8             40           -.
Marine brigades-.. -....i                                                 1.17               9               3           6              33          3.51
Air Force tactical wings                                                  1.82              24              10          14              42         18.20
                                                                                                                                                      -
Strategic
 _.       forces
          .-... .- _...        ..-~...                ___-                                                                                          --
Navy ships (SSBN)                                   ~-___              0.28                 36              11          15             31           3.08
Air Force wings                    ___-_-   --.-~            --..-____ 0.72                 27               5          22             29           3.60
Reserve forces                                        ~__._-            --~.                                                                         --
Army-division
   _._           __.--.~.~ --.--_-..--~...                           - 1.13                 10              4            6             40           4.52
Navy                                                                   0.03                154a            25          12ga            16           0.75
Air Force wings -~         ---- ~~~~.-.                                0.13                 50              3           47              6           0.39

DOD.wide agencies                                                      $32.40           $32.40         $10.40          $24              32         10.40
                                                                                                                                                       -

Total savings in 1997                                                                                                                           $120.48b
                                                             aPersons in thousands
                                                             “Totals may not add due to rounding.




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                                          Chapter 5
                                          Defense Altmnatives




Table 6.9: Other lllurtrative   DOfOn8e
Budget Reductions                         Dollars in billions
                                                                                                                              Total
                                          llluetrative Terminations                          1991        1997            1991-1997
                                          Army
                                            ATACMS             -                             $0.2         $0.1                     $1.4
                                            Blackhawk helicopter                              0.5          0.5                      3.3
                                            Hellfire missile                                  0.2          0.1                      0.9
                                            Light helicopter (R&D)                            0.5          0.1                      3.0

                                          Navy                                                                               _--
                                            Seawolf Submarine                                 3.5          5.1                     17.7

                                          Air Force
                                             AMRAAM                                           1.4          1.2                      9.6
                                             B-2 Bomber                                       2.6          2.7                     35.0
                                             C-l 7 Transoort                                  1.0          4.9                     23.7
                                             MX (Peacekeeper) Missile                         0.7          0.0                      4.0
                                             Rail garrison                                    1.9          0.0              --      4.8
                                             Small (Midgetman) ICBM                           0.2                 a                       a
                                             Tacit rainbow missile                            0.3          0.5                      2.3

                                          Joint and Other Systems
                                             Milstar satellite                                1.1        Class                   Class
                                             National aerosoace olane (R&D)                   0.2           0.5                     2.5

                                          Illustrative Reductions
                                          --
                                          -Navy
                                             DDG-51 Destroyer (from 10 to 6 every 2
                                                years)                                       $1.4         $0.0                   $11.1
                                             D-5 Strategic missile (Equip only 9 Tridents)      0          2.0                     6.0

                                          Air
                                          -- Force
                                             F-l 6 Fighter (From 150 to 72 per year)          1.5           1.1                  10.1
                                                                                                                         (continued)




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                                                                                                  Total
Illustrative Reductions                                       1991            1997           1991-1997
Other                                                                -
  Strate ic defense initiative (hold at 1990
     leve P)                                                    0.9             8.9                  37.1
  Independent R&D                                               3.1             4.0                  24.8
  10 percent of all other procurement                           7.4             9.1                  55.5
                                                                                                       -
Total potential savings                                      $28.6           $40.8                $255.gb
Legend
AMRAAM = advanced medium range air-to-air missile
ATACMS = Army tactical missile system
DDG = guided missile destroyer
ICBM = intercontinental ballistic missile
R&D = research and development
aDOD has not published budget data for later than fiscal year 1994

‘Totals may not add due to rounding.
Note: Amounts do not include termination costs

Sources of reduction proposals: CBO, DOD, Defense Budget Task Force, and the House and Senate
Armed Services Committees.

Source of data: Projected by GAO using selected acquisition reports where available-otherwise      poten-
tial savings were estimated by GAO.




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Chapter 6

Nondefense Alternatives


                       Different budget restraint options imply different views about the
                       proper role of the federal government. The traditions of incremental
                       decisionmaking, the structure of the Congress, and the evolution of
                       political coalitions have not encouraged a systematic approach to
                       defining this role or to examining its effect on the budget. In the 46
                       years since the end of World War II, the response to problems at the
                       federal level has been to create a large variety of federal programs with
                       little explicit concern for balance and consistency. Indeed, not until the
                       passage of the Congressional Budget Act of 1974 did the Congress even
                       make its budget decisions in the context of a stated overall fiscal
                       strategy.


                       The spending reductions presented in this chapter represent one
Defining the Federal   approach to defining the role of the federal government in society more
Role                   explicitly and reconciling that role to the fiscal realities of the 1990s.
                       Four specific deficit reduction packages are used to illustrate ways to
                       achieve the fiscal policy goals outlined in chapter 3. These options
                       would involve domestic budget reductions below the 1997 baseline of
                       $45 billion, $90 billion, $120 billion, and $170 billion. These four pack-
                       ages apply 10 major domestic spending cut strategies which are listed in
                       table 6.2 later in this chapter.

                       Even the smallest reduction package would imply a significant change in
                       federal domestic policy, going well beyond what the Congress as a whole
                       has been able to support in the past. At the high end of the range, the
                       federal role would change dramatically. Domestic expenditures would
                       decline by about 16 percent; excluding Social Security, the reduction
                       would be 22 percent.

                       As table 6.1 shows, Social Security, Medicare, and retirement and disa-
                       bility programs represent 59 percent of domestic program outlays,
                       excluding interest costs. Accordingly, any major reduction in domestic
                       spending cannot ignore these programs which represent by far the
                       largest potential source of cuts.




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                                      Chapter 6
                                      Nondefense    Alternatives




Table 9.1: Distribution of Baseline
Nondefense Program Outlays for 1997   Dollars in billions
                                                                                                               Amount                Percent
                                      Nonmeans-tested entitlements
                                        Social Security                                                            $370                      32
                                        Medicare                                                                    218                      19
                                        Federal retirement and disability benefits                                   94                       8

                                        Subtotal                                                                   $682                      59

                                      Means-tested entitlements     (includina Medicaid)                            $175                     15

                                      Other nondefense programs
                                      ..~-__~.--                                                                     295                     26

                                      Total Nondefense Program Outlays                                           $1,152                     100
                                      Note: Amounts exclude defense and net interest outlays and proprietary receipts credited to receipt
                                      accounts.
                                      Source: GAO estimates extrapolated   from CEO baseline estimates


                                      As one moves from the low end of the range of domestic cuts to the high
                                      end, the choices that can be exercised in defining the federal govern-
                                      ment’s role in our society become increasingly limited. At the high end of
                                      the range, the effect would be to limit that role to certain core functions
                                      such as revenue collection, law enforcement and justice, and some low
                                      income support programs. The other remaining programs or activities
                                      would be largely limited to those that are financed with earmarked
                                      taxes or user fees.

                                      One reason for these consequences is that we have rejected the option of
                                      using trust fund surpluses to mask the shortfall in revenue to support
                                      the general operations of government. This is not to imply that just
                                      because they are self-financed, trust fund activities are necessarily more
                                      meritorious. That is a separate issue. As stated in chapter 2, we believe
                                      that the fundamental problem with general operations is that the
                                      decline in funding has not been accompanied by a decline in spending.


                                      The following section reviews briefly the nature of 10 deficit reduction
Structure of the                      strategies we have identified. Each of these strategies represents a cate-
Chapter                               gory of domestic spending. In each case, we have selected a range of
                     Y                specific program actions to include in our four deficit reduction options.
                                      A range of savings for each of these strategies is identified in table 6.2.
                                      Detailed selections of illustrative program cuts that underlie these strat-
                                      egies are contained in appendix IV of GAO/OCG-QO-6A. As with other parts


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                    Chapter 6
                    Nondefeuse   Alternatives




                    of this report, the choice of specific measures is illustrative only. Their
                    inclusion does not imply that we do or do not favor a particular program
                    reduction unless there is a specific statement to the contrary. Nor do we
                    favor any one or set of deficit reduction strategies. These are designed
                    only to provide an organizing principle that avoids the need for the
                    reader to consider the hundreds of possible individual spending reduc-
                    tions. Even when the detailed program cuts are grouped under 10 strate-
                    gies, there are many possible ways of reaching the four reduction levels.

                    The last section of this chapter displays various combinations of the 10
                    reduction strategies to reach four alternative levels of spending cuts,
                    ranging from $45 billion to $170 billion. These combinations are also
                    purely illustrative and not meant to imply a preference for one strategy
                    over another. Appendix IV of GAO/or&-go-6A    includes program lists that
                    provide further background on each of these four choices.


                    As we noted earlier, we divided federal domestic spending into 10 cate-
Ten Approaches to   gories which form plausible approaches for reducing outlays and allow
Spending Cuts       policymakers to determine how much has been reduced from the major
                    types of nondefense spending. With very few exceptions, each strategy
                    was used to some extent to achieve the four spending reduction levels.
                    Table 6.2 shows the range of usage when each strategy was employed.




                    Page 78                                         GAO/OCG99-5   The Budget Deficit
            .


                                        Chapter 6
                                        Nondef’enee   Alternetivee




Table 6.2: Domestic Deficit Reduction
Strategies                              Dollars in billions
                                                                                                                        1997 savings
                                        Strateav                                                                     From                      To
                                        Postpone or reduce nonmeans-tested retirement and disability
                                          programs and tax greater portion of Social Security benefits                $5.8                  $39.9
                                        Restructure health care                                                        9.6                   54.5
                                        Improve efficiency of federal workforce                                        2.6                    9.0
                                        Phase out farm price supports                                                  2.1                    8.0
                                        Reduce subsidies to business                                                   2.5                    3.9
                                        Reduce subsidies to individuals                                                0.7                    3.1
                                        Increase user charges
                                           Special benefits                                                             8.5                   9.6
                                           Reaulatorv and inspection costs                                              3.3                   3.3
                                           Market pricina for private use of federal assets                             2.2                   4.7
                                        Curtail international activities                                                1.3                   1.5
                                        Restrict scientific and medical research                                        2.3                   2.8
                                        Restructure grants to states and localitiesa                                                         31.1
                                        Total                                                                        $40.9’               $171.4
                                        aAnother approach would be to reduce grants to states and localities, resulting in savings which range
                                        from $1.7 to $14.8 billion.




Nonmeans-Tested                         The Social Security program dwarfs the programs in this category,
Entitlements                            sometimes called middle class entitlements. The retirement and disa-
                                        bility portions are financed through the Old Age, Survivors, and Disa-
                                        bility Insurance trust funds. (The portion that finances medical services
                                        for the elderly-Medicare-      is discussed separately below.) Although
                                        the Social Security system operated primarily on a pay-as-you-go basis
                                        in its early years, the Social Security Amendments of 1977 and 1983
                                        have resulted in a partially funded system that has caused the trust
                                        fund to begin to run substantial and growing surpluses. As discussed in
                                        chapter 2, we believe that these and other trust fund balances should be
                                        used to increase the national savings rate.

                                        We favor achieving approximate balance in the general fund portion of
                                        the budget. While reductions in Social Security benefits would increase
                                        the trust fund surplus (and could thereby increase the national savings
                                        rate), they would not reduce the general fund deficit. Nevertheless,
                                        there is a way to reduce Social Security benefits and ease the drain on
                                        the general fund because much of Social Security is not taxed. Recipi-
                                        ents of Social Security benefits continue to be treated much more favor-
                                        ably under the income tax system than recipients of retirement income



                                        Page 79                                                           GAO/OCG+O-5         The Budget Deficit
                           Chapter 6
                           Nondefense   Alternatives




                           from other sources. Correcting this inequity could produce substantial
                           increases in income tax revenues.

                           The 1983 amendments provided that up to one half of the Social
                           Security benefits received by higher income individuals be included in
                           their taxable income. (The provision phases in when adjusted gross
                           income from other sources exceeds $26,000 for individuals or $32,000
                           for couples.) At the same time, most new beneficiaries today have paid
                           Social Security contributions during their working years that amount to
                           no more than about 16 percent of the lifetime benefits they can expect
                           to receive. Taxing Social Security in the same way that private pensions
                           are taxed would require beneficiaries to count the other 85 percent (or
                           more) of their benefits as taxable income. Moreover, this approach
                           would be less burdensome than a cost-of-living adjustment (COLA)reduc-
                           tion for lower income beneficiaries because of the progressive nature of
                           the income tax structure.

                           If this alternative were chosen, we recommend that the amounts col-
                           lected be deposited in the general fund along with other income tax col-
                           lections, as is the case for taxes collected on private pension benefits.
                           (Revenues from the limited taxation called for in 1983 have been depos-
                           ited in the Social Security Trust Fund. In view of the current large and
                           increasing balances, that is no longer necessary.) Strictly speaking, of
                           course, this alternative would reduce the deficit by increasing receipts
                           rather than reducing outlays. However, since it is widely viewed as an
                           alternative to a benefit reduction, we have adopted the convention of
                           displaying it with other benefit cuts.

                           The full taxation of Social Security benefits in excess of contributions
                           could be coupled with a COLA delay for other middle-income and high-
                           income retirement programs, primarily military and civil service retire-
                           ment. A l-year COLA delay, along with the full taxation of Social Security
                           benefits in excess of contributions, would yield about $36 billion in sav-
                           ings by 199’7. A more modest alternative would be to (1) impose a l-year
                           COLA reduction of one half the amount under current law and
                           (2) increase the tax on Social Security benefits to 85 percent but retain
                           the current income thresholds. This approach would yield about $12 bil-
                           lion in 1997.


Restructure the American   Substantial cuts in the federal health care budget will be essential if
Health Care System         domestic spending restraint is to make a significant contribution to def-
                           icit reduction. In view of this, federal health care programs, such as


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                                     Medicare and Medicaid, would have to be modified to hold down the
                                     short-term growth of costs. These modifications, however, are likely to
                                     have only a temporary effect, leaving the growth rate of federal expend-
                                     itures over the long run unchecked. Controlling the escalation of such
                                     expenditures while assuring good quality care to beneficiaries is likely
                                     to be very difficult unless the overall rate of expenditure growth in the
                                     American health care system is also controlled. Appendix III of GAO/
                                     OCG-90.6~ discusses the causes of health care expenditure growth and
                                     briefly outlines an approach to developing reforms that might bring that
                                     growth under control.

                                     To achieve the short-term cost reduction objectives, we have identified
                                     in table 6.3 a range of cost-saving reforms in Medicare and Medicaid. At
                                     the high end of the range, these changes would significantly reduce gen-
                                     eral fund and trust fund outlays for these programs. These changes
                                     would involve making Part B co-payments substantially higher and
                                     increasing Part B premiums above the current rate of 25 percent of the
                                     program’s actuarial cost. An alternative to raising the Part B copay-
                                     ments would be raising or eliminating the limit on income subject to the
                                     Medicare payroll tax and providing the increased revenues for the Medi-
                                     care Part A trust fund. However, since this taxes future rather than cur-
                                     rent beneficiaries, it is more appropriately categorized under revenue
                                     measures, which are discussed in chapter 7.

Table 6.3: Upper Range of Possible
Health Care Reductions               Dollars
                                     .._.--- in billions                                                                              _----
                                     Policy change                                                                           Savings
                                                                                                                              -___--- in 1997
                                     Gradually increase premium to cover 50 percent of costs for
                                        physicians’ services under Medicare
                                     .-_.______I__                                                                             ____..     $32.4
                                                                                                                                        ._~---...
                                     Targeted reduction of disproportionate share and teaching
                                        adjustments                                                                                           4.2
                                     Increase Medicare program safeguard funding (net savings)                         --         --.         1.3
                                     Move immediately to a prospective reimbursement system for capital
                                        expenditures under Medicare                                                                           1.3
                                                                          --
                                     Reduce
                                         - ._.-- _Medicare’s
                                                   .-. .--~.---~___payments to physicians for overvalued services                             1.6
                                     Modify way hospitals are paid under federal employees health benefits
                                        program                I_-                                             ___.___                         1.3
                                     Reduce VA medical care for nonservice-connected illnesses                -__-__              .-.--.-.__  5.2
                                     Other                                                                                                    7.2
                                     Total                                                                                                  $54.5




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                            At the low end of the range, minimal savings of about $4.1 billion in
                            1997 could be realized by reforms which would have a less direct impact
                            on Medicare and Medicaid beneficiaries.

                            At the same time that these short-term budget reductions are being con-
                            sidered, we need to develop a national consensus as to the structural
                            reforms required to bring the health care cost spiral permanently under
                            control. To this end, we believe that the Congress and the executive
                            branch should start now to take the steps necessary to build a consensus
                            among providers, payers, and consumers regarding such reforms.

                            To provide information which could be used in this process, we are con-
                            ducting a series of studies of cost containment strategies in the health
                            care systems of other nations. Our preliminary findings suggest that
                            nations which are more successful at controlling health care costs have
                            created institutional mechanisms for setting cost goals; monitoring
                            health care system expenditures; and facilitating resolution of conflicts
                            between the interests of providers, payers, consumers, and
                            governments.


Improve the Efficiency of   The federal civilian workforce costs about $120 billion a year, about
the Federal Workforce       45 percent of which is incurred by domestic agencies, excluding the
                            Postal Service. In the past, budget-cutting strategies to limit the growth
                            of personnel costs have focused on limiting the annual adjustments in
                            pay rates for the cost-of-living adjustments. We believe this would be an
                            unwise approach to the issue. There is growing evidence that current
                            federal pay scales (particularly in some high cost localities) are inade-
                            quate to attract and retain employees of the caliber needed to carry out
                            government functions with reasonable efficiency. Limiting federal pay
                            COLASwould only worsen the problem.

                            An alternative strategy would focus on reducing the total cost (relative
                            to the baseline) of the nondefense workforce through aggressive produc-
                            tivity enhancement programs. To implement such a strategy, each
                            agency’s total budget for personnel compensation and benefits would be
                            frozen for 1 or more years at the fiscal year 1991 level. Alternatively,
                            the limitation could include some increase, but not the full amount to
                            cover the COLA.Thus, there would be either no new money to fund sala-
                            ries above those paid in the base year or an insufficient amount. Special
                            accounting measures and controls would be necessary to ensure that the
                            savings are achieved.



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                       General salary increases and some special adjustments could be pro-
                       vided at the discretion of the agency head, but only to the extent that
                       they could be funded from productivity increases that allowed the
                       agency to operate with fewer total staff. If the authorized general salary
                       increase were 4 percent, for example, a 4-percent increase in produc-
                       tivity would need to be achieved before the full amount of the salary
                       increase could be paid.

                       To be feasible, this workforce improvement program would require new
                       authority for federal managers to remove marginal workers. Such
                       authority would have to recognize the need for due process and protect
                       employees from politically motivated adverse actions. If productivity
                       improvements yielded savings in excess of the amount needed to fund
                       authorized general salary increases and authorized special adjustments
                       (such as locality pay), the agency head would be permitted to distribute
                       a substantial part of the excess to the workforce in special gain-sharing
                       bonuses of up to 25 percent of base salary. The balance of any excess
                       savings would be available for reallocation by the President and Con-
                       gress to high priority needs elsewhere in the government.

                       This approach to personnel cost-saving is very flexible. The specific
                       design would depend on the degree to which other domestic budget deci-
                       sions increased or decreased the need for federal employees.


Phase Out Farm Price   The key to any major reduction in the cost of farm programs is phasing
Supports               out over 6 years specific crop subsidies, quotas, tariffs, and other sim-
                       ilar provisions that impede free and efficient trade. Most U.S. crops do
                       not receive direct, special consideration. The dozen or more crops that
                       receive extensive market protection would have to adjust to operating in
                       open market conditions.

                       In addition, a similar 6-year phase out of those programs that subsidize
                       specific farmers could be considered. This would include all Farmers
                       Home Administration subsidies and conservation subsidies. Removing
                       specific crop subsidies as well as farm subsidies would improve the
                       opportunity for all U.S. farmers to compete fairly for land and other
                       resources. A change in policy of this magnitude would probably change
                       the U.S. farm structure and cause, at least in the short term, a downturn
                       in the agriculture sector as program funds are withdrawn. In the longer
                       term, however, U.S. agriculture is likely to be stimulated, resulting in
                       new investment, new business interests worldwide, new products, new
                       services, and new customers.


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                                     Consumers would benefit from this invigorated agriculture, with more
                                     competitive supermarket prices and products. Also, taxpayer savings
                                     could range up to $8 billion in 1997. Part of the savings could be
                                     invested in new marketing initiatives abroad, a new conservation effort,
                                     and improved agriculture research and innovation.


ReduceSubsidi.esto                   Several programs that subsidize businesses could be reduced or elimi-
Business                             nated because either (1) the conditions originally justifying them have
                                     changed, (2) in the context of a comprehensive deficit reduction package
                                     (with the prospect of lower capital costs and a stronger economy) they
                                     are less essential, or (3) they are ineffective. Table 6.4 lists these subsi-
                                     dies, which go to exporters, some consumers of electric power, coal pro-
                                     ducers, nonprofit organizations, a small proportion of small businesses,
                                     and foreign depositors in U.S. banks.

Table 0.4: Upper Range of Possible
Business Subsidy Reductions          Dollars in billions
                                     Policv chanae                                                                Savinas in 1997
                                     End EXIM Bank                                                                              $0.3
                                     Reduce REA subsidies                                                                        0.8
                                     Reform PMA debt policies                                                                    0.3
                                     End clean coal fundina                                                                      0.5
                                     Discontinue not-for-profit postal subsidies                                                 0.5
                                     Eliminate Stafford loan eligibility for students attending schools with
                                        default rates over 40 percent                                                            0.3
                                     End SBA loans and loan guarantees (except minority and disaster
                                        programs)                                                                                0.4
                                     Other                                                                                       0.8
                                     Total                                                                                      $3.9
                                     Legend

                                     EXIM = Export-Import Bank

                                     REA = Rural Electrification   Administration
                                     PMA = Power Marketing Administrations

                                     SEA - Small Business Administration




ReduceSubsidies to                   Major social arguments can be made for income support programs based
                                     on need, service, disability, or some combination of all three. The justifi-
Individuals y                        cation of subsidies to special classes of people who do not qualify for
                                     federal assistance on the basis of low incomes is less clear. Table 6.5 lists
                                     major programs in this category that could be considered for possible


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                                     cuts or elimination. These total an estimated $3.1 billion in outlays for
                                     1997.

Table 6.5: Upper Range of Possible
Individual Subsldy Reductions        Dollars in billions
                                     Policy change                                                        Savings in 1997
                                     Eliminate health orofessions education subsidies                                   $0.3
                                     End VA home loan program                                                            1.0
                                     gprove correlation between school lunch program subsidies and
                                        familv income                                                                    0.3
                                     Reduce cost and increase borrower payments to 28 percent of
                                        income-rural housing program                                                     0.5
                                     Other                                                                               1 .o
                                     Total                                                                              $3.1


                                     VA = Department of Veterans Affairs



Increase User Charges and            User charges and fees can be categorized into three broad areas: pay-
Fees                                 ments for special benefits, payments for the costs of regulations legiti-
                                     mately borne by the regulated industry and its consumers, and payment
                                     that approximate market pricing, thereby capturing monopoly profits
                                     for the taxpayer. Table 6.6 lists options for increasing major user
                                     charges and fees. User charges across the full range of these categories
                                     could raise up to $17.6 billion.




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Table 6.6: Upper Range of Possible User
Charge and Fee increases                  Dollars in billions  _---~
                                          Policy ..-.-.-_____~____
                                                   change            ..----     __-                                Savings in 1997
                                          Special benefits
                                            Increase taxes to cover costs imposed bv aviation users                             $6.7
                                            Extend Bureau of Customs’ passenger
                                                                         -___-._____and merchandise fees                         1.0
                                            Other                                                                                1.9
                                            Subtotal                                                                              9.6

                                          Regulatory and inspection costs                                                         3.3

                                          Market pricing for private use of federal assets
                                            Naval Petroleum Reserve Leasing                                                       0.6
                                            Raise crop insurance premiums                                                         0.6
                                            Impose a royalty payment on communications
                                              users of electromagnetic spectrum                                                   2.2
                                            Other                                                                                 1.3
                                            Subtotal                                                                              4.7

                                          Total                                                                                $17.6



Curtail Inte rnational                    Dramatic political, military, and economic changes have swept the world
                                          over the past 18 months, providing an opportunity to reshape the
Activities                                budget for international activities in a way that responds to these new
                                          realities. Table 6.7 lists activities that could be curtailed to reduce
                                          spending in this area. Budgets for the Economic Support Fund and the
                                          Foreign Military Financing Program have been linked largely to the U.S.
                                          strategy for containing the Soviet Union. Included in these budgets for
                                          fiscal year 1991 is over $800 million for three European countries to be
                                          used for base access and for strengthening host country forces. With the
                                          end of the Cold War, the rationale behind these programs needs to be
                                          reviewed. In an additional example, the United States Information
                                          Agency has focused its activities on countering Soviet propaganda and
                                          promoting the virtues of a free society and a market economy. Detente
                                          has led to a much lower level of anti-US. propaganda, and developments
                                          in Eastern Europe and the Soviet Union have demonstrated the merits
                                          of political freedom and market economics. In addition, the Public Law
                                          480 food distribution program could be refocused on genuine humanita-
                                          rian assistance, with surplus food supplies likely to decline as farm pro-
                                          grams become more market oriented. Cuts in these areas could save $1.5
                                          billion by 1997.




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Table 6.7: Upper Range of Possible
Curtailment of International Activities   Dollars in billions
                                          key     change                                                       Savings in 1997
                                          Public Law 480 Title 1 Food Aid                                                     $0.9
                                          Economic Support Fund-lo-percent
                                          ..-________                             cut                                     -..- 0.4
                                          Foreign
                                          --.~-_-  Military Financing Program-$-percent   cut            -                    0.2
                                          Total                                                                               1.5



Restrict Scientific and                   While the federal government has a clear role in the support of scientific
Medical Research                          and medical research, particularly basic research, other research has
                                          questionable merit because of its rapid growth or questionable high-cost
                                          approaches. Table 6.8 lists research areas that could be cut to facilitate
                                          savings. For example, National Institutes of Health research grants have
                                          increased 50 percent in real terms between 1983 and 1990. Also, the
                                          Superconducting Super Collider and the manned space station (which is
                                          largely unfunded in the baseline) are controversial not only in terms of
                                          engineering feasibility, but particularly in terms of cost effectiveness.
                                          Terminating the Super Collider and manned space station and cutting
                                          National Institutes of Health by 10 percent would save $3.3 billion.

Table 6.8: Upper Range of Possible
Reductions in Selected Scientific and     Dollars in billions                                                       ---
Medical Research                          Policy change                                                        Savings in 1997
                                          Cancel the space station    -___                                                   $2.2
                                          Cancel Superconducting Super Collider                   -._-                        0.2
                                          Reduce NIH research funding                                                         0.9
                                          Total                                                                              $3.3




ReduceGrants to States                    The diversity of problems in U.S. society is matched by the approaches
and Localities                            to dealing with them. The federal system permits, within the public
                                          sector, responses at the national, state, or local level. Since the 1960s
                                          however, almost no major program designed to assist individuals has
                                          been created that is administered primarily at the national level. (An
                                          exception is the Supplemental Security Income Program.) On the other
                                          hand, some programs may be funded and regulated in such a way as to
                                          make them national in everything but name (the Food Stamp Program is
                                          a possible example). The appropriate role for each level of government
                                          is, of course, a matter of continuing debate as the society as well as the
                                          administrative and financial capacities of various levels of government
                                          continues to change.


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    The intergovernmental aid system is based on 492 grant programs that
    will distribute $133.8 billion to states and localities in fiscal year 1990.
    In addition, states and localities benefit from $64.1 billion in federal tax
    expenditures. Federal costs in this area could be reduced through either
    of two approaches:

. compiling a list of programs that could be cut on the grounds that some
  regard them as ineffective or
. restructuring the existing federal relationship with states and localities
  by devolving many domestic responsibilities to the state/local sector.

    Under the first approach, which would leave the existing federal system
    in place, we identified 29 categorical grant programs for termination or
    restriction. In 1997, this would entail a spending reduction of about
    $7 billion. By contrast, the second approach could consolidate about 400
    grant programs into 6 mega-block grants and reduce them over 6 years
    to achieve savings of about $20 billion in 1997.

    Both approaches can be used to achieve substantial savings. For
    example, under the restructuring approach, further reductions in the
    level of the consolidated grants could yield 1997 savings of about
    $40 billion, which would reduce these funds by about two thirds.

    The radical restructuring   is based on three premises:

. federal aid to poor people is a higher national priority than other kinds
  of intergovernmental aid and therefore income security should remain a
  shared federal/state responsibility;
l states have improved their ability to respond to public service demands
  and initiate innovation and should be the primary vehicle for policy-
  making and program administration; and
l federal mandates on state and local governments have increased during
  a period in which federal aid is declining, and any restructuring should
  provide maximum flexibility for states to pursue national objectives.

    The success of this restructuring would depend heavily on the institu-
    tional and fiscal capacities of state and local governments to support
    and administer the domestic programs involved. Because these capaci-
    ties vary greatly, the distribution formulas of the federal grants system
    need to be reviewed to target the remaining federal funds in the light of
    these capacities.




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Illustrative Reduction   bined to produce domestic cuts from $46 billion to $170 billion. The
Packages                 reductions could be arrayed in many different ways. These illustrations
                         suggest the kinds of choices that need to be faced. Of course, any termi-
                         nations or reductions will be unpopular with beneficiaries of the pro-
                         gram. But to achieve deficit reduction, any proposal that is rejected
                         would need to be replaced by another reduction proposal.

                         In each of the packages, we have shown in the 1992 column the amount
                         that could be saved in that year. Depending on the amount of deficit
                         reduction planned in the defense and revenue components of the budget
                         and the pace at which these amounts are to be achieved, the amount
                         required in the nondefense component in 1992 may be less than is indi-
                         cated for the packages. This amount can be adjusted as necessary by
                         phasing in the specific reduction items.

                         Appendix IV of GAOIOCG-90-6~ lists the programs from which savings for
                         these four options were selected.


Option 1: $45 Billion    As we indicated earlier, the smaller reduction packages provide a
Reduction                broader range of choices than larger ones. The particular combination of
                         cuts presented in table 6.9 focuses on new user charges and reduced
                         subsidies to individuals. Cumulatively, these two strategies make up 46
                         percent of the 1997 overall target.




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Table 0.9: Option l-User   Charge and
Subsidy Emphasis                        Dollars in billions
                                                                                                            Outlay reductions
                                        Reduction strategy
                                        -_____                                                             1992              1997
                                        Nonmeans-tested retirement and disabilitv                          $2.0                       $5.8
                                        Health care                                                         6.1                        9.6
                                        Federal workforce                                                   2.2                        2.6
                                        Farm once subborts                                                  2.0                        2.1
                                        Reduce subsidies to business                                        1.6                        2.5
                                        Reduce subsidies to individuals                                     0.5                        0.7
                                        User charges
                                           Sbecial benefits                                                     7.3                    9.6
                                           Regulatory and inspection costs                                      2.7                    3.3
                                           Market pricing for private use of federal assets                     3.5                    4.7
                                        Curtail international
                                                         .--- activities                                        0.0                    0.0
                                        Slow arowth of selected scientific and medical research                 1 .o                   2.3
                                        Reduce grants to states
                                           Reduction approach                                                1.5                       1.7
                                          .--
                                        Total Reductions                                                  $30.3                     $45.0


                                        As noted earlier, there are many ways to achieve outlay reductions of
                                        this magnitude. An alternative would be to selectively eliminate or
                                        streamline funding for specific programs. This would entail evaluating
                                        factors such as whether (1) existing funding reaches the target popula-
                                        tion, (2) program objectives are being accomplished, and (3) the stated
                                        objective is still a high enough priority to warrant the current level of
                                        federal funding or some lower level.


Option 2: $90 Billion                   For this option, presented in table 6.10, the focus shifts to deeper reduc-
                                        tions in health care programs with continued emphasis on user charges,
Reduction                               subsidies to individuals and businesses, and some reduction in grants to
                                        states and localities. A major portion of the savings come from
                                        nonmeans-tested retirement and disability programs. While the cuts are
                                        large in terms of dollars, they represent only a small percentage of the
                                        programs.




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Table 6.10: Optlon P-Health Care, User
Charge, Subsidy, and State arant         Dollars in billions
Emphasis                                 .---
                                                                                                                Outlay reductions
                                         Reduction strategy                                                    1992              1997
                                         Nonmeans-tested retirement and disability                             $5.3                 $16.9
                                         Health care                                                           14.0                  34.9
                                         Federal workforce                                                      2.2                   2.6
                                         Farm price supports                                                    1.6                   6.2
                                         Reduce subsidies to business                                           2.1                   3.5
                                         Reduce subsidies to individuals                                        1.7                   2.9
                                         User charges
                                            Soecial benefits                                                     6.4                  8.5
                                           Regulatory and inspection costs                                     - 0.0                  0.0
                                           Market pricing for private use of federal assets                      1.8 ---              2.2
                                         Curtail international activities                                        1.1                  1.3
                                         Slow growth of selected
                                                              ----- scientific and medical research              1.3                  2.8
                                         Reduce grants to states             ~-
                                           Reduction approach                    -                              6.8          ~--- __- 8.2
                                         ?&al Reductions                                                      $44.3                $90.0




Option 3: $120 Billion                   As presented in table 6.11, this more demanding level of reductions
Reduction                                shifts dramatically to the nonmeans-tested entitlement programs. As the
                                         size of the reduction package increases, it is necessary to look to the
                                         programs that compose the bulk of the outlays.




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Table 8.11: Optlon 3-Entitlement, Health
Care, Urer Charge, Subsidy, and State      Dollars in billions
Orant Emphado                                                                                                  Outlay reductions
                                           Reduction strateay                                                 1992              1997
                                           Nonmeans-tested retirement and disability                         $18.6                  $39.9
                                           Health care                                                         8.5                   22.9
                                           Federal workforce                                                   2.5                    9.0
                                           Farm price suooorts                                                 1.6                    6.2
                                           Reduce subsidies to business                                        2.1                    3.9
                                           Reduce subsidies to individuals                                     2.0                    3.1
                                           User charaes
                                             Special benefits                                                   7.3                   9.6
                                             Regulatory and inspection costs                                    2.7                   3.3
                                             Market pricing for private use of federal assets                   3.2                   4.4
                                           Curtail international activities                                     0.0                   0.0
                                           Slow growth of selected scientific and medical research              1.3                   2.8
                                           Reduce grants to states
                                             Reduction approach                                                8.9                   14.8
                                           Total Reductions                                                  $58.8                $120.0




Option 4: $170 Billion                     At this level, presented in table 6.12, we have essentially exhausted the
Reduction                                  options developed in the 10 strategies. Many will view cuts of this total
                                           size as unrealistic. Others might want to consider additional options.
                                           This option continues to rely heavily on entitlements, health care, and
                                           user charges. Other strategies, such as subsidies to individuals and busi-
                                           ness, become less significant since they constitute lower and lower por-
                                           tions of the cumulative reductions as the target outlay reductions
                                           increase. The remaining factor coming into play as a last resort in this
                                           option is the full impact of a reduction in aid to the states. It would
                                           result in a major withdrawal of the federal government from existing
                                           programs, some of which might be continued with increased state and
                                           local support.




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Table 6.12: Option 4-Minimal Federal
Involvement Except for Self-Financed   Dollars in billions
Programs                                                                                                   Outlay reductions
                                       Reduction strategy                                                 1992              1997
                                       Nonmeans-tested retirement and disability                          $18.3                $38.7
                                       Health care                                                         16.2                 54.5
                                       Federal workforce                                                    2.5                  9.0
                                       Farm price supports                                                  1.9                  8.0
                                       Reduce subsidies to business                                         2.1                  3.9
                                       Reduce subsidies to individuals                                      2.4                  3.1
                                       User charges
                                          Special benefits                                                  7.3                   9.6
                                          Regulatory and inspection costs                                   2.7                   3.3
                                       --
                                          Market pricing for private use of federal assets                  3.2                   4.4
                                       Curtail international activities                                     1.2                   1.5
                                       Slow arowth of selected scientific and medical research              1.3                   2.8
                                       Reduce grants to states
                                          Restructuring approach                                          25.5                  31 :i
                                       Total Reductions                                                  $84.7               $170.0




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Chapter 7

Revenue Alternatives


                    As the analysis in chapter 3 makes clear, deficits are a burden on the
                    economy and on the taxpayer. Once government has decided to spend a
                    certain amount of money, the real resources represented by that money
                    will be withdrawn from the economy, either through taxes or through
                    borrowing. If the economy is operating fairly close to capacity and the
                    spending is financed by borrowing, the resources will come from
                    reduced domestic spending or increased borrowing from abroad. The
                    taxpayer may not see the direct connection, but will observe the effects
                    in higher interest rates (making it more difficult to buy houses and
                    cars), lower rates of investment by U.S. businesses (meaning fewer jobs
                    are created and real wages are lower), and the increased sale of U.S.
                    assets to foreign citizens and governments.

                    Taxes extract resources from the economy visibly and directly, but the
                    burden to the nation is no greater. In the long run, the burden would
                    likely be less with taxes, since they will lead to a higher rate of domesti-
                    cally financed investment, producing higher real income for Americans
                    in the future.

                    This chapter outlines alternative methods of raising revenue at three of
                    the levels of additional revenue needs discussed in chapter 4: $60 billion,
                    $120 billion, and $170 billion annually. There are three broad alterna-
                    tives for raising these levels of revenues: (1) raising rates within the
                    existing income tax system, (2) broadening the income tax base by
                    including items in the tax base that are currently excluded, and
                    (3) raising existing consumption taxes or introducing new ones.
                    Although any one of these alternatives could potentially be used to raise
                    any of the suggested amounts of revenue, a mixed approach would prob-
                    ably be preferable from an equity and efficiency standpoint, especially
                    for larger amounts.


                    Total federal taxes, consisting of both general fund and trust fund reve-
Mix of Taxes Has    nues, have risen as a percentage of GNP from about 17.5 percent in the
Shifted Over Time   1950s to 19 percent in the 1980s. They are projected to rise to over 19.5
                    percent in the period from 1990 through 1995. Trust fund revenues
                    have grown in their share of GNP, largely reflecting significant increases
                    in Social Security taxes which are dedicated to financing a particular set
                    of benefits.

                    However, as noted in chapter 2, the burden of general fund taxes, con-
                    sisting of individual and corporate income taxes as well as some excise
                    taxes, has fallen from about 15.4 percent to 12.1 percent of GNP during


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                                             Chapter 7
                                             Revenue Altematives




                                             the same period when the burden of the general fund deficit was
                                             growing from 0.9 percent to 5.2 percent of GNP.

                                             The relative contribution of the various federal taxes has changed dra-
                                             matically over this period. Two components-corporate      income and
                                             excise taxes-have fallen substantially; one component-employment
                                             taxes-has risen substantially; and another component-individual
                                             income taxes-has risen slightly. Table 7.1 illustrates this shifting com-
                                             position of federal taxes.

Table 7.1: Receipts, Outlays, and Deficits
                                             (Percent of GNP)                                                    --___
                                                                                                  1950s       1960s        1970s___.- 1980s
                                             General fund
                                               Receipts:         -.___--___
                                                   Individual income taxes                           7.6      ___8.0__-.....^__
                                                                                                                       -       8.3            8.8
                                                                                                                                        ---_-.--
                                                   Corporate income taxes                            4.9         3.9           2.8            1.8
                                                   Excise.__-taxes-.._                               2.4         1.5           0.7--.--       0.6
                                                   Other
                                             _- .._.--..- .._...--_.-... .----~_                     0.6         0.8           1.0            0.9
                                                   Subtotal, receipts                               15.4        14.2          12.7          12.1

                                               Total outlavs                                        16.3        15.3          15.5         17.3

                                                Deficits
                                               ~.~.  -------..-                                     (0.9) -___ (1.1) ___- (2.8)
                                                                                                                             ____--- (5.2)

                                             Trust funds
                                               Receipts: -....-.______-..---            ...__________                             --~____
                                                  Employment taxes and contributions                    2.0      3.5           5.1        6.6
                                                  Excise taxes                                          0.1      0.5           0.5        0.4
                                                  Subtotal, receipts                                    2.1      4.0           5.6        6.9

                                               Total outlays                                            1.6      3.7           5.0           5.8

                                                Surpluses                                               0.5      0.3           0.6           1.1

                                             Unified
                                             -_--__- budget
                                                Receipts                                            17.5        18.2         18.3          19.0
                                                Total outlays                                       18.0        19.0         20.4          23.1
                                                Deficits                                            (0.4)       (0.8)         (2.1)        (4.1)
                                             Note: Totals may not add due to rounding




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                                          The U.S.‘s ratio of taxes to gross domestic product is lower than those of
The Aggregate Tax                         almost all of the other members of the Organization for Economic Coop-
Burden on the U.S.                        eration and Development. The US’s burden ranks low whether one
Economy Is Relatively                     compares taxes levied by all levels of government in each nation or only
                                          those levied by central governments. The exclusion of Social Security
Low by International                      taxes from the comparison also has no effect on the US’s relative posi-
Standards                                 tion. By contrast, the United States has one of the largest deficits as a
                                          share of gross domestic product (GDP), ranking fifth out of 22 countries
                                          in this dimension.

Table 7.2: Tax Revenues Relative to GDP
for 23 OECD Countries, 1988a                                                                             Central
                                                                        Total tax revenue (all   government tax Central government
                                                                                     levels of     revenue as a tax (excluding Social
                                                                           government) as a       percenta ;$           Security) as a
                                                                         percentage of GDPb               4       percentage of GDP
                                          Sweden                                         55.3               40.0                     31.3
                                          Denmark
                                          --.                                            52.1               36.1                     35.0
                                          Netherlands                                    48.2               46.5                     26.0
                                          Norwav                                         46.9               37.1                     24.6
                                          Belgium
                                          ---.--..                                       45.1               42.3                     27.6
                                          France                                         44.4               40.1                     20.9
                                          Luxembourg                                     42.8               37.5                     26.8
                                          Austria                                        41.9               33.0                     21.5
                                          ireland                                        41.5               39.8                     34.7
                                           Finland
                                           -____--.                                      37.9               28.2                     23.4
                                                                                                                                      -
                                          -New   ..--Zealand
                                                       -___.                             37.9               35.8                     35.8
                                           Germany                --.                    37.4               25.6                     11.6
                                           United Kingdom
                                          _-____-.____-__                                37.3               32.9                     26.0
                                           Italy
                                          A----___
                                                                                         37.1               36.2                     23.9
                                                                                                                                      -
                                           Greece            ----                        35.9               35.2                  -- 23.6
                                           Portugal _____-
                                           -.I_                                          34.6               32.7                     23.4
                                           Canada                                        34.0               18.8                     14.3
                                           Spain                                         32.8               28.8                     17.3
                                           Switzerland                                   32.5               20.2                      9.6
                                           Japan                                         31.3               23.2                     14.1
                                           Australia                                     30.8               24.6              ~..    24.6
                                          United StatA
                                                   ______-                               29.8               29.6                    11.7
                                          Turkev
                                          I--.--.--.
                                                                                         22.9               20.6                    17.1

                                          Unweighted average                             38.7               31.9                    22.8
                                          U.S. rank out of 23                              22            20 (tied)                    21
                                          %anked by total tax revenue as a percentage of GDP.

                                          %cludes      Social Security taxes.




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                           The following revenue discussion is organized around three major
Each Approach to           approaches to raising revenues. The first would use rate increases under
Raising Revenue Has        the existing corporate and individual income tax system. The second
Limitations                would broaden the base of the existing corporate and individual income
                           tax. The third would raise existing excise tax rates, introduce new
                           excise taxes, and/or impose a broad-based consumption tax.

                           Each of these various approaches has advantages and disadvantages. In
                           choosing among revenue options, policymakers should consider not only
                           the revenue raised by a tax but, also, the criteria commonly used in eval-
                           uating tax policy decisions. Broadly conceived, these include

                           Economic efficiency - the extent to which taxes avoid distorting the allo-
                           cation of resources in the economy and promote economic growth.

                           Equity - the extent to which taxes distribute the tax burden fairly by
                           --
                           (1) providing equal treatment to people in similar circumstances and
                           (2) allocating the tax burden on the basis of ability to pay.

                           Administrability - the extent to which a tax can be implemented without
                           undue administrative and compliance costs.

                           Some of these same criteria can also be used to compare any of the
                           approaches and options discussed in the remainder of this chapter with
                           the economic efficiency and income distributional impacts of the
                           nation’s current reliance on borrowing and debt to finance the deficit.


Raising Income Tax Rates   The major advantage of using rate increases is that it does not require
                           complicated legislation or additional administrative complexities unless
                           higher tax rates lead to reduced compliance.

                           Even though the individual income tax has increased compared with
                           GNP, the corporate income tax as a percentage of GNP is less than half of
                           what it was in the 1950s partly due to such tax changes as lower rates
                           and to higher corporate debt/equity ratios. Moreover, because marginal
                           income tax rates for individuals are very low from a historical perspec-
                           tive, some increase could be justified on the basis of returning rates to
                           levels comparable to those at some point in the past. Since it is a
                           straightforward policy change, estimating the revenue yield is not diffi-
                           cult. Also, identifying who will bear the tax burden would be simple,
                           with the notable exception of increases in the corporate income tax rate



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                        since the ultimate incidence of this tax is a subject of much disagree-
                        ment among tax analysts.

                        The primary disadvantages of higher tax rates are the effects on incen-
                        tives and changes in behavior resulting from those incentives. For
                        example, higher income tax rates in general reduce the incentive to work
                        and to save, but there is little evidence that the effects are very large. Of
                        more concern is that higher taxes on certain forms of income make other
                        untaxed forms of income more attractive. This effect makes the cash
                        and barter economy more important. It also makes purchasing a home
                        and taking compensation in the form of untaxed fringe benefits rather
                        than as regular wages more attractive. The effect of higher tax rates on
                        all of these types of decisions reduces the overall efficiency of the
                        economy, though the effect can be mitigated by a broad tax base.


Broadening the Income   Broadening the current income tax base by including some items cur-
                        rently excluded or eliminating certain deductions would have a number
Tax Base                of equity and efficiency advantages. The equity advantages are twofold.
                        First, people with the same income do not currently pay the same tax
                        when some of them receive their income in tax-preferred or tax-exempt
                        form while others do not. Second, the items that are excluded or
                        deducted from the income tax base, such as income on pension funds or
                        state and local income taxes, are much more concentrated among upper
                        income groups, Broadening the tax base would therefore enhance equity
                        between those with similar incomes, since type of income would be less
                        relevant, and it would increase the effective progressivity of the tax
                        system.

                        The efficiency effects result from reducing the difference in the effec-
                        tive tax rate on alternative forms of income. Under the current system,
                        people have an incentive to “consume too much” health insurance,
                        retirement benefits, and housing, because the tax system subsidizes
                        them. Reducing or eliminating tax preferences would treat all forms of
                        income in a more balanced way, leveling the playing field even more
                        than the Tax Reform Act of 1986 did.

                        The staff of the Joint Committee on Taxation (JCT) has estimated that
                        the revenue yield of the income tax in 1995 would be $406.7 billion
                        larger with the use of a broad based definition of income in comparison




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                                      with the current definition.’ A list of the larger tax expenditures is
                                      included in table 7.3. A more comprehensive list, containing over 120
                                      separate tax expenditures that each amount to more than $10 million
                                      per year, was prepared by JCT staff and published as Estimates of Fed-
                                      eral Tax Exuenditures For Fiscal Years 1991-1995.

Table 7.3: Estimates of Largest Tax
Expenditures-l    995                 Dollars in billions
                                      Net exclusion of oension contributions and earninos                                                      $61
                                      Exclusion of employer contributions for health insurance                                                  50
                                      Deductibility of mortgage interest on owner-occupied housing                                              40
                                      ““;“,,zbility   of nonbusiness state and local income and personal property
                                                                                                                                                  27
                                      Exclusion of untaxed social security benefits                                                               26
                                      &zess deoreciation                                                                                          25
                                      Deferral of capital gains on sales of principal residences                                       __--       14
                                      Exclusion of interest earned on public purpose state and local government
                                        debt                                                                                                     14
                                      Exclusion of investment income on life insurance and annuitv contracts                                     IO
                                      Total                                                                                                   $267
                                      Note: Dollar figures would be realized only if the elimination of the various exclusions and deductions
                                      applied to existing beneficiaries as well as future beneficiaries. The total amount in the table does not
                                      recognize interaction effects.


                                      There are two disadvantages to broadening the income tax base. First,
                                      many of the items excluded from the tax base are excluded for a partic-
                                      ular social purpose. Mortgage interest is excluded because, at least in
                                      part, owning one’s own home is thought to be socially beneficial. Retire-
                                      ment security and protection against large health-related outlays lay at
                                      the base of the special treatment given pensions and employer-provided
                                      health benefits. The second disadvantage is that each of these tax
                                      expenditures has a powerful political constituency behind it. Most of the
                                      base broadening alternatives discussed here were suggested by the Trea-
                                      sury Department in early tax reform proposals in 1985. However, the
                                      alternatives met with such opposition that they were discarded, under
                                      the then-existing ground rules of a revenue-neutral package. Similar
                                      focused opposition is likely to arise again, unless the affected groups are
                                      made aware of the burdens they currently bear in financing the govern-
                                      ment through borrowing. Strategies for overcoming opposition could
                                      include adopting across-the-board cuts in tax expenditures to spread the
                                      sacrifice over a larger number of taxpayers.

                                      ‘This figure was derived by adding the revenue loss for each tax expenditure and does not account
                                      for the interaction effects among the various tax expenditures.



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                         One additional point needs to be made about base broadeners. There are
                         a set of provisions in the tax code that are set to expire in 1990 unless
                         Congress acts to extend them. These provisions are not counted in the
                         baseline for calculating tax expenditures. If they are extended, there
                         will be additional revenue losses that must be made up, either through
                         expenditure reductions or tax increases. However, if they are allowed to
                         expire, there will be no need to alter our calculations. The staff of the
                         JCT has estimated that these expiring provisions would lose over $6 bil-
                         lion in 1995 if they were extended. Included among these provisions are
                         the research and experimentation tax credit and the low-income housing
                         credit.


Consumption and Excise   There are two primary types of consumption taxes, those levied on a
Taxes                    narrow base of goods or services- excise taxes-and those levied on a
                         broad tax base such as value-added and retail sales taxes. The argu-
                         ments for excise taxes are somewhat different than the arguments for
                         broad-based consumption taxes. Excise taxes were once a very impor-
                         tant source of revenue and were often raised to finance wars and
                         national emergencies. However, these taxes have declined as a share of
                         total revenues since most are imposed on a dollar-per-unit basis and ad
                         hoc adjustments to their rates have not kept up with inflation.

                         In recent years, they have often been proposed as revenue raisers that
                         also discourage particular types of activity. For example, excise taxes
                         on tobacco and alcohol can be viewed as attempts to discourage smoking
                         and drinking. A related perspective is that these taxes should compen-
                         sate society for the costs the particular activities impose.

                         In contrast, one of the major advantages of a “pure” consumption tax
                         covering all goods and services is that it is neutral with respect to the
                         choice of which goods and services are consumed as well as the choice
                         between consumption and savings.” If rebates are paid on exports and
                         taxes are imposed on imports, there is also no advantage or disadvan-
                         tage for domestic as compared with foreign goods. Even though the
                         income tax is biased against saving and the consumption tax has no such
                         bias as long as current saving is for future spending, there is little evi-
                         dence that a consumption tax would raise the national savings rate to
                         any significant extent if substituted for an income tax.

                         “If a consumption tax were to follow the experience in other countries of exempting a number of
                         goods and services to reduce regressivity, it would introduce some distortions into consumption
                         choices.



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                                                     ,
.
    Chapter 7
    Revenue Alternatlve~~




    The primary argument against raising existing excise taxes-an argu-
    ment that also applies to broad-based consumption taxes-is that these
    taxes are regressive or have a disproportionate impact on lower income
    groups. Very low income groups tend to consume larger portions of their
    annual income than do higher income groups. However, differences in
    consumption relative to income are not that substantial if we look at
    these patterns over more than 1 year. In fact, only at the very highest
    income levels does the proportion of income consumed fall off very
    much.:’ Consumption patterns for particular items such as tobacco prod-
    ucts, alcoholic beverages, and motor fuels are generally similar to those
    for overall consumption. As a result, the regressivity of consumption
    and excise taxes is often overstated.4

    Regressivity, at the low income end, can be offset through some combi-
    nation of indexed income support programs or refundable tax credits.
    However, because there is little that can be done to offset the regres-
    sivity of a flat rate consumption tax for very high income levels, the tax
    package would be mildly progressive at low incomes and regressive at
    very high income levels unless a compensating change were made to
    increase effective tax rates at the high income level.

    A second argument against introducing a broad-based consumption tax
    is that it would take substantial up-front resources and lead
    time-something     like 18 months has been suggested-to get the system
    up and running. The additional tax would probably be administered by
    the Internal Revenue Service (IRS), increasing the urgency of already
    needed managerial improvements. In addition, the Customs Service
    would probably be responsible for dealing with exports and imports.
    Therefore, Customs responsibilities would be greatly extended and coor-
    dination between the IRS and Customs would have to be substantially
    strengthened.

    Finally, a broad-based consumption tax would also generate opposition
    from state governments, since many consider the retail sales tax as their
    tax. The majority of state tax policymakers responding to a 1989 GAO




    “The appendix volume (GAO/OCG-90-6A) provides further discussion of       the   distributional effects of
    the various revenue proposals discussed in this chapter.

    ‘A recent CBO study showed that the impact of gasoline, alcohol, and tobacco taxes on the lowest
    income quintile may be overstated by a factor of two, if annual rather than long-run income is used.



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                      survey opposed a broad-based federal consumption tax, viewing it as an
                      intrusion on state tax systemsh


                      To illustrate the full implications of each approach to raising revenue,
Options for Raising   we initially show how each alternative amount could be raised using a
Revenue               single approach. We illustrate and discuss the implications of raising
                      three levels of annual revenue by 1997: $60 billion, $120 billion, and
                      $170 billion. As the amount of revenue to be raised increases, reliance
                      on a single approach becomes less and less reasonable. Therefore, since
                      it is likely that a mixture of approaches would be more acceptable, we
                      have also developed illustrations combining approaches.

                      It is important to keep in mind that the revenue targets could be reached
                      through any number of combinations. To illustrate this point, we
                      selected a variety of options through which to achieve the revenue
                      objectives. Thus, our use of a given option should be viewed as illustra-
                      tive and not construed as implying our endorsement of that particular
                      approach.

                      We drew most of our specific options from CBO’S February 1990 report
                      on deficit reduction because it addressed an extensive array of options
                      and provided corresponding 5-year revenue estimates prepared by the
                      staff of the Joint Committee on Taxation6 The revenue estimates are
                      based on the economic assumptions prevailing at that time. The esti-
                      mates for all the options discussed in this chapter as well as some others
                      presented by CBOare included in a separate volume to this report; infor-
                      mation describing the distributional effects of the various options dis-
                      cussed in this chapter is also presented in that volume. In each of the
                      options we present, we vary the base broadeners to demonstrate that
                      there are a variety of ways base broadeners could be combined to reach
                      revenue totals, and we do not intend to suggest that any given package
                      of base broadeners necessarily corresponds with a particular level of
                      revenues.



                      ‘Tax Policy: State Tax Officials Have Concerns About a Federal Consumption Tax (GAO/GGDQO-SO,
                      March 1990). It should be also noted that, from the perspective of the federal government, the growth
                      in states’ reliance on the income tax could be viewed as an intrusion on the federal income tax base.

                      “Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, February 1990.
                      Additional sources are listed in appendix V of GAO/m -90 _SA W         ‘acted revenue figures
                      beyond f‘isczdyear 1996 through fiscal year 1997, generally by e&%~~tbe     growth trends in the
                      relevant source.



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Options for Raising   Although a single approach is not necessarily preferable at any revenue
$60 Billion           level, using only one approach to raise $60 billion is more reasonable
                      than using a single approach to raise larger amounts. To raise $60 bil-
                      lion, the requisite rate increases would be more modest than at higher
                      amounts and fewer loopholes would have to be eliminated. It also
                      becomes more reasonable to simply limit certain tax expenditures
                      without eliminating any. While it would require large excise tax rate
                      increases and new excise taxes, it would be feasible to raise $60 billion
                      with excise taxes alone. However, introducing a new broad-based con-
                      sumption tax such as a value-added tax (VAT) does not appear warranted
                      for this lower revenue level, given the substantial startup and lead time
                      involved. The following discussion summarizes an array of options for
                      raising $60 billion in new tax revenues.

                      Summary       of Selected Options   for Raising   $60 Billion

                      Income tax rate increases

                      Raise individual rates to 16 percent, 30 percent, and 33 percent.
                      Raise corporate rate to 35 percent.

                      Income tax base broadeners

                      Eliminate one or two of the largest tax expenditures or cap a whole
                         range of tax expenditures (see table 7.4 for an example).

                      ConsumDtion-excise       taxes

                      Increase excise taxes on alcohol to restore their 1970 value, and equalize
                         based on the rate for distilled spirits.
                      Double the tax on cigarettes.
                      Raise motor fuels tax by 20 cents a gallon.
                      Impose tax on transfer of securities.

                      Mixed income tax rate-excise        taxes

                      Add a 33 percent individual tax bracket.
                      Increase excise taxes on alcohol and tobacco as above.
                      Raise motor fuels tax by 20 cents a gallon.




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                                Revenue Altemativw




                                Mixed base broadeners-excise                 taxes

                                Subtract itemized deductions only on the basis of 15 percent marginal
                                  rate.
                                Raise motor fuels tax by 20 cents a gallon.

Using a Single Approach Could   If marginal individual income tax rates were increased to 16 percent, 30
Raise $60 Billion               percent, and 33 percent, and the highest corporate income tax rate were
                                increased to 35 percent, cso has estimated that about $60 billion in addi-
                                tional revenue would be raised.7 Other combinations of rate increases
                                also could be considered to raise $60 billion. The lowest bracket rate
                                generates the most tax revenue per percentage point tax increase,
                                because it applies to the most taxable income. Therefore, if increased
                                progressivity is desired, it would require much larger rate increases in
                                high income brackets to generate sufficient revenue. For example, if the
                                lowest bracket is to remain at 15 percent, the top bracket would have to
                                increase to about 40 percent to raise the required revenue.

                                On the other hand, eliminating a small set of the larger tax expenditures
                                could also generate $60 billion. In fact, taxing pension income and con-
                                tributions fully would raise about $60 billion. Alternatively, including
                                employer-provided health insurance premiums in income along with
                                closing a few small loopholes could also raise the required amount. How-
                                ever, $60 billion could also be generated by capping or limiting a number
                                of tax expenditures. The advantage of this last approach is that the
                                social goals that are the basis for these tax benefits can still be achieved,
                                at least in part, but the forgone revenues, especially those accruing to
                                higher income groups, can be limited. The disadvantage would be a
                                slight increase in complexity, especially if certain fringe benefits are to
                                be included in income. Some tax expenditures that could be capped or
                                eliminated are shown in table 7.4.




                                7The CBO estimates include a rate increase for the so called “phase out” range of taxable income. In
                                this range, the benefit of personal exemptions and taxation at the lowest marginal rate is removed
                                through a 6 percent surcharge. Thus, the effective rate structure would be 16 percent, 30 percent,
                                36 percent, and 33 percent.



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Table 7.4: Revenue Effects of Capping or
Eliminating Certain Tax Expenditure        Dollars in billions
                                           Change in taxation                                                                 Revenue raised
                                           Tax at a 5-percent rate investment income on life insurance,
                                              annuities. bensions and IRAs                                                                   $12
                                           Tax 50 percent of Social Securitv benefits                                                         10
                                           Tax 30 percent of capital gains
                                                                       -    from home sales                                                   10
                                           Cap employer-paid health insurance benefits at $3,000 per year                                     10
                                           Cap deductibility of state and local taxes at 9 percent of adjusted
                                              gross income                                                                                        7
                                           Disallow deductions for 50 percent of meals and entertainment
                                              exbense                                                                                             5
                                           Tax employer-paid life insurance benefits                                                              3
                                           Limit mortgage interest deduction to $12,000 for individual and
                                              $20,000 for ioint return                                                                         3
                                           Eliminate all private purpose tax-exempt bonds                                                      3
                                           Tax capital gains held until death on a carryover basis                                             2
                                           Total                                                                                             $65


                                           Using excise taxes to raise $60 billion would probably require either a
                                           large increase in taxes on motor fuels or some new energy or environ-
                                           mental taxes.x Increasing excise taxes on alcohol and tobacco could raise
                                           over $30 billion, if the alcohol taxes were based on alcohol content and
                                           if the rates were raised to levels equivalent to their 1970 values, and if
                                           cigarette taxes were doubled. A motor fuels tax increase of 20 cents a
                                           gallon would raise almost $20 billion more. To reduce the regressivity of
                                           this option, a tax on the transfer of securities could be included.

                                           There does not appear to be sufficient reason to introduce a VAT if only
                                           $60 billion in new revenue is required. Since a 5-percent comprehensive
                                           VAT with no exceptions raises $180 billion, a 2-percent VAT would raise
                                           over $70 billion. However, given the set-up costs and additional adminis-
                                           trative and compliance costs, as well as the amount of lead time required
                                           for implementation, it does not appear worth it for so little in new reve-
                                           nues, An alternative would be a VAT with exemptions for basic goods to
                                           reduce the regressivity of the tax. A problem with this option is that the
                                           exemptions make the tax harder to administer and give benefits to
                                           people who consume exempt goods whether they are rich or poor. A
                                           more savings or investment-oriented approach might use the extra con-
                                           sumption tax revenue raised by a higher-rate VAT to either cut taxes on

                                           XIncreases in the motor fuel tax raise an additional concern. Currently, these taxes are devoted to
                                           trust funds. Using any additional revenues from this tax to offset the general fund deficit would
                                           require changes in the underlying legislation. The same is true for revenues generated by higher taxes
                                           on Social !!lecurity benefits.



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                            corporate investment by reinstating the investment tax credit or liber-
                            alize the constraints on using individual retirement accounts (MS) or
                            other tax-preferred savings instruments. The evidence on the effective-
                            ness of these devices is very mixed, so it is not clear that national sav-
                            ings would go up or that efficient investment spending would be
                            increased on a long-term basis.

Combination Approaches to   Revenues of $60 billion could also be raised by some combination of two
Raising $60 Billion         or three of the approaches, such as a mix of excise tax increases and
                            income tax base broadeners. For example, to offset the concern that
                            excise tax increases might fall most heavily on the poor, base
                            broadeners could be selected that would affect other income groups
                            more heavily. To mitigate the political controversy associated with lim-
                            iting selected base broadeners, taxpayers could be allowed to subtract
                            itemized deductions only on the basis of the lowest marginal tax rate
                            (currently 15 percent). Alternatively, the same goal could be accom-
                            lslished by cornDining a 3$-perc@nt individual income tax rate with
                            increased excise taxes.


Options for Raising         If some intermediate amount of revenue, such as $120 billion needs to be
$120 Billion                raised, then either a single approach or some mixture of approaches
                            could be employed. The following section illustrates some possible
                            options for raising $120 billion using three pure approaches and two
                            mixed approaches.

                            Summary        of Selected Options   for Raising   $120 Billion

                            Income tax rate increases

                            Increase individual rates to 17 percent, 32 percent, and 36 percent.
                            Increase corporate tax rate to 36 percent.

                            Income tax base broadeners

                            Eliminate or cap a range of base broadeners.

                            Consumption            tax

                            Impose a 5-percent value-added tax with one-third of revenue set aside
                              to offset regressivity through tax rebates or low-income entitlements.




                            Page 106                                            GAO/OCG+O-5   The Budget Deficit
Mixed income tax rate-base broadener                     aDDroach

Raise individual income tax rates to 16 percent, 30 percent, and 33 per-
  cent.
Raise corporate rate to 35 percent.
Cap or eliminate an assortment of deductions or exclusions from income
  tax base for remainder.

Mixed consumption-income                 tax base broadener           approach

Raise cigarette tax to 32 cents per pack.
Increase taxes on distilled spirits, beer, and wine to 25 cents per ounce
  of alcohol.
Impose a $5 per barrel tax on domestic and imported oil.
Impose tax on mobile and stationary sources of air pollution.
Impose tax on water pollutants.
Cap or eliminate an assortment of deductions or exclusions from income
  tax base for remainder.

Using income tax rates alone is certainly feasible. However, as the
amount of revenue needed rises, the rate increases necessary will also
rise. Because higher rates are likely to decrease the overall efficiency of
the economy, there may be some limit on how high the rates should rise.
Increasing individual tax rates to 17 percent, 32 percent, and 36 percent,
along with increasing the corporate rate to about 36 percent would gen-
erate about $120 billion.”

Base broadeners could raise this amount as well. Again, this approach
runs counter to the social purpose of these tax expenditures, and the
cost/benefit trade-off needs to be taken into account. Many combina-
tions of a few large or several smaller tax expenditures could be elimi-
nated to raise $120 billion. It would be hard to generate all of the
revenue by simply using caps on existing tax expenditures unless the
caps were very low.

A pure consumption tax approach to anything above about $80 billion
would probably have to be broad based since excises are very unlikely
to provide sufficient revenue. Such a broad-based consumption tax,
even one with a generous tax rebate and income support program to
reduce regressivity, could readily raise $120 billion.

%ecause the CHO estimates include a 5 percent surcharge for the “phase-out” range, the effective
rates are 17 percent, 32 percent, 37 percent, and 36 percent.



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                           If the consumption tax approach is used, the basic trade-off would be
                           between the overall efficiency of a broad-based consumption tax versus
                           the setup and ongoing administrative costs of moving to a new tax
                           regime. The trade-off between consumption and income taxes is gener-
                           ally one between efficiency and equity. A VAT or a national retail sales
                           tax has certain efficiency benefits because it is neutral between con-
                           sumption and savings. The income tax, on the other hand, has greater
                           flexibility to deal with equity issues more effectively.

                           A mixed approach could have either an income tax or a consumption tax
                           orientation. If the income tax approach is used, then it could combine
                           base broadeners with rate increases. If the allowed group of base
                           broadeners is very limited, then more revenue must be generated
                           through higher rates.

                           A consumption-oriented approach could use a combination of increased
                           excise taxes and base broadeners to reach the $120 billion target. When
                           considered as a package, this approach could realize some of the advan-
                           tages of excise taxes while offsetting the regressivity of these taxes
                           with progressive base broadeners.


Options for Raising $170   In this section we discuss a set of options that might be used to raise the
Rillion                    maximum amount of additional revenue postulated in chapter 4. First,
                           we looked at what sort of income tax rate increases, base broadeners, or
                           consumption/excise tax package would be necessary to achieve $170 bil-
                           lion in additional revenue by 1997. Since the results are qui.te extreme,
                           we then turn to a few mixed approach packages that could achieve the
                           same goal. A summary of these packages is presented in the following
                           section.

                           Summary        of Selected Options   for Raising $170 Billion

                           Income tax rates only

                           Raise individual rates to 18 percent, 34 percent, and 37 percent.
                           Raise corporate rate to 36 percent.

                           Base broadeners        only

                           Eliminate the top four tax expenditures listed in table 7.3.




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                                Consumption            tax only

                                Impose a S-percent value-added tax.

                                Mixed income tax rate-base broadener                       approach

                                Raise individual rates to 16 percent, 30 percent, and 33 percent and
                                  raise corporate rate to 35 percent.
                                Cap or eliminate an assortment of deductions or exclusions from income
                                  tax base for remainder. (See table 7.5 for an example.)

                                Mixed consumption-income                  tax rate approach

                                Impose a S-percent value-added tax with adjustment to offset regres-
                                  sivity
                                Add a 33 percent bracket.
                                Raise top corporate rate to 36 percent.

Using Only One Approach to      There are a number of ways that income tax rates could be used to raise
Raise Revenue Appears Extreme   $170 billion. In our analysis, we will attempt to keep the proportional
                                differences in rates reasonably consistent with those that currently
                                exist. Extrapolating from data published by CEQ we calculate that an
                                individual rate schedule of 18 percent, 34 percent, and 37 percent, along
                                with a corporate rate of 36 percent, would generate the $170 billion.

                                There are certain trade-offs within this approach. Each percentage point
                                increase in the lowest tax rate generates about $21 billion, whereas each
                                percentage point increase in the middle bracket generates over $15 bil-
                                lion At the upper end, a percentage point only produces $3 billion. Our
                                extrapolations of CBO’Sestimates for the corporate income tax imply
                                about $3 billion for each percentage point increase in the ratesI Most
                                combinations of rate increases sufficient to raise $170 billion would
                                raise average marginal tax rates back to levels that existed in the 1970s
                                when they were higher than any period since World War II, and apply
                                them to a broader income tax base. However, the highest marginal rate
                                would still be well below the 70 percent rate that was in effect as late as
                                1980.




                                 “‘It should be noted that the higher rates become, the less revenue each additional percentage point
                                increase will bring in because of base erosion. For this reason, extrapolation of revenue generated by
                                the larger rate increases may be overstated.



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Using base broadeners to raise $170 billion means ending preferred tax
treatment for some long-standing forms of untaxed or under-taxed
income. The staff of the Joint Committee on Taxation estimates that the
total value of tax expenditures will be about $400 billion in 1996. Of
this, almost 90 percent relates to the individual income tax. As is shown
in table 7.3, the top five tax expenditures add up to $200 billion of the
$360 billion in tax expenditures attributable to the individual income
tax. What this means is that $170 billion cannot be raised under this
approach without touching some of the largest tax expenditures. It also
means that all of the required amount could be raised if these five were
eliminated, assuming that the tax changes were applied to all existing
pensions, mortgages, or other long-term arrangements as well as to new
ones.

If any one or any set of the tax expenditures is considered off limits,
some other set of base broadeners must be substituted. For example, if
the deductibility of state and local taxes is continued, $27 billion in rev-
enue needs to be made up by including items further down on the list.
Some candidates might be the deferral of capital gains tax on the sale of
a principal residence and the exclusion of interest on state and local
bonds. If both were included in income, they would add up to about the
same as eliminating the deductibility of state and local taxes.

It is not realistic to expect to raise $170 billion from excise taxes alone.
In order to construct a meaningful consumption tax package that will
raise that much money, we need to include some broad-based consump-
tion tax, like a value-added or national retail sales tax. According to our
extrapolation of CBO estimates, a E-percent value-added or retail sales
tax on a very comprehensive base would raise over $180 billion in 1997.
This would allow about $10 billion to be used to offset regressivity.

Any chipping away at the VAT base would require higher taxes on partic-
ular goods if the entire amount is to be raised from consumption taxes.
For example, if food, housing, and medical care were eliminated from
the VAT base, the net revenue raised by a 5-percent VAT would be close to
$116 billion annually. This means that the VAT rate would have to be
raised, or that some set of excise taxes would have to be raised substan-
tially, if the entire $170 billion is to be generated by taxes on
consumption.

All of these pure approaches present some important difficulties. Signif-
icantly higher tax rates could reduce the overall efficiency of the



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                                 Revenue Alternatives




                                 economy by, for example, reducing work and savings incentives. How-
                                 ever, if the revenues generated permit significant deficit reduction, the
                                 net effect on the economy could be positive.

                                 Closing remaining loopholes in the income tax system to raise $170 bil-
                                 lion would raise substantial opposition. It is also true that many of these
                                 tax expenditures do serve a social purpose, at least to some extent. Elim-
                                 inating the tax expenditure completely may not make sense from a
                                 social cost benefit perspective. For example, eliminating the tax expen-
                                 diture for health insurance could substantially reduce the private provi-
                                 sion of health insurance and, as a result, increase financial demands on
                                 the health delivery system.

                                 The consumption/excise tax approach does reasonably well on effi-
                                 ciency grounds; however, it may fall short on equity grounds. Whether
                                 or not the federal tax system has become less progressive over the last
                                 decade, this kind of tax increase would reduce the progressivity of the
                                 system substantially unless other compensating tax or expenditure
                                 changes were made.

A Mixed Approach Is Called For   While a number of mixed approaches are possible, we will focus on two
                                 alternative ways to raise $4170 billion. One of these is an income tax
                                 approach that combines rate increases and base broadeners. The second
                                 is primarily a consumption tax approach, but it includes certain income
                                 tax features to offset some of the regressivity inherent in the consump-
                                 tion tax.

                                 Increasing the first bracket from 15 to 16 percent, the second bracket
                                 from 28 to 30 percent, extending the 33 percent rate to all taxable
                                 income above $70,000 for a married couple, and raising the corporate
                                 rate to 35 percent would raise about $65 billion. To generate the addi-
                                 tional $115 billion necessary under the income tax approach would
                                 require a set of base broadeners or further rate increases. Raising this
                                 much revenue using base broadeners probably means eliminating one or
                                 two of the larger tax expenditures. The illustration in table 7.5 places
                                 limits on certain tax expenditures, including a large proportion of Social
                                 Security benefits and eliminates the deductibility of state and local
                                 taxesI


                                 ’ ’ In chapter 6 on nondefense spending, one of the options included taxation of Social Security bene-
                                 fits in lieu of restricting the COLA for that program. However, since the $170 billion revenue option
                                 would involve no nondefense reductions, including taxation of Social Security benefits in this revenue
                                 option does not constitute double counting.



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                                     Revenue Alteruatives




                                     The revenue estimates in table 7.6 are based on the existing rate struc-
                                     ture. If the level of rates is raised, the amount of revenue generated by
                                     closing loopholes will go up. If taxing 50 percent of Social Security bene-
                                     fits or including all of state and local taxes in taxable income is consid-
                                     ered too extreme, less extreme restrictions could be substituted.
                                     However, these weaker restrictions would not generate as much rev-
                                     enue. As a result, either the restrictions would have to be tightened,
                                     some other tax expenditure would have to be included in the list, or
                                     some rates would have to be further increased.

Table 7.5: lllustratlon of Raising
$115 Billion From Selected Base      Dollars in billions
Broadenerb                           Restriction on tax expenditure                                          Revenue raised
                                     Eliminate deductibility of state and local taxes                                    -__ $41
                                     Tax 50 percent of Social Security benefits                                               10
                                     impose a lO$ercent tax on investment income of life insurance,
                                        annuities, pensions, and IRAs                                                        25
                                     Kit deduction for mortgage interest to 15 percent rate                                  19
                                     Cap deductible health insurance premiums at $3,000 per family per
                                        year                                                                                 IO
                                     Disallow 50 percent of deduction for meals and entertainment
                                        expenses                                                            _____---__       5
                                     Tax capital gains held until death on a carryover basis                              -- 2
                                     %x employer-paid life insurance premiums                                                3
                                     Totar                                                                                $115


                                     The second approach would begin with a broad-based consumption tax
                                     that would raise about $180 billion with a &percent rate. However,
                                     some of this revenue would be set aside to deal with regressivity at the
                                     lower end of the income scale. To be conservative, we would devote 20
                                     percent of tax revenue to tax rebates and low income entitlement pro-
                                     grams in an attempt to offset the impact of the tax on low income house-
                                     holds. This would leave net revenue of about $140 billion. The
                                     consumption tax has a much smaller proportional impact on very high
                                     incomes, so to raise the additional revenue and to add some progres-
                                     sivity at the upper end, an increase to 33 percent in the tax rate
                                     applying to high incomes might be suggested. This would generate about
                                     $14 billion in additional revenue. If the top corporate rate were also
                                     raised to 36 percent, another $7 billion could be raised.




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                      There are two general concerns about the transition to new tax rules.
Transition Issues     The first involves changing the ground rules under which taxpayers
Should Be Considered have organized their economic affairs. Employees have entered into
in Phasing in Changes fringe benefit agreements with their employers and individuals have
                                made important decisions concerning housing choices and retirement
                                savings all under the expectation that various tax preferences would
                                remain in existence. Thus, there may be good reason to ease the shock of
                                changing these ground rules. For example, if the mortgage interest
                                deduction is terminated, one approach would be to disallow some
                                increasing proportion of the mortgage interest deduction over a phase-in
                                period of several years. Similarly, dramatic increases in the gasoline
                                excise tax or the imposition of a new, broad-based energy tax could be
                                phased in over a period of years. This approach would allow taxpayers
                                to adjust to the changed environment more gradually and is consistent
                                with how the Tax Reform Act dealt with eliminating the consumer
                                interest paid deduction.

                                The second concern centers around the macroeconomic effects of any
                                substantial shift in fiscal policy. As discussed in chapter 3, the shift will
                                be beneficial to the economy in the long run, but could cause a substan-
                                tial reduction in aggregate demand in the short run. Thus, the combina-
                                tion of tax increases and spending cuts (including debt service savings)
                                each year should total about $50 billion. Both spending cuts and tax
                                increases should be phased in to conform to that pace if the fiscal policy
                                target is to be reached without undue risk to the economy. However, if
                                income tax rates are to be raised, this should be done in the earlier
                                years, to avoid creating an incentive to shift the reporting of income
                                between years. Thus, the timing as well as the magnitude of spending
                                and tax changes are interrelated.

                                There is an additional specific reason for a transition period in the case
                                of the value-added tax. This is the only new tax that involves a large
                                administrative structure and an extensive taxpayer education effort. As
                                a result, it will probably take about 1 to 2 years after passage of a VAT
                                for the tax to actually be put into effect. If the VAT is an important part
                                of an agreed-upon package, this means either taking into account the
                                phasing in of revenue or imposing some transition tax to fill in the gap.




                                Page 113                                         GAO/~90-5    The Budget Deficit
Enforcement of a Multiyear Budget Agreement


                  New procedures to enforce a budget agreement may be part of, but are
                  separable from, the broader topic of budget reform, which is discussed
                  in chapter 9. For example, a constitutional requirement for a balanced
                  budget is often mentioned as a possible budget reform issue, but it has
                  little to do with enforcing the provisions of a budget agreement. In this
                  chapter, we discuss procedures for enforcement without making a rec-
                  ommendation. In chapter 9, we outline our position on budget reform.

                  In the US. political system there is no certain way of ensuring that
                  future action will be consistent with a budget agreement. Indeed, any
                  completely effective enforcement mechanism would be inconsistent with
                  the democratic process. That is why we continue to emphasize the need
                  for a clear multiyear agreement supported by the congressional leader-
                  ship and the President. We do not believe that enforcement procedures
                  are an effective substitute for that bipartisan support. Nonetheless, we
                  have been asked for our analysis of enforcement alternatives, and we
                  are aware that there is considerable support for the view that better
                  enforcement should be an integral part of any new budget agreement.

                  In this chapter we consider four approaches to enforcement which are
                  not mutually exclusive.

              . The first is improving the structure, clarity, and implementation of an
                agreement. This does not involve any new procedures, but makes any
                other procedures, including the ones now in place, more effective.
              . The second enhances the executive branch’s ability to reverse legislative
                actions that are inconsistent with an agreement.
              . The third creates or improves congressional procedures to make it diffi-
                cult for the Congress itself to violate an agreement.
              l The fourth provides specific remedies such as those provided in the GRH
                sequester process. In cases where violations take place, these remedies
                are designed to offset the effect of the violation, provide an incentive to
                avoid a future violation, or both.

                  The second, third, and fourth approaches all involve substantial proce-
                  dural changes and have their drawbacks. Procedures enhancing execu-
                  tive authority will concern those who oppose a shift of power between
                  the branches. Changes in legislative procedures will face skeptics who
                  point out that even if codified in law, such procedures can be waived or
                  changed by simple majority votes in the Congress. The fourth approach
                  has the disadvantage of automatic formula budgeting that has plagued
                  the GRH sequester process.



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                       Budget Agreement




                       The 1987 agreement provided ample evidence of the importance of clear
Increasing the         and explicit terms. Much of the agreement was adhered to; however, dif-
Effectiveness of All   ficulties arose when there was disagreement or ambiguity as to its
Approaches             meaning. In this regard an agreement would be easier to enforce if it
                       used caps on specific expenditure categories and floors on revenues
                       rather than deficit targets, as GRH does.’

                       Another general feature to improve enforcement would be the creation
                       of an independent review board to monitor the implementation of the
                       agreement. This board would have quite different responsibilities from
                       the budget concepts commission recommended in chapter 9. It would
                       rule on whether targets were being met, the legitimacy of questionable
                       budgeting or financing practices, and the reasonableness of economic
                       assumptions. The rulings of such a board could be either advisory or
                       mandatory, although if they were mandatory it would probably have to
                       be an executive branch agency to avoid arguments about the separation
                       of powers.

                       It may also be desirable to enact as many of the provisions of an agree-
                       ment its possible the first year on a multiyear basis. By lacking in the
                       bulk of the savings, even those that are not effective until later years, it
                       would be harder for future presidents and Congresses to undo the intent
                       of an agreement. All changes in the tax code, entitlements, and other
                       mandatory programs, user fees, and asset sales could be included in a
                       reconciliation bill. Such a bill could also include any legislation needed to
                       improve enforcement. Multiyear appropriations could also be enacted
                       incorporating agreed-to levels for discretionary programs minus a
                       reserve for future contingencies.


                       Additional enforcement powers that could be given to the President
Enhanced Executive     include item veto, enhanced rescission authority, some form of entitle-
Authority              ment authority, and a second sequester process.

                       Item veto authority would give the President the ability to pick and
                       choose among items of appropriation as to where he would propose to
                       offset what he determined to be an overage in an appropriation.
                       Enhanced rescission would permit the executive to make that determi-
                       nation at any level of detail because rescissions may be proposed for

                       ‘Spending caps should be separate for defense, Social Security (or all trust funds), other mandatory
                       entitlement programs, nondefense discretionary programs, interest on the debt, and the Resolution
                       Trust Corporation’s savings and loan bailout payments. Receipt floors should be divided into So&l
                       Security (or all trust funds) and other receipts.



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Chapter 8
Enforcement  of a Multiyear
Budget Agreement




part of an appropriation account. It is not clear why these powers are
explicitly related to enforcement of a budget agreement except to the
extent that they enhance presidential power in general and could be
used to help enforce an agreement, as well as for other unrelated pur-
poses. If an appropriation is in excess of an agreement allocation
(assuming this can be determined given that normally the 13 appropria-
tions bills are acted upon at different times), it appears that the appro-
priate remedy would be a normal veto, which would force the Congress
either to override or meet the target within its own set of priorities. The
item veto (or the enhanced rescission option) raises the related question
as to its use in instances where the Congress met the agreement target
but included items to which the President objected. If these powers are
related strictly to enforcement of an agreement, then presumably their
use would be restricted solely to instances where the agreement levels
had been exceeded.

The authority to adjust administratively entitlement benefits if an
agreement goal is not reached now exists only under carefully specified
circumstances in connection with the GRH sequester. It might be pro-
vided in the future, possibly with the restriction that it is to be used
only when the Congress has agreed to, but has not enacted, reconcilia-
tion legislation designed to achieve savings contained in a budget agree-
ment. This remedy could be justified on the grounds that in the absence
of legislation the President’s veto power does not apply. It would also
provide the Congress a strong incentive to comply with the terms of a
budget agreement. In view of these factors, it is curious that it has not
been more widely discussed in the context of the current budget
negotiations.

A “second sequester” process, which has been suggested as a possibility
by the administration, raises at least as many problems as it solves. One
reason it is advocated is to correct any unduly optimistic economic or
technical estimates that were made with the first sequester. Yet it also
would be entirely based on estimates, albeit with 2 months of actual
outlay data and some additional economic data available. Furthermore,
the estimates would be entirely under the control of the executive
branch. The second sequester, if it took place, would be even more dis-
ruptive to agency operations than the first one, since the fiscal year
would be well underway. Those activities that would be less likely to be
disrupted, such as long-term procurement, would also be those that pro-
duced relatively low short-term outlay savings.




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                     Budget Agreement




                     The Congressional Budget Act established procedures by which the two
Improved             Houses of Congress would make the individual legislative actions fit into
Congressional        the overall targets contained in the budget resolution. Those procedures
Processes            have changed, most notably with the enactment of GRH. A number of
                     further changes are under consideration. For the House one option
                     would make it more difficult to waive points-of-order on exceptions to
                     the budget resolution by requiring super majorities and limiting the
                     authority of the Committee on Rules. A more major change would be to
                     capture multiyear implications of current decisions in the enforcement
                     process. This could be done by subjecting future fiscal years to the same
                     legislative process that now applies only to the next fiscal year. Another
                     alternative would restructure the budget resolution, which is now based
                     on nonbinding allocations by budget functional categories, in terms of
                     binding allocations that coincide with jurisdictional boundaries of the
                     Congress. Allocations to appropriations committees could be specified
                     along the lines of the 198’7 budget agreement, so as to establish clear
                     guidelines on the suballocations to defense, international, and domestic
                     programs. These suballocations could be divided into mandatory pro-
                     grams under the jurisdiction of authorizing committees, and discre-
                     tionary programs that are the responsibility of the appropriations
                     committees. Further allocations of discretionary appropriations could be
                     made by subcommittee (the so-called Section 302-b allocations).

                     These and other procedural reforms essentially deal with the degree to
                     which the Congress wants to focus more authority on the centralized
                     budget process, which is under the direction of the budget committees
                     and the leadership, at the expense of the authorizing and appropriations
                     committees.

                     These are only some of the important ideas on ways to strengthen con-
                     gressional procedures, a full catalogue of which is beyond the scope of
                     this report. They share a common liability, which is that from the execu-
                     tive branch perspective they are all rules of the Congress and subject to
                     change without regard to the presidential veto power. Ultimately, even
                     super-majority rules are controlled by a simple majority.


                     The fourth approach to enforcement would be neutral in its distribution
Providing Remedies   of responsibility between the two branches. This approach is neutral in
           Y         the sense that the outcomes have been agreed to ahead of time by both
                     branches.




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    Chapter 8
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    Budget Agreement




    This was the idea behind the sequester process, but it did not work. Key
    discretionary calculations, after Bowsher v. Synar, became the sole pre-
    rogative of the executive branch. Moreover, no matter what causes the
    deficit target to be exceeded, the sequester was focused on a small por-
    tion of the budget-primarily    the annually funded domestic and mili-
    tary programs. In addition, the entire process was based on estimates
    controlled by the executive branch and potentially subject to political
    manipulation. (As an illustration, an executive branch decision to
    decrease a forecast of GNP by $60 billion, or 1 percent, could cause a cut
    in domestic and military appropriations by $10 billion each.) The
    sequester process could be made more objective and more practical by
    two changes:

l use actual data, so control of the estimates is not an issue, and
. modify the sequester instrument, so that the causes of overruns are
  related to the remedies.

    A key, however, is that the remedies themselves be enacted into law and
    be credible. Credible and objective procedures are more likely to provide
    strong incentives to adhere to a budget agreement initially, rather than
    trying to correct violations after the fact.

    One approach that might provide such incentives would be to enact into
    law automatic adjustments in tax rates and entitlement benefit pay-
    ments that would offset revenue shortfalls or expenditure overruns as
    measured by the actual levels reported by Treasury at the close of the
    fiscal year. Unanticipated deficit increases due to revenue shortfalls and
    interest payments or other uncontrollable financial overages, such as
    deposit insurance and loan defaults, would trigger automatic increases
    in withholding rates or surtax payments. Entitlement overruns would
    trigger automatic benefit reductions explicitly authorized by the Con-
    gress in advance to make up the shortfall. Faced with the prospect of
    these corrective actions neither the administration nor the Congress
    would be inclined to pretend to meet budget targets through optimistic
    economic assumptions or unrealistic technical estimates. Moreover, leg-
    islated benefit increases not anticipated in the budget targets would
    prove illusory, since they would either be offset or rolled back by this
    adjustment mechanism.

    The use of actual financial data in the enforcement process would force
    the budget process to pay attention to the bottom line for the first time.
    Obviously, a truly unanticipated slowdown in the rate of economic
    growth could, under this scheme, precipitate an unwanted automatic


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Chapter 8
Enforcement  of a Multiyear
Budget Agreement




fiscal response. Given the current technology in making budget calcula-
tions, appropriate corrective action could be built into the process
without great difficulty. For example, allowances for shortfalls in
budget receipts could be included with specific dollar amounts related to
major shortfalls in GNP.

A variation of this approach would be to apply the sequester process
only to program-related outlays, that is, excluding receipts and interest
payments. This could result in less pressure to forecast the deficit accu-
rately (since overages in interest and underruns in receipts would go
uncorrected), but it would be a more practical and perhaps more real-
istic alternative.

If a budget agreement were implemented through statutory outlay ca.ps
on individual discretionary appropriations, there may have to be exemp-
 tions from existing impoundment control restrictions on the President.
This would provide the executive branch more power over spending
levels and priorities than is now the case. If agencies were required to
 comply with outlay caps using only administrative means, it could inter-
ject higher costs and substantial inefficiencies in the management of
operations.




Page 119                                        GAO/OCG-90-S   The Budget Deficit
Chapter 9

Budget Reform


                      The previous chapter discussed mechanisms that might be used to
                      enforce a budget agreement. However, focus on enforcement should not
                      divert attention from the desirability of implementing basic budget
                      reforms. This chapter addresses ways that the budget process could be
                      made more effective and accountable.


                      For most of the years of our republic, until the mid-19809, budgetary
Move Beyond           outcomes at the federal level essentially reflected the give-and-take of
Automatic Budgeting   good faith negotiations and compromise-both       within the legislative
                      and executive branches and between them. Unfortunately, that changed
                      to a significant degree when the usual procedures were overwhelmed by
                      the fiscal and political strains of the early 1980s. Not only did elected
                      officials face deficits of almost unprecedented peacetime magnitude,
                      they also found themselves increasingly divided over fundamental
                      policy choices.

                      Presidential budgets were increasingly seen as “dead on arrival” in the
                      Congress, and the Congress itself came under divided party control
                      (Republicans in the Senate, Democrats in the House of Representatives)
                      during the 1981 through 1986 period-the first such divided Congress
                      in 50 years. Furthermore, within each chamber, a fragmentation and
                      duplication of budget-related responsibilities among several kinds of
                      committees and leadership structures created immense coordination
                      problems and contributed to a heavy budget workload that seemed to
                      crowd out other important legislative activities.

                      In this early 1980s environment of increasing partisanship and divi-
                      sions, the budget process appeared to be breaking down. Agency offi-
                      cials faced increasing uncertainty as temporary continuing resolutions
                      rather than full-year appropriations provided much of their funding. In
                      the fall of 1984, when neither regular appropriations nor a continuing
                      resolution was passed by the start of the fiscal year, some federal agen-
                      cies started closing nonessential activities and furloughing employees.
                      Most importantly, no progress was being made in reversing the pattern
                      of annual deficits and an accumulating governmental debt. Over the
                      fiscal years 1981 through 1985, the gross federal debt outstanding
                      doubled, rising to an alarming 46 percent of GNP.

                      The frustration in Congress over the government’s inability to make
                      decisive and disciplined budgetary decisions led to enactment in 1985 of
                      the GRH emergency deficit reduction law, the central features of which
                      were, and are, statutorily set declining annual deficit targets to produce


                      Page 120                                       GAO/~9045    The Budget Deficit
Chapter 9
Budget Reform




a balanced budget and a provision for automatic, across-the-board cuts
(“sequestration”) in the event that a year’s regular spending and rev-
enue legislation are not estimated by OMB as achieving that year’s deficit
target.

In 1985 when the Congress was considering this legislation, we
expressed our serious doubts about such a “mechanistic” and “formula”
approach to budgeting. The events of the years since enactment of the
GRH law have not changed our minds. The bottom line is that 5 years of
technical compliance with that law have resulted not in meaningful def-
icit reduction, but rather in a whole new generation of off budget and
other misleading budget reporting practices that hide the true magni-
tude of the problem. “Cooking the books” has become a way of life in
Washington. Placing off budget $30 billion in borrowing for the savings
and loan bailout is but one example.

The disappointing fact is that official actions have contradicted the def-
icit reduction goals set forth in the original GRH legislation. In 1987, the
Congress and the President decided that they could not accept the conse-
quences of the existing GRH schedule of declining deficit targets, and
they amended the law to extend the target date for a balanced budget by
2 years. At this writing, it appears that another such amendment is
likely. Such unwillingness to make the painful revenue and spending
choices implied by the GRH legislation has resulted in some sobering
numbers: whereas the general fund deficit stood at $266 billion when
GRH went into effect, we project in chapter 2 that it will reach almost
$400 billion in 1997.

The pattern of gimmickry and stagnation in addressing the deficit points
to the inherent weakness of applying technical approaches, such as GRH
automatic enforcement mechanisms, to essentially political problems. If
there is insufficient underlying political will and capacity for decisive
action, such mechanisms, particularly if they would trigger major
spending or revenue adjustments, will probably not be either automatic
or effective. We believe that improvement in federal budgeting requires
more fundamental reforms to enhance the capacity of the legislative and
executive branches to reach timely, realistic agreements through good
faith negotiations and compromise. We certainly would not recommend,
however, simply returning to the laws and conventions of PWGRH
budgeting because they also were flawed and inadequate for sustaining
a realistic deficit reduction plan of action. Set forth below are the addi-
tional principles that we think should guide efforts to revitalize federal
budgeting.


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                       For most of our history, budgeting was heavily oriented toward the
Adopt a Joint Budget   executive branch. Presidential or agency budget submissions normally
Resolution Procedure   framed the debate and the Congress’ practice was to play a reactive role
                       and make minor changes. There was also a certain spirit of comity that
                       limited actions, such as an understanding that the President would not
                       impound funds to unilaterally reverse congressional policy decisions.

                       The Congress became much more assertive in the 1970s in reaction to
                       the President’s expanded use of impoundments and public disenchant-
                       ment with the institution of the presidency arising from the Watergate
                       events. The result was the 1974 Congressional Budget and Impoundment
                       Control Act, which considerably increased the powers of the Congress
                       over budgetary matters. The Congress would henceforth express its own
                       budget policy in an annual “concurrent resolution” on the budget (not
                       requiring Presidential signature), and the President would be prevented
                       from effecting certain impoundments (“rescissions”) without explicit
                       congressional approval.

                       We do not question the basic balance the 1974 act established between
                       the branches over fiscal matters, However, we would suggest replacing
                       the concurrent budget resolution requirement with a “joint resolution”
                       requirement. A joint budget resolution requiring presidential signature
                       would still provide a vehicle for the Congress to express its budget
                       policy while at the same time encouraging earlier budget negotiations
                       between the two branches. It would reflect an inescapable reality-
                       namely, that in the final analysis, budget policy is a joint matter
                       between the branches, Recognizing this reality by requiring a joint
                       budget resolution early in the annual budget cycle would institutionalize
                       the budget summit approach found to be so necessary in recent years.


Expedited Rescission   gress to adopt an “expedited” procedure for considering presidential
                       rescission proposals, Rescission bills would have privileged status and,
                       unless chamber rules are waived, would be quickly brought to the floor
                       for a vote. If the Congress votes for the rescission bill, and the President
                       signs it, the prior budgetary decisions are overturned. If the Congress
                       votes against the bill, or takes no action at all, the prior budgeting deci-
                       sions are left unchanged. We believe that this procedure, unlike a line-
                       item veto procedure, would not fundamentally alter the Congress’ and
                       the President’s roles, Expediting consideration of the President’s rescis-
                       sion proposals is appropriate in today’s budgetary environment of



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                       omnibus spending legislation in which individual items often receive
                       little or no attention during initial passage.


                       The current budget deficit problem has been years in the making and
Institute Meaningful   will require years to solve. Bringing the level and mix of defense
Multiyear Budget       spending into line with new realities and adopting and carrying out a
Planning               sounder health care strategy are but two examples of the underlying
                       problems or challenges requiring actions over several years. For such
                       efforts, the government needs a sound multiyear budget planning pro-
                       cess, one it does not have.

                       Although the current GRH law’s set of declining budget deficit targets is
                       a multiyear budget plan agreed to by the President and the Congress,
                       the first of its kind in federal budgeting, it suffers from a fundamental
                       defect. It is a static plan and it relates to only one number, the total
                       deficit, The assumption behind this piece of “emergency”* legislation is
                       that a one-time plan of fixed deficit targets will suffice. Experience since
                       enactment of that law demonstrates the fallacy of that assumption. The
                       targets have been changed once and will undoubtedly be changed again.
                       Multiyear budget planning in a government such as ours should be an
                       integral part of the normal budget process. Joint executive-legislative
                       plans on broad categories of the budget should be regularly developed
                       and revised in that process, which is not being done at this time. The
                       appropriate vehicle for setting forth an executive-legislative plan and
                       periodically revising it as needed would be a joint budget resolution cov-
                       ering a multiyear period. In the context of the 6-year deficit reduction
                       program suggested in this report, we believe a 6-year resolution would
                       be appropriate. However, a 5-year resolution would also be feasible, in
                       expectation that the &year plan could pick up additional years of any
                       extended strategy as part of subsequent revisions.

                       While any such plan would surely have to be adjusted from time to time
                       to reflect changing circumstances, there would have to be some disci-
                       pline in carrying out the approved plan. Departures from the plan
                       should flow from fully debated changes approved in the joint budget
                       resolution process itself rather than from individual bill actions that vio-
                       late the terms of the plan. To help provide this discipline, existing con-
                       gressional budget process legislation should be amended to require


                       ‘The law’s official title is the “Balanced Budget and Emergency Deficit Control Act of 1986”
                       [Emphasis added].



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                       budget reconciliation for each of the budget plan years.2 This would min-
                       imize the likelihood of adopting plans that lack force because of incom-
                       plete follow-up legislation, a situation that occurred last year when the
                       Senate adopted a concurrent budget resolution covering 3 years but
                       passed reconciliation legislation covering only the first of those years. It
                       would also be advisable for the Congress to adopt points-of-order
                       against committee or subcommittee actions that exceed section 302 allo-
                       cations for years beyond the coming fiscal year.3

                       The Congress should also review the layering of functions and commit-
                       tees that has the effect of complicating procedures and lessening bud-
                       getary discipline. Over the past decade, several congressional study
                       groups or individual Members have examined these matters and pro-
                       duced assorted recommendations, including recommendations for better
                       integrating congressional leadership and the committees involved in
                       budgeting. We think it is time for the Congress to take up the various
                       proposals and adopt appropriate changes. We recognize that such
                       reforms are not easy to make but believe that they are necessary if the
                       Congress is to operate more effectively on budget-related matters.

                       A successful joint resolution process resulting in realistic, multiyear
                       plans could go a long way toward satisfying the principal objective of
                       biennial budgeting proponents, which is to free up time for
                       nonbudgetary business in the Congress and the executive branch. The
                       November 1987 budget summit agreement covering fiscal years 1988
                       and 1989 showed this potential. That agreement for fiscal year 1989
                       paved the way for the least contentious and time-consuming budget
                       cycle in years, allowing all of the major appropriations bills for that
                       year to be passed on time-the first such timely completion in 12 years.


                       It is difficult to see how substantial and lasting progress can be made on
Improve the Budget’s   getting the budget under control when there exists so much doubt and
Numbers                confusion over the “actual” and projected amounts reported in the
                       budget. The problem runs deeper than “cooking the books.” It goes to

                       ““Reconciliation” in the Congress is the process of passing a package of non-appropriations legislation
                       to alter spending and revenue levels. The largest spending amounts affected by reconciliation pertain
                       to entitlement programs, such as Medicare.
                       %ction 302 of the 1974 Congressional Budget Act provides for allocations, as part of adopting a
                       budget reduction, to committees and subcommittees of the budget resolution’s approved spending
                       totals. When spending legislation exceeds the allocations, budget discipline can be undermined. Under
                       current House and Senate procedures, points-of-order may be laid against such reported bills to
                       enforce allocations for the coming fiscal year, but not the years beyond that.



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the very core of the budget measurement concepts that are used. The
budget’s almost exclusive focus on immediate cash transactions means
that decisionmakers often make commitments that will create future
obligations without recognizing the full costs of these programs. Thus
decisionmakers are frequently faced with surprises when forced to pay
bills that come due without warning, and they spend inordinate time
and effort trying to find ways to finance commitments made years ago
but never adequately funded.

A current and striking example is the hundreds of billions of dollars that
Americans must pay for the savings and loan bailout. The total could
easily reach $500 billion! These costs were not incurred overnight but
grew over a period of years. Yet the liability became an overriding con-
cern only when the government began spending cash to resolve insol-
vent thrifts. A similar example is the practice of treating new loan
guarantees, now running at about $100 billion annually, as cost free
because they involve no cash outlays in the first year. In reality, they
could entail substantial future costs because of defaults.

Some progress has been made in recent years to correct these weak-
nesses in the budget. For example, pensions for military personnel are
now accrued in the budget, as are pensions for civilian employees hired
since 1984. However, the costs for many programs remain understated
in the current budget. Thus we recommend the adoption of full accrual
reporting as a necessary part (along with reported cash outlays and
receipts) of sound budgeting. The Congress and the President will con-
tinue to be faced with budget surprises in the absence of accrual
budgeting, which was recommended in 1955 by the second Hoover Com-
mission and in 1967 by the President’s Commission on Budget Concepts.

We strongly recommend that the budget process recognize the full costs
of programs when policy initiatives or events in the economy create the
likelihood or certainty of future program payments. This would include
estimating the expected losses on proposed direct loans, loan guaran-
tees, and insurance claims and obtaining appropriations to cover these
costs before program commitments are made. The administration, the
Senate and House Budget Committees, CBO, and GAO have all proposed
credit budgeting reform along these lines, and we recommend prompt
enactment of legislation to accomplish this reform.

The budget should also begin to accrue all retirement benefits earned by
military and civilian workers, including health benefits. Failure to
accrue these costs causes total operating expenses to be significantly


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                            understated. Similarly, recognizing budget costs for federal payroll and
                            similar liabilities as they are incurred would eliminate the incentive to
                            claim budget “savings” by shifting paydays from one fiscal year to
                            another. Using billions of dollars worth of agricultural payment-in-kind
                            certificates and similar credits in lieu of cash should also be included in
                            budgetary totals to close this emerging form of backdoor spending.

                            We recognize that full accrual budgeting cannot be implemented immedi-
                            ately because estimates of many of these accruals need to be developed.
                            However, accruals should be phased in as principles are adopted and
                            reliable data are generated. Until then, preliminary estimates should be
                            presented and discussed in supplementary budget materials.

                            In addition, the budget should include a broader statement of the gov-
                            ernment’s contingent liabilities that goes beyond data currently pro-
                            vided. It would also be useful to have a summary statement of unmet
                            needs that are not yet embodied in legislation or proposed in the budget
                            because of fiscal constraints.


                            The federal government’s adoption of a unified budget for fiscal year
Change the Unified          1969 marked a major advance in the way the government presented its
Budget                      budget plan and accounted for its revenues and expenditures. The need
                            for a unified budget remains as strong today as it was in 1969. This does
                            not mean, however, that there are no problems with the structure of the
                            current budget. There definitely are, as new policy and fiscal issues
                            have arisen that were not anticipated when the budget’s current struc-
                            ture was adopted 20 years ago. As explained below, the present budget
                            structure’s exclusive focus on a single, bottom-line cash deficit obscures
                            important differences among programs and makes it difficult for the
                            public and many officials to understand what is actually going on in the
                            government’s finances.


Major Problems in the       Since 1969, the budget’s annual surplus or deficit has reflected the com-
Unified Budget’s            bined results of trust and general revenues and expenditures. At the
                            time the unified budget was adopted, it was not anticipated that the
Treatment of Trust Fu.nds   trust funds would soon accumulate large annual surpluses, but that is
                            exactly what happened in the 1980s as a result of conscious policy
                            choices to build large reserves in the retirement programs, principally
             Y              Social Security and the pension plans for federal civilian and military
                            employees.



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                            As discussed in earlier sections of this report, the growth in trust fund
                            surpluses in recent years has masked the fact that the general fund def-
                            icit has also been growing. The focus on the unified budget deficit has
                            forestalled action to reduce the general fund deficit, thereby under-
                            mining the economic purpose for accumulating trust fund reserves.

                            A restructured budget with a separate trust fund section and subtotal
                            for the retirement trust funds (and other trust funds where reserves are
                            accumulated for liabilities to make future payments) would focus atten-
                            tion on the general fund deficit and be consistent with a strategy of
                            using the trust fund surpluses to restore domestic savings to more ade-
                            quate levels. The goal of that strategy should be to achieve over time an
                            approximate balance of revenues and expenditures in the general fund.


Serious Shortcomings in     The budget is not organized in a way that facilitates tailoring budgetary
the Unified Budget’s        decisions to the special needs of the government’s business-type entities.
                            These enterprises, such as the Postal Service and Tennessee Valley
Treatment of Enterprise     Authority with programs costing about $40 billion and $6 billion a year,
Programs                    respectively, have several characteristics which distinguish them from
                            other government activities. They

                          . sell a product or service to the general public,
                          . are established to be self-financed for the most part by fees paid by
                            users of the product or service, and
                          . have expenses which fluctuate with consumer demand.

                            If an enterprise-type activity is to operate successfully as a business, it
                            needs more flexibility than some government programs. For example, it
                            needs to be able to set its user fees to recover its operational costs. Also,
                            it must be able to make relatively independent investment decisions to
                            plan for and react to changes in consumer demand. While it would be
                            appropriate to treat enterprises differently than other programs, the
                            provisions of GRH and related budget legislation apply equally to enter-
                            prise investments and other government activities. Recently, for
                            example, the Postal Service was required to reduce the hours of window
                            service in local post offices in order to contribute to overall deficit
                            reduction efforts. Actions such as this one, if perpetuated, would be
                            counterproductive and undermine the Postal Service’s capacity to pro-
                            vide efficient service to the public, discourage patronage, and threaten
                            the Service’s ability to cover its costs.




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                          The problems discussed above partly explain the periodic efforts by the
                          Congress or the administration to remove federal programs like the
                          Postal Service from the budget. The incentives to remove these pro-
                          grams from the budget would be lessened by a restructured budget more
                          relevant to the government’s current and future needs. This is why we
                          also propose a budget with separate sections and subtotals for enter-
                          prise activities.


The Unified Budget Does   The focus on a single deficit total does not distinguish between operating
Not Handle Investment     deficits and capital financing requirements. This is misleading and has
                          resulted in an unsound GRH deficit reduction strategy which does not
Programs Properly         distinguish in its deficit goals between the $165 billion spent on capital
                          investments and the $1.2 trillion for operating expenses in fiscal year
                          1989. These two kinds of spending are not the same. Capital invest-
                          ments, unlike operating expenses, produce assets that generate future
                          streams of benefits to the government or economy. The benefits may be
                          in the form of cash, facilities that can be used over several years, or
                          other economic returns.

                          This federal budget focus on a single deficit total differs from that seen
                           in many states which practice capital budgeting. At least 37 states use a
                          capital budget, either as part of a comprehensive budget or as a separate
                           budget. Recognizing that capital investment is different from operating
                           expenses, most of the 34 states with balanced budget requirements
                          target those requirements only to their operating budgets. Debt
                           financing is used for their capital projects, subject to separate state debt
                           limits. Further, the states control their debt by requiring their annual
                           debt service costs to be included in the operating budgets and thus sub-
                          ject to balanced budget requirements.

                          The current budget also creates a budget bias against capital investment
                          programs. Because the budget does not annualize the costs of capital
                          projects, a proposed new investment appears more costly, on a yearly
                          basis, than it really is. Under the present budget rules, a $50 million
                          outlay to construct a hydroelectric plant (a capital investment) in a
                          given year contributes to the year’s deficit just as a $60 million outlay
                          for vehicle or airplane fuel costs (an operating expense) does. However,
                          the full $60 million in federal assets has not been used up. Only the cost
                          of using the hydroelectric plant for the year-$2 million if the plant has
                          a 25-year life -is a true cost for that year. This budget treatment often




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                                         leads to uneconomical decisions. For example, decisionmakers fre-
                                         quently decide to forgo the construction of a facility because of the siz-
                                         able, initial cash outlays that would be reflected in the budget and
                                         choose instead another option for space acquisition-leasing-with
                                         lower initial budget impact but higher long-term costs.

                                         The costs of direct loan programs (another type of capital investment)
                                         are also distorted because the budget does not reflect the fact that in
                                         making a loan, the government receives a financial asset and that at
                                         least a portion of the loan outlays will be repaid in the future. Under
                                         current budget treatment, a portfolio of $100 million in new direct loan
                                         outlays counts toward the deficit the same as $100 million in grants,
                                         even though some of the loans will be repaid in the future. This problem
                                         would be corrected by the credit budget reform legislation discussed ear-
                                         lier in this chapter.

                                         An argument can also be made for including expenditures for human
                                         development, such as education and training, in the definition of capital.
                                         However, substantial disagreement exists about the definition of human
                                         capital and how to depreciate these expenditures correctly. This issue
                                         needs to be dealt with and resolved before capital budgeting can be fully
                                         implemented. In the meantime, capital budgeting can be adopted in
                                         stages. A logical progression would be to first include financial capital
                                         (direct loans) in a capital budget and then expand the concept to cover
                                         physical and human capital as definitional questions are resolved. These
                                         delays should not, however, delay restructuring of the budget into gen-
                                         eral, trust, and enterprise components.

                                         Our proposal, therefore, also includes the notion of dividing the general,
                                         trust, and enterprise sections of a newly-restructured budget into oper-
                                         ating and capital parts. Table 9.1 shows fiscal year 1989 budget results
                                         restructured along these lines.

Table 9.1: Rertructured Federal Budget
for Fiscal Year 1989
                                         -Dollars in billions
                                         _,-._-                                          Total       General         Trusts          Enterprise
                                         Operating surplus/deficit(-)                  $-123           $-259           $142                  S-6
                                         Capital financing requirements                   -29             -25             0                   -4
                                         Unified budget financing requirements         $-152           $-284           $142                 $-10

                                         “The trust fund category includes only the trust funds in which revenues are earmarked to finance enti-
                                         tlement benefits. Other trust funds, in which revenues are earmarked to finance other activrties but
                                         spending is controlled by annual appropriations, are included in the general fund category along with
                                         other discretionary spending.




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                      The above framework could easily be adapted to incorporate as subcat-
                      egories the parts of any budget agreement between the executive and
                      legislative branches, such as defense, entitlements, and nondefense dis-
                      cretionary activities.


                      The reforms we have suggested in this chapter would not entail funda-
Other Matters for a   mental changes in institutional roles or raise constitutional questions.
Budget Commission     However, there are other proposals that would, namely proposals for a
                      balanced budget amendment to the Constitution or a line-item veto (or
                      enhanced rescission powers) for the President. We would strongly
                      advise against further action on such proposals until they have been
                      studied carefully by a high-level, bipartisan study group modeled on the
                      1967 President’s Commission on Budget Concepts. The implications of
                      such proposals are complex and imperfectly understood at this time,
                      and possible changes of this nature should be weighed carefully for their
                      long-term effects on our system of government.




                      Page 130                                      GAO/OCGSO-6   The Budget Deficit
l!k%ter Management of the Government
Is Essential

                           The changes in fiscal policy discussed in chapters 3 through 7 are logi-
                           cally complemented by the discussion of possible budget process
                           changes in chapters 8 and 9, In addition, however, we need better man-
                           agement of whatever resources are allocated to carry out functions in
                           the public sector.

                           Many Americans have come to believe that all that is necessary to elimi-
                           nate the deficit is more efficiency in managing government operations.
                           Improved efficiency alone is not the answer and, more often than not,
                           will also involve increased investment. However, improving manage-
                           ment of the government’s operations- including our $1.2 trillion annual
                           budget and our trillions of dollars in assets, revenues, and debt-can
                           make an important contribution toward reducing the deficit.

                           Tens of billions of dollars can be saved annually by heightening atten-
                           tion to controls, increasing the focus on longer term planning, and
                           improving the flow of management information. We have estimated that
                           in recent years, problems in these areas have had a cumulative cost of
                           between $100 and $200 billion, excluding losses associated with the sav-
                           ings and loan bailout. These problems also undermine confidence in the
                           government and fuel skepticism about legitimate needs to raise revenues
                           and make sacrifices for critical program expenditures.

                           Experience has demonstrated the difficulty of capturing increased effi-
                           ciency in the form of reduced spending. But that is not the only consid-
                           eration. Management improvements may free up resources to be used
                           for better purposes or may translate into better performance. Regard-
                           less of how they are eventually reflected in the budget, management
                           improvements are essential in an era of constrained resources.


                           Appointed public officials tend to be preoccupied with developing poli-
Inattention to             ties, not managing programs. Consequently, management controls often
Management Controls        are not in place or do not work properly. A few illustrations of the con-
Has Proven Extremely       sequences
                                 follow.
Costly                 l Over $34 billion of DOD’S $100 billion in inventories is unneeded. Elimi-
                         nation of this unneeded inventory through better systems and controls
                         would reduce carrying costs (obsolescence, warehousing, and interest)
                         alone by several billion dollars per year.
                       . Over $100 billion is expected to be paid out in fiscal year 1990 to over
                         33 million Medicare beneficiaries. Cutbacks in payment safeguards and



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                          claims processing activities could result in over $1 billion in erroneous
                          benefit payments.
                        . Problems in managing accounts receivable recorded by IRS in excess of
                          $60 billion place IRS in the forefront of agencies needing improved sys-
                          tems. Better management systems could speed up the resolution of dis-
                          puted collections in past due accounts.

                            The 1982 Federal Managers’ Financial Integrity Act was supposed to be
                            a key management tool for uncovering and dealing with such weak-
                            nesses. The act requires heads of federal agencies to annually assess
                            controls over their operations and provide reports to the President and
                            the Congress on actions taken to correct major problems. This law has
                            stimulated some agency improvements, primarily in identifying
                            problems areas, but our reports have shown that efforts to date clearly
                            have not produced the results intended by the Congress.’ Critical
                            problems remain and more concerted effort is needed by the executive
                            branch to implement the act. To help foster such actions, we have
                            undertaken a special effort targeted at 14 of over 100 high-risk areas
                            most likely to result in large losses and unnecessary costs.


                            Federal leaders make too many decisions without adequate information
Approach to Decision-       and without an understanding of long-term implications. This sometimes
making Does Not Lead        results in poor decisions which cost the nation much more than
to Efficient Use of         necessary.
Resources                   Several recent catastrophes and lingering dilemmas underscore the
                            serious consequences of this approach to decision-making.

                        . One cause of the savings and loan debacle was the government’s failure,
                          in deregulating the industry, to require proper accounting by the thrifts
                          and to invest in adequate supervision over the industry’s greater lending
                          latitude.
                        . A long-standing emphasis on production over maintenance has contrib-
                          uted to severe operational and related environmental problems in the
                          country’s nuclear weapons complex. Fixing this problem is estimated to
                          cost over $100 billion over the life of the effort,
                        l DOD’S 5-year defense plan is still not linked to budget plans. This discon-
                          tinuity leads to inefficiencies and wasted efforts.


                            ’ Financial Integrity Act: Inadequate Controls Result in Ineffective Federal Programs and Hillions in
                            Losses(GAO/AFMD-90-10, November 28, 1989).



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                           Chapter 10
                           Better Management   of the Govemment
                           Is Essential




                           The government’s ability to address its management control needs and
Information Is a Key       make informed decisions is constrained by a lack of reliable, timely data.
Factor                     Examples include the following:

                       . The fact that the government had over $5 trillion in exposure on loans,
                         insurance, and other risk-related programs came as a surprise to many
                         top federal officials, despite the fact that data related to this exposure
                         have been included in supplemental budget materials for many years.
                         Governmentwide accounting and its integration into policy-making for
                         contingent liabilities of all sorts are still inadequate.
                       l Only about one third of government outlays are covered in audited
                         financial statements. Audits show that agencies often report informa-
                         tion which is materially inaccurate. For example, Air Force reports to
                         OMB and Treasury have contained tens of billions of dollars in
                         inaccuracies.
                       l Accounting systems in government agencies do not provide adequate
                         information necessary for efficient day-to-day management; for
                         example, effective cost accounting systems do not exist.


                           The government has had a variety of programs, initiatives, and other
Major Improvements         endeavors to improve federal management controls, planning efforts,
in Federal                 and accounting systems. However, these efforts have a long way to go
Management Are             before they are effective, and additional initiatives are needed. The
                           problems mentioned here continue to impact a broad range of govern-
Needed                     ment programs and operations and touch every major federal agency.

                           Better management of the government is potentially a part of deficit
                           reduction-it   can reduce the baseline deficit by reducing unnecessary
                           costs and losses now reflected therein. For example, carrying costs of
                           unneeded inventories can be taken out of the DOD segment of the base-
                           line without affecting programs. More importantly, better management
                           can help prevent future increases in the baseline by avoiding the repeti-
                           tion of savings and loan type problems. Without needed management
                           improvements, there is a real possibility of having to adopt even more
                           revenue increases or cost reduction measures to achieve the targeted
                           budget surplus because of unknown future events and costs.

                           Better management in the government, however, will require an
                           improved workforce, institutional change, intensified oversight on the
                           part of OMB and the Congress, and better long-range planning.




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Is Essential




Ways must be found to provide the compensation necessary to attract
the highly skilled technical people needed to supervise systems improve-
ment projects and scientific initiatives. In some areas, government
training efforts are woefully deficient. More skilled people at all levels
are needed to improve controls, planning and information.

Institutional changes in the approach to federal management, especially
in the financial management arena, will be required to sustain the atten-
tion and continuity of effort necessary to achieve better controls and
systems in government programs. For example, the federal government
does not have a legislatively established chief financial officer (cm).

We urge the Congress to enact legislation to

establish a chief financial officer structure for the federal government,
with a CFOfor the United States, counterpart CFOSin each of the major
agencies, and supporting personnel to provide continuity when political
leadership changes; and
require the annual preparation and audit of agency financial statements
and an oversight report to the President and the Congress containing the
annual financial statements, audit report, evaluations of controls and
agency compliance with laws and regulations, a summary of the Finan-
cial Integrity Act report including corrective actions taken, and other
information concerning an agency’s financial management.

A legislatively mandated CFOwould be responsible for developing and
implementing a long-range governmentwide financial management
improvement plan which would address both systems and controls. A
CFOstructure of the kind recommended would help give financial man-
agement the prominence, permanence, and continuity necessary to
achieve reform and enable the government to better manage its financial
affairs.

Requiring the annual preparation and audit of agency financial state-
ments is another essential part of the solution. We find major problems
with the accuracy of the financial information and supporting systems
whenever financial audits of federal agencies are performed. For
example, an audit of the Federal Housing Administration’s fiscal year
1988 financial statements showed a loss of about $4.2 billion which was
almost five times the amount the agency initially reported. What does
that say about its systems and controls?




Page 134                                       GAO/ocG-gO-6   The Budget Deficit




                                                                         ’ 9‘
.
    chapter 10
    Better Management   of the Government
    Is Jksential




    Preparing auditable financial statements demonstrates that an organiza-
    tion’s financial systems and personnel are capable of accumulating, ana-
    lyzing, summarizing, and reporting on its financial condition and
    operating results. An inability to do that means there are serious weak-
    nesses in the organization’s systems and controls. The knowledge of
    problems is an essential prerequisite to solving them.

    OMB  can improve agency response to needed improvements in systems
    and controls by linking the Financial Integrity Act internal control
    review process to the budget. We also believe that the Congress, through
    its committees, should hold annual hearings using the oversight report
    as the focal point in the process of reviewing agency actions to correct
    control and systems weaknesses. The Congress, through such hearings,
    could insure that proper corrective measures are actually implemented.

    Finally, substantial improvements in government long-range planning
    are also needed to manage the deficit reduction plan suggested in this
    report. The Congress and the administration must have an improved
    ability to see ahead. Financial management improvements we have
    sought, including reliable financial statements, will provide the essential
    historical and factual information for this planning process that is not
    now available. The agencies’ ability to look ahead, as well as OMB budget
    planning, is hampered by the lack of reliable and comprehensive data on
    costs, commitments, and contingencies. More emphasis on the long range
    planning process by government managers is also needed. The difficul-
    ties in estimating the future costs of the savings and loan crisis are but
    one example our nation’s inadequate planning efforts, just as the very
    existence of that crisis exemplifies inadequate governmental policy-
    making and management.




    Page 135                                        GAO/OCG90-5   The Budget Deficit
Appendix

L&ters From Congressional Requesters


Letter From Senators
Exon and Orassley




                                                       WASHINGTON,     DC 205 1 O-2702


                                                                     May 22,      1980



                       Charles A. Bowsher
                       Comptroller  General of the United             States
                       General Accounting   Office
                       441 G Street
                       Washington,  DC 20548
                       Dear Mr. Bowsher:
                             We are increasingly      concerned    about the implications      of the
                       budget deficit.       It is essential     that Congress and the President
                       reach agreement on an appropriate           long-term  fiscal    policy  for the
                       nation   and that we put the budget on a sustainable             path toward
                       that goal.      Because of our concern,        which we know you share, we
                       would like    to enlist     the resources     of the General Accounting
                       Office   in an effort     to lay out the key choices        for Congress and
                       the American people.
                            We are asking for this assistance        not only because of the
                       GAO's well-established       reputation  for integrity     and objectivity,
                       but also because of its extensive        knowl'edge,   gained through many
                       years of audits      and evaluations,   of the details     of the programs
                       and policies    that must be changed if we are to put our financial
                       house in order.
                           We ask your     advice   and analysis         in the          following    areas:
                           1. What is your best estimate   of the debt and current
                           path of the deficit absent aggressive  efforts to reduce                            the
                           deficit?
                            2. What should be our long-term               budget goal?  That is, should
                            we aim for balance in the unified              budget or for some other
                            target?
                            3. How rapidly      should we seek to reach that goal, considering
                            the potential    effects   of deficit reduction on the economy and
                            a realistic   assessment of the speed with which federal
                            programs can adapt to changes in available      budgetary
                            resources?
                            4. How should we judge the relative   merits of increased                           taxes
                            and reduced spending as ways to reduce the deficit?




                              Page 136                                                         GAO/GCG-90-5The Budget Deficit
Charles Bowsher
May 22, 1990
page two

     5. How should we deal with unavoidable,         but so far unfunded
     costs (such as those associated     with the savings       and loan
     situation),     and other pressures to increase     spending    in
     response to unmet needs that you have identified           in recent
     reports     and testimony?
     6. Are there any areas of deficit   reduction   which the
     Congress and the President have overlooked    which could provide
     signif icant savings?
     7. What is the range of choices                we should consider         in seeking
     to achieve     an appropriate         rate of progress        in reducing    the
     deficit?    Please identify           several    alternative     deficit
     reduction    strategies,        including     one showing how we could cut
     spending enough to achieve an appropriate                    pace of deficit
     reduction   without      additional       taxes,     and others    showing how the
     picture   changes with various            forms and levels       of additional
     taxation.
     8. How should the presentation             of the budget be changed to
     convey the problems and choices            better to Congress and the
     taxpayer?
     9. What other changes in budget concepts            and practices    are
     needed if we are to put the budget on the appropriate             track
     and keep it there?        Please discuss   reform of the budget
     treatment    of credit    programs and suggest any incentives        that
     might encourage     the collection     of debts owed the government
     and the disposal       of unneeded assets,    while at the same time
     avoiding   the risk of improper manipulation         oL budget
     estimates.
      We recognize    that the development     of revenue and outlay
estimates    needed for various       parts of the analysis      would be
greatly   helped by assistance        from the Congressional      Budget Office
and the staff      of the Joint     Committee on Taxation.       Accordingly,      by
copy of this letter,       we are requesting    Director     Reischauer     of CBO
and Chief of Staff       Pearlman of the Joint     Committee to provide         you
such assistance      as you may need, to the extent        feasible     consistent
with their    other responsibilities.
      Anticipating      that Congress will      be concentrating       on the budget
in September,        we would appreciate      a report    on these issues,
including       such recommendations      as you may deem appropriate,           that
would be available         when Congress returns       from the August       recess.
We have no objection          to your sharing    with others,       on an informal
basis,     information     developed   in response to this request as the
work proceeds        and to your making the report         publicly    available
immediately        upon delivery    to us.




       Page 137                                                GAO/OCG-!40-5 The Budget Deficit
                                                                                         .



                4.wndix
                Lettens From Congressional Requesters




I




          Charles  Bowsher
          May 22,  1990
          page three

                This    request    has been the subject       of discussions     between
          Assistant       Comptroller   General Harry Eavens and other members of
         _ltoUK      aff and .Mr. Christopher       McLean    of Senator Exon’s staff       and
    /hisF Mr.--%3 im’Kolesnik      of Senator Grassley’s        staff.    Please  contact   Mr.
             McLean  or Mr. Kolesnik     if further     discussions     are necessary     and to
             keep us advised of progress        in the work.
                Thank you for     your   assistance.




                Page 138                                             GAO/OCGSO-5   The Budget Deficit
                      An-~
                      Lettere From C4mgressionaJRequestms




Letter From Senator
Moynlhan




                             Dear Mr.    Bowsher:
                                I have learned of the study that Senators
                             Exon and Grassley    have requested     you to
                             perform concerning    the outlook    for the budget
                             deficit,  the fiscal    policy  that the nation
                             should be pursuing,     and the options    to get us
                             there.
                                As you know, I am much concerned           about these
                             issues.      And, because of my responsibilities
                             as chai,rman of the Subcommittee           on Social
                             Security     and Family Policy     of the Senate
                             Committee on Finance,       I have had a particular
                             concern about the misuse of the Social
                             Security     Trust Funds.     Accordingly,     I would
                             like to join in requesting         the study proposed
                             by Senator Exon and Grassley.            I also will
                             support    their    request to Ron Pearlman of the
                             Joint    Committee on Taxation       for such
                             assistance       as you may need.
                                Let me know how else        to support   your
                             efforts.
                                                    Sincerely,



                             The Honorable   Charles Bowsher
                             General Accounting     Office
                             Washington,   DC 20548




                      Page 139                                             GAO/OCGQO-IS The Budget Deflclt
                                      Appendix
                                      Letters    From Cougressional    Requestora




Letter From Senator
Bradley

                      BILL BRADLEY
                       NEW   JERSW




                                                                      %Mtalj5tates$3mte
                                                                             WASHINGTON, DC 206 10


                                                                            July    24,   1990




                                     The Honorable
                                     Charles A. Bowsher
                                     Comptroller   General of the United                   States
                                     General Accounting    Office
                                     Washington,   D.C.   20548

                                     Dear       Mr.   Bowsher:    ih      Kmsk
                                             I have learned of             the study that Senators        Exon and
                                     Grassley    have requested              you to perform concerning        the outlook
                                     for the federal     budget            deficit,   the appropriate      fiscal  policy
                                     that the Nation should                be pursuing,    and alternative
                                     strategies    for moving            toward that goal.
                                            As you know from our private            conversations,        I am deeply
                                     concerned       about these issues because of their             implications
                                     for the future          of our Nation's    economy.      In addition,       of
                                     course,      these matters       have an important     bearing     on my
                                     responsibilities          as a member of the Senate Committee on
                                     Finance.        Accordingly,       I would like to join in requesting           the
                                     study proposed by Senators             Exon and Grassely.         I also endorse
                                     their    request      to Chief of Staff Pearlman of the Joint
                                     Committee on Taxation            that the staff    of the Joint       Committee
                                     provide      such assistance        as you may need, to the extent
                                     feasible       consistent     with their   other responsibilities.
                                           I would like.to             be kept informed  of the                progress   of the
                                     at*udy and to receive             a copy of the resulting                 report   as soon
                                     as it is available.
                                                                                                     Sincerely,



                                                                                                 I
                                                                                               '     Bill      Bradley         u

                                     BB/kaa




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