oversight

Federal Budget: The President's Midsession Review

Published by the Government Accountability Office on 1999-07-27.

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

                United States General Accounting Office

GAO             Observations
                Of David M. Walker
                Comptroller General of the United States




                FEDERAL BUDGET

                The President’s
                Midsession Review




                This statement was originally prepared in anticipation of a hearing
                before the Senate Budget Committee, July 21, 1999.




GAO/OCG-99-29
        This statement discusses the President’s Midsession Review and the
        implications of the President’s proposals on fiscal policy and the federal
        budget. The press has focused on the fact that both OMB and CBO have
        revised upward their projections for the unified budget surplus. The
        phrase “$1 trillion more” has been widely reported in the media. Further,
        these new projections show an on-budget surplus throughout the next
        10-15 years.

        An earlier-than-expected and larger-than-expected surplus is only good
        news for the future health of our economy—if two conditions are met.
        First, the surplus must be realized. Second, the surplus must be put to
        prudent use. To the extent that the surplus is used for debt reduction, it
        offers the benefit of lower interest costs. And the miracle of compound
        interest means that savings in today’s interest payments will yield benefits
        tomorrow.

        The surplus we celebrate today came about not only through
        stronger-than-expected economic growth but also as the result of some
        difficult policy choices you and the President made over the past years.
        Now, after the recent years of tight discipline and focus on fiscal
        responsibility, the surplus offers a chance to debate the relative merits of
        different priorities. Should some of the surplus be used to meet pent-up
        demand for spending in certain domestic discretionary areas? For an
        increase in defense spending? For tax cuts? To secure existing unfunded
        entitlement promises? For debt reduction? For a combination of all of
        these? Most would not argue for devoting 100 percent of the surplus to
        debt reduction over the next 10 years. However, unless a good portion of
        the surplus is saved, it will not be used to redeem debt, and we will lose a
        portion of the interest savings. And it is critical to save a good deal of the
        surplus because known demographic trends require that we hand the next
        generation a stronger economy and a lower debt burden.

        A Federal Reserve Board chairman once described his job as to “take away
        the punch bowl when the party was just getting going.” My job as
        Comptroller General of the United States, I believe, is to serve as an
        accountability cop at the surplus celebration party and to offer a note of
        caution about how we deal with this welcome shift from an environment of
        persistent deficits to one of projected large surpluses.




Leter   Page 1                                                           GAO/OCG-99-29
                     There are several reasons to be prudent:

                     1. These large on-budget surpluses are still projections, and the history of
                     budget projections—especially over a long period—should give us pause
                     about making large and long-lasting commitments that consume the
                     surplus. Even in the near term these projections are optimistic and may not
                     be realized since, among other things, they assume full compliance with
                     existing tight caps on discretionary spending. Further, the fact that even
                     given these assumptions a little over half of the surplus occurs 11-15 years
                     from now should make us even more cautious about committing these
                     surpluses for permanent changes on either the revenue or the spending
                     side.

                     2. We enter this surplus period with a large debt built up from years of
                     running deficits. Deficits are an indication that the American people are
                     getting more government benefits and services than they are paying for.
                     Just as families that have built up debt during years in which expenses
                     exceeded income use newfound income to reduce that debt, so the federal
                     government might think about using surplus to reduce its debt. This is
                     especially important given known demographic trends whereby fewer and
                     fewer workers will be supporting a growing retired population for longer
                     periods of time.

                     3. In addition—and this makes the previous point even more salient—we
                     face looming cost pressures over the next decades which will lead to a
                     significant decline in budgetary flexibility unless current policies are
                     changed. Absent any changes in Social Security, Medicare, and Medicaid,
                     the budget will increasingly be absorbed by payments to the retired—
                     making it more difficult to meet other priorities. In addition, Social
                     Security and Medicare are not the only cost pressures on the horizon. Bills
                     will also come due for a variety of other commitments and contingencies
                     such as cleanup costs from federal operations known to result in hazardous
                     waste, including defense facilities and weapon systems, and federal
                     insurance programs.

                     The following discusses each of these in turn and then moves on to discuss
                     briefly the President’s proposals.



Projections Are      The history of budget forecasts should remind us not to be complacent
                     about the certainty of these large projected surpluses and make us cautious
Uncertain            about committing them to large permanent tax cuts or spending increases.



             Leter   Page 2                                                         GAO/OCG-99-29
In a recent outlook book, CBO compared the actual deficits or surpluses
for 1988 through 1998 with the first projection it had produced 5 years
before the start of each fiscal year. Excluding the estimated impact of
legislation, CBO says its errors averaged about 13 percent of actual outlays.
Such a shift in 2004, for example, would mean a potential swing of about
$250 billion in the surplus.

It is important to remember that it was not so long ago that forecasts were
for “deficits as far as the eye can see.” Today we are pleasantly surprised
by upward revisions in surplus estimates. Yet only a decade ago we were
being unpleasantly surprised by upward revisions in deficit estimates. I
note this not to raise questions about either OMB or CBO analysis but
rather to remind us all about the inherent uncertainty of projections.

All projections are heavily dependent on assumptions that, while
reasonable, may still not hold. And in a budget of nearly two trillion dollars
a year, the smallest change in one assumption can lead to very large
changes in the fiscal outlook—especially when carried out over a decade.
Indeed, the dramatic increase in surplus projections between this past
winter and this summer are the result of very small changes in economic
assumptions.

But it is not just uncertainty about the economy that should give pause
about these projections. Both CBO and OMB use what is called the
“capped baseline.” That is, they assume that total discretionary spending—
including defense and emergencies—remains within the legislated caps for
fiscal years 2000, 2001, and 2002.1 After fiscal year 2002, the projections
assume that discretionary spending grows only with inflation. Under this
assumption, total discretionary spending over the next 10 years would be
reduced by $595 billion below the fiscal year 1999 levels of nonemergency
discretionary spending adjusted for inflation over the same 10-year period.2
Although this is the only assumption that CBO and OMB appropriately can
make in projections, a look at recent history makes it unlikely. It is much
more likely that there will be some spending increases, and if discretionary
spending exceeds these levels—either because of emergencies or because
of an agreement to raise the caps—the surplus, and hence the interest



1
 OMB actually assumes that discretionary expenditures exceed the caps, but OMB also assumes offsets
for those expenditures—thus the analytic point holds.
2
 This calculation is based on CBO projections.




Page 3                                                                            GAO/OCG-99-29
                        savings, will be smaller. Some would also argue that projected periods of
                        surplus would prompt a tax cut, and that, too, would shrink the surplus.

                        The further out the projection the more uncertain it is. Given that, it is
                        worth noting that a little more than half the surplus projected by OMB
                        comes in years 11-15 of the projection period. This has real significance
                        for the policy debate: Making large long-term commitments on either the
                        tax or spending side of the budget is very risky.



Surpluses Follow Debt   We need to view these surpluses not in a vacuum but in the context of
                        where we’ve been. Figure 1 below shows the deficit or surplus as a share
Buildup                 of the economy since 1797.



                        Figure 1: Deficit/Surplus as a Share of GNP/GDP
                                                10


                                                    5
                        Percent of G NP/G DP




                                                    0


                                                -5


                                               - 10


                                               - 15


                                               - 20


                                               - 25


                                               - 30
                                                97




                                                               17




                                                                           37
                                                         07




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                                               17

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                                                                                                              F iscal Y ear

                        Note: Data until 1940 are shown as a percent of gross national product (GNP); data from 1940 to
                        present are shown as a percent of gross domestic product (GDP).


                        Traditionally, in the United States, periods of high deficits and debt buildup
                        have tracked recessions or wars and have been followed by periods of
                        shrinking debt—usually from a combination of fiscal restraint and
                        economic growth. According to CBO’s baseline budget projections—which
                        assume compliance with the discretionary caps—even after 2 years of




                        Page 4                                                                                                                               GAO/OCG-99-29
                        budgetary surplus, debt held by the public stands at about 40 percent of
                        GDP, a level that the United States rarely reached before 1940.

                        This debt is the result both of previous economic slowdowns and of the
                        structural imbalance between spending and revenues over the last 29 years.
                        For 29 years, the U.S. government took in less in taxes than it spent; the
                        difference was made up by borrowing from the public.

                        Now we face the happy reverse—but because of the previous deficits we
                        enter this surplus period with this overhang of debt. If the surplus were to
                        be used entirely for spending increases or tax cuts, the budget might be in
                        balance on an annual basis, but we would have done nothing to make up
                        for the years of deficit spending—and we would have done nothing to
                        remove the burden of the debt from future generations. Importantly, our
                        demographic situation is far different now than during previous times when
                        we emerged from prolonged periods of deficits. Longer life expectancy, the
                        aging baby boom generation, and a relatively smaller working population
                        means demographic trends will be working against rather than for the
                        financial condition of the Social Security and Medicare programs.

                        This debt issue is especially salient given the third reason for prudence: the
                        looming cost pressures that face the nation and their implication for budget
                        flexibility.



Looming Cost            Nothing in either the OMB or the CBO midsession update changes the fact
                        that our society is aging and the obligations relating to my generation, the
Pressures and Reduced   baby boom generation, will begin coming due in the not-too-distant future.
Budgetary Flexibility   Further, increasingly people live a long time in retirement. In addition,
                        Medicare and other health care costs historically have outpaced inflation.
                        What I said in February remains true today, “We face a demographic
                        tsunami in the future that poses significant challenges for the Social
                        Security system, Medicare, and our economy as a whole.”3

                        Over the next several decades the United States will experience an
                        unprecedented shift in our demographic profile, and this shift will have
                        consequences not only for Social Security and Medicare expenditures but
                        also for the rest of the federal budget and economic growth. Less than


                        3
                          Social Security and Surpluses: GAO’s Perspective on the President’s Proposals
                        (GAO/T-AIMD/HEHS-99-95, February 23, 1999).




                        Page 5                                                                            GAO/OCG-99-29
10 years from now the first baby boomers will be eligible for early
retirement benefits, and—with increasing life expectancy—they will
expect to live a long time in retirement. The oldest of this generation will
reach early retirement age (62) in 2008, and the youngest will reach it in
2026. As the baby boom generation retires, labor force growth is expected
to slow considerably and eventually stop altogether. This demographic
shift is expected to cause a decline in economic growth rates as growth in
total hours worked disappears. As the labor force growth stagnates, labor
productivity will become even more important to economic growth.
Without a major increase in productivity, low labor force growth will
inevitably lead to slower growth in the economy and slower growth of
federal revenues. This slower revenue growth will come at the same time
that a large retired population will place major expenditure demands on
federal programs for the elderly.

GAO’s updated model results continue to show that even if the total surplus
is saved and the budget caps adhered to, these changing demographics
referred to above will—if all assumptions hold—inevitably lead to renewed
deficits and growing debt, absent a change in fiscal policy. These deficits
will result primarily from the combined spending pressures of Social
Security, Medicare, and Medicaid. As more and more of the baby boom
generation retires, these pressures will fuel new deficits—even if we save
the whole surplus—and the nation will once more find itself in the vicious
circle of escalating deficits, debt, and interest costs.

This longer-term problem of re-emerging deficits provides the critical
backdrop for any permanent changes in tax or spending. Absent changes in
current fiscal policy—and even assuming the spending caps are adhered to,
and all surpluses are saved and devoted to debt reduction—spending for
Social Security, health, and interest alone would absorb a little over half of
all federal revenues by 2018. By 2066, this spending would consume the
entire federal budget. Budgetary flexibility declines drastically, and there is
increasingly little to no room for programs for national defense, the young,
infrastructure, and law enforcement—i.e., essentially no discretionary
programs at all. Figure 2, below, illustrates these trends.




Page 6                                                           GAO/OCG-99-29
Figure 2: Composition of Spending as a Share of GDP Under “Save the Unified
Surplus” Simulation
                      6 0%


                      5 0%
P erc ent o f G D P




                      4 0%


                      3 0%      Revenue


                      2 0%


                      1 0%



                       0%
                               1 998                         203 0*                         205 0                           2 070


                             S o c ia l S e c u rity   M e d ic a re & M e d ic a id   N e t In te re s t   A ll o th e r s p e n d in g


*In 2030, all other spending includes offsetting interest receipts.


Unimaginable as this picture is, as figure 3 below shows, it becomes even
more dramatic if we assume the entire surplus is used—and none of it is
saved. In that scenario, lower GDP and higher interest payments lead to a
world in which revenues cover little beyond Social Security, health and
interest payments in 2030 —and by 2050 revenues don’t even cover those!




Page 7                                                                                                                     GAO/OCG-99-29
Figure 3: Composition of Spending as a Share of GDP Under “No Unified Surplus”
Simulation
                        60%



                        50%
P e rc e nt o f G D P




                        40%



                        30%       Revenue


                        20%



                        10%



                        0%
                                1998                            20 3 0                         20 5 0


                              S o c ia l S e c u r ity   M e d ic a r e & M e d ic a id   N e t In te r e s t   A ll o th e r s p e n d in g




Although views about the role of government differ, it seems unlikely that
many would advocate a government devoted solely to sending checks and
health care reimbursements on behalf of the elderly.

Therefore, under any fiscal and economic scenario, reforms reducing the
future growth paths of Social Security, Medicare, and Medicaid are vital to
restoring fiscal flexibility for taxpayers of the future. Early action yields
great returns—the miracle of compounding again. Figure 4 below
illustrates this for Medicare.




Page 8                                                                                                                     GAO/OCG-99-29
                      Figure 4: Federal Deficits as a Share of GDP Under Alternate Medicare Simulations
                                       20



                                       15
                      Percent of GDP




                                       10



                                       5



                                       0



                                       -5
                                            1998   2010        2020         2030             2040      2050          2060     2070

                                                   No action          Action taken in 2002          Action taken in 2012



                      Figure 4 also shows that although reducing debt helps, debt reduction
                      alone is not enough. Even if we were to save the entire surplus, entitlement
                      reform would still be necessary. This is even clearer when we realize that
                      Social Security and Medicare are not the only long-term cost pressures
                      facing us. Federal commitments such as those for insurance, Medicaid,
                      and environmental liabilities for the Departments of Energy and Defense
                      cleanup will also likely result in large costs that encumber future fiscal
                      resources and constrain future financial flexibility to meet emerging needs.



Midsession Policies   Overall the President proposes to reduce debt held by the public by more
                      than he did in his February budget. He also proposes to spend more in
                      several areas. The big items in the budget, however, remain Social Security
                      and Medicare. There is still a need for fundamental reform of these
                      programs to assure their long-range solvency and sustainability.

                      The President has changed the form of his Social Security proposal.
                      Instead of transferring to the Social Security Trust Fund additional
                      Treasury securities equal to a share of the unified surplus, the President
                      proposes to use the Social Security surplus to reduce debt held by the
                      public and then—beginning in 2011—to transfer to the Trust Fund
                      securities equal to the “fiscal dividend”—i.e., interest savings—that results
                      from lower publicly held debt. The Social Security Trust Fund already



                      Page 9                                                                                         GAO/OCG-99-29
earns interest on its surplus. Under the new proposal it will receive, in
effect, a second interest payment equal to interest savings that result from
paying down publicly held debt. This is simply a general fund transfer
pegged to the interest saving. Unlike the February proposal, the general
fund transfer does not start until 2011. However, this general fund transfer
is open-ended in duration.

The policy in the Midsession Review envisions more debt reduction than
that in the President’s February budget. Under his most recent proposals,
the entire Social Security surplus goes to debt reduction. The President
projects that his proposals would reduce debt held by the public by
$3.6 trillion over the next 15 years, virtually eliminating publicly held debt
by 2015. Almost two-thirds of projected unified budget surpluses would be
used to reduce the debt through lockbox provisions dedicating all of Social
Security’s surpluses and about a quarter of the on-budget surplus
transferred to Medicare for debt reduction.

The debt reduction proposed by the President—although less than the
baseline, which assumes that all surpluses would be saved—would confer
significant short- and long-term benefits to the budget and the economy.
GAO’s work on long-term budget outlooks illustrates the benefits of
maintaining surpluses for debt reduction. Interest on the debt today
represents the third largest program in the federal budget. Reducing the
publicly held debt reduces these costs, freeing up budgetary resources for
other programmatic priorities. Under the President’s plan, if all
assumptions hold, interest would fall from $229 billion in 1999 to about
$10 billion by 2014. For the economy, running surpluses and reducing debt
increases national saving and frees up resources for private investment.
This in turn leads to stronger economic growth and higher incomes over
the long term.

Over the last several years, our simulations have illustrated the long-term
economic consequences flowing from different fiscal policy paths. Our
models consistently show that any path saving all or a major share of
projected budget surpluses ultimately leads to demonstrable gains in GDP
per capita over a 50-year period. GDP per capita would more than double
from present levels by saving most or all of projected surpluses, while
incomes in the simulation actually fall during this period if we failed to
sustain any of the surplus. Although rising living standards are always
important, they are especially critical for the 21st century, for they can
increase the economic capacity of the projected smaller workforce to




Page 10                                                         GAO/OCG-99-29
maintain a good standard of living as well as to finance future government
programs and the commitments for the baby boomers’ retirement.

While the President is to be commended for the amount of debt reduction, I
remain concerned about the consequences for trust fund financing and
reform. It is fair to note that nothing in his midsession proposal changes
the fundamental structural imbalance in Social Security. The system’s cash
flow still turns negative in 2014 and Social Security becomes a draw on the
general fund. When federal deficits re-emerge, however, baby boomers will
still be retiring with long expected lifespans in retirement. If the
President’s proposal to transfer interest savings to the Social Security Trust
Fund is adopted, the Trust Fund solvency on paper is extended, but the
structural imbalance will remain. The new securities will be redeemed and
constitute a new claim on the general fund until they run out in 2053.4
Absent substantive program reform, our children will be saddled with a
budget heavily burdened by commitments to fund entitlement programs for
the elderly.

At heart the President’s Social Security reform proposal is a combination of
debt reduction and a general fund transfer. As I have said before, I believe
there are legitimate arguments on both sides of the question of bringing
some general fund financing to Social Security—but the issue should be
debated openly and on its merits.

Medicare is a more complicated story. Under the President’s proposal
some of the on-budget surplus would be transferred to Medicare, invested
in federal Treasuries and so used to reduce publicly held debt. As with
Social Security, this formalizes a new claim on general fund revenues for
the Hospital Insurance Trust Fund. The President also proposes to add a
new benefit, namely a prescription drug benefit that is only partially funded
by premiums. At the same time, the long-term cost pressures facing this
program remain. Fundamental program reforms to reduce the future
growth of the Medicare program are critical both to budget flexibility in the
future and to any attempt to modernize and upgrade the benefit package.

The President’s proposal to grant additional securities—both to Medicare
and in the interest transfer to Social Security—creates the risk of reducing
transparency about the underlying financial condition of these trust funds.
In fact, the transfers would interfere with the vital signaling function that


4
 According to a White House press release dated June 28, 1999.




Page 11                                                          GAO/OCG-99-29
                       trust fund mechanisms can provide for policy makers about underlying
                       fiscal imbalances in covered programs. The greatest risk is that these
                       transfers could induce an unwarranted complacency about the financial
                       health of these programs. From a macro perspective, the critical question
                       is not how much a trust fund has in assets—or solvency—but whether the
                       government as a whole has the economic capacity to finance the trust
                       fund’s claims to pay benefits now and in the future—namely, sustainability.



Concluding             After some years of restraint and difficult policy choices, the goal of budget
                       balance has been achieved. Now the Congress and the President face a
Observations           series of decisions that will have a major impact on the economic future of
                       the nation.

                       I believe the first issue is how much of the current and projected surpluses
                       should be used for debt reduction. We come to these surpluses with a high
                       level of debt built up from years of deficits. Devoting a significant portion
                       of the surplus to reducing that debt would yield benefits in terms of lower
                       interest costs and greater future economic capacity.

                       Few would expect the entire projected surplus to go to debt reduction.
                       Therefore, decisions must be made about how to use some portion of the
                       surplus to respond to those demands that have had to be held in abeyance
                       during the effort to reach budget balance: How should these funds be
                       allocated for spending or tax cuts? The critical decision is how to strike a
                       balance between today’s needs and addressing tomorrow’s challenges.

                       Finally, the surplus presents both opportunity and obligation. The new
                       surplus projections offer an opportunity to address today’s needs, but we
                       should not forget our obligation to build for the future. Every generation is
                       in part responsible for the world it passes on to the next. That
                       responsibility may be especially great for us given the burden the aging of
                       our society and declining worker-to-retiree ratios will place on society and
                       the economy. We have a stewardship responsibility to reduce the debt
                       burden we leave, to provide a strong foundation for future economic
                       growth, and to ensure that our future commitments are both adequate and
                       affordable. Common sense tells us that it is better to make the tough
                       choices today while we have a healthy economy, sufficient resources to
                       meet some current needs while still building for the future, and a relatively
                       large cohort of workers. National saving pays future dividends—but we
                       need to begin soon to permit compounding to work for us. In addition, we
                       have an obligation to get on with meaningful reform of the Social Security



               Leter   Page 12                                                         GAO/OCG-99-29
                   and Medicare programs in order to make them both affordable and
                   sustainable for the future. Finally, we should avoid attempts to create new
                   unfunded promises before we have made significant progress on
                   addressing current funding gaps.



Contact and        For information about this product, please contact Susan Irving at (202)
                   512-9142 or by e-mail at irvings.aimd@gao.gov or Paul L. Posner at (202)
Acknowledgements   512-9573 or by e-mail at posnerp.aimd@gao.gov.


                    This statement was originally prepared in anticipation of a hearing
                    before the Senate Budget Committee, July 21, 1999.




(935327)   Leter   Page 13                                                       GAO/OCG-99-29
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