A Surplus, If We Can Keep It: How the Federal Budget Surplus Happened

"It?s the economy, stupid." The battle cry of Bill Clinton?s 1992 presidential campaign has been recycled to explain how a $290 billion budget deficit has been transformed into a $100 billion surplus that is expected to quadruple in the decade ahead. I would argue, however, that the hand of Washington has had as much to do with liquidating the deficit as the economy?s invisible hand. Policies matter. Wrong decisions in the 1980s condemned the nation to a decade of high deficits; right ones in the 1990s have liberated it from past budgetary misdeeds.

Liquidating the deficit ranks as one of the supreme budgetary accomplishments in American history. In 1993, the Office of Management and Budget projected that the fiscal 1998 deficit would be $339 billion; the Congressional Budget Office projected $357 billion. That was not the only year for which budget experts were wide of the mark. In both their five-year projections and their annual budget estimates, OMB and CBO persistently overestimated the deficit. In 1993, CBO projected that policies then in place would yield cumulative deficits of $1.5 trillion over the next five years. Actual deficits totaled less than a third that.

An analysis of economic performance, spending policies, and revenue trends during the 1980s and 1990s makes clear how the federal budget was balanced. Whether it will still be balanced a decade from now when the first wave of baby boomers reaches retirement is much less certain.

The Economic Boom

Every budget is hostage to the economy. Congress and the president cannot balance the budget when national output is declining and unemployment is soaring. Budget receipts are highly sensitive to changes in economic conditions, spending less so, but even a small shortfall in economic performance can affect the budget in a big way. CBO has estimated that if the annual real growth rate over the next decade were just 0.1 of a percentage point less than it has assumed, the fiscal 2010 budget surplus would be $40 billion below current projections.

When the deficit peaked in 1992, the United States was emerging from a brief recession. When the budget was balanced in 1998, the economy was completing the seventh consecutive year of growth, during which 13 million jobs were added and inflation averaged less than 3 percent. The budget was the beneficiary of economic success. Revenues escalated as corporate profits and personal incomes rose; spending dropped as welfare rolls declined, the crisis in the banking sector was resolved, and inflation in the health care sector moderated.

But economic good times alone do not account for the budget?s unexpected turnaround. Measured in terms of growth rates, the eight consecutive years of expansion during the 1980s (from the end of the Reagan-era recession in 1982 to the onset of the Bush-era recession in 1990) outperformed the boom of the 1990s (see table 1). The two expansions were structured differently, which may partly explain their different revenue impacts. During the 1980s expansion, which followed a decade of "stagflation," growth began at a high rate and tapered off. The 1990s expansion, which followed a long period of growth that was briefly interrupted by the 1990?91 recession, began with low growth that accelerated as the expansion continued.

Spending Policies

Although a cooperative economy made the budget surplus possible, the surplus would not have materialized if budget policy in the 1990s had repeated the mistakes of the 1980s. Differences between the revenue and spending paths taken during the two decades led to quite different budgetary outcomes.

On the spending side of the ledger, the key differences were in budget enforcement rules, defense spending, discretionary appropriations, and entitlements.

During the 1980s, Washington postured against deficits with futile gestures that reflected the inability of a Republican president and Democratic Congress to agree on tough budget measures. The 1985 Gramm-Rudman-Hollings (GRH) law promised annual cuts in the deficit and a balanced budget within six years. Although the law threatened the automatic cancellation of budget resources if the projected deficit exceeded the target, the actual deficit was above the statutory limit every year. With clumsy and unworkable sequestration procedures, GRH induced Congress and the president to lie about the deficit by substituting illusory cuts for real ones and by pretending that the budget picture was better than it actually was.

In 1990, with the projected deficit spiraling out of control, the warring branches replaced GRH with the Budget Enforcement Act (BEA), a law that focuses on revenue and spending rather than the size of the deficit. Almost a decade later, BEA remains in effect, and although it has not always been strictly enforced, it has helped improve the budget condition. It has two principal rules?a limit on annual appropriations and a requirement that any revenue or spending legislation that would increase the deficit (or decrease the surplus) must be offset. In sharp contrast to GRH, it does not regulate changes in the budget caused by fluctuations in economic conditions or in the cost of existing entitlement programs. It controls only the parts of the budget that the president and Congress directly influence?and thus holds politicians accountable only for the things they control.

Congress and the president have had a complicated budgetary relationship under BEA. At times, one branch has deterred the other from violating the rules; at other times, both have conspired to evade the rules by designating routine expenditures as emergencies, manipulating the effective dates of tax legislation to hide the full budgetary impact, and using a bewildering variety of bookkeeping tricks. BEA has elevated "scoring" (measuring the budgetary impact of legislation) to a valued political art, but it also has dampened the ability of vote-seeking politicians to cut taxes or boost spending. As with other budget rules, its effectiveness has weakened over time as claimants for federal money have devised means to outwit the process or disable its controls. Hefty surpluses have also weakened BEA. Budget controllers cannot enforce the rules with the same zeal when money is abundant as they can when resources are tight.

Discretionary Spending

It is difficult to separate the impact of BEA from the conditions under which it has operated. Had there been no discretionary caps, defense spending still would have been held down by changes in world affairs, domestic spending pressures, and oversize deficits.

The 1980s began with a steep boost in defense spending; the 1990s, with the collapse of the Soviet empire and the end of the Cold War. Defense spending, which began to level off during the second half of the 1980s, continued to fall through most of the 1990s. Adjusted for inflation, defense outlays were almost $100 billion less in 1998 than they had been a decade earlier. If the Cold War were still raging, there probably would be no surplus.

As after past wars, some defense savings were reallocated to domestic programs. Because the budget enforcement rules built a "firewall" between discretionary appropriations and direct spending, domestic appropriations reaped most of the savings. These programs, which fell more than 15 percent during the 1980s, grew more than 25 percent during the next decade. In fact, real discretionary domestic spending is much higher today than it was when Ronald Reagan launched his campaign to roll back social programs. As a share of gross domestic product, however, discretionary domestic spending has fallen?from 4.5 percent in 1981 to 3.2 percent in 1999.

During the 1990s, the president and Congress exploited BEA spending caps to demonstrate their commitment to control the budget and to reduce the size of the government while spending somewhat more than the BEA rules intended. Led by Clinton, the Democrats came out ahead in this contest; they got credit for fiscal prudence while securing more money for popular programs. Outmaneuvered, congressional Republicans reluctantly approved the increases, sometimes after getting billions more for defense. But the marginal growth in discretionary appropriations was too small to derail the march to a balanced budget.

Direct Spending

Spending growth in entitlements was held down during the 1990s by the BEA pay-as-you-go rule requiring legislated increases in these programs to be offset by cuts in other direct spending or by revenue increases. But even in the absence of PAYGO, big deficits would probably have inhibited the president and Congress from establishing new entitlements and impelled them to seek savings in old ones. After all, few initiatives made it though Congress during the pre-BEA 1980s. And despite PAYGO, Clinton won some new entitlements, such as the children?s health insurance program enacted late in the 1990s.

The PAYGO decade did see some publicized cutbacks, though their net effect on federal spending has probably been small. Medicare was nicked repeatedly, with some of the claimed savings used to offset the cost of benefit enhancements. At the century?s end, Clinton transformed the Medicare debate from worrying about the coming retirement boom to adding prescription drugs to the list of eligible benefits. Welfare was converted from an open-ended entitlement to a fixed block grant to states, and changes were made in eligibility rules and program benefits to move recipients from welfare to work. When the reforms were enacted in 1996, a six-year savings of $54 billion was projected. Steep, largely unexpected declines in welfare rolls?6.5 million fewer recipients in 1998 than 1993?boosted short-term federal spending above what it might have been had the old AFDC program continued. Nevertheless, over the longer term, welfare spending will decline if the reforms endure. Congress also overhauled farm price supports in 1996, but the projected savings will probably not materialize. Whenever farmers run into trouble, politicians pour in billions of dollars of emergency money.

All told, the 1990s were a fiscally static period in entitlement policy. Leaving aside deposit insurance, mandatory spending was a higher share of GDP in 1999 than in 1990. Means-tested entitlements grew the most, both because of new legislation (such as increases in the earned income tax credit) and because of built-in growth in old programs.

Tax Policy

If the economy and spending changes do not adequately account for the surplus, the only other place to look is on the revenue side of the budget. During the 1990s, tax policy largely reversed actions of the previous decade. During the 1980s, the highest marginal tax rate (50 percent on earned income and 70 percent on unearned income?interest and dividends) was reduced to 28 percent (or 31 percent if a "bubble" in the rates is included). But in the 1990s, the rate was boosted to 39.6 percent, and with various phase-outs of exemptions and deductions included, the effective rate is now above 40 percent. The first tax increase was enacted in 1990 when George Bush was president; the second in 1993 when Bill Clinton was in the White House. The first deprived Bush of reelection; the second helped the Republicans take over Congress in 1994 but ultimately aided Clinton?s reelection. While politically risky, the tax increases pumped up federal revenues. Federal receipts rose from 18.2 percent of GDP in 1990 to 20.5 percent in 1998, adding $190 billion in revenue. If the 1989 tax structure were still in place, there would be no surplus to discuss.

The targets of the 1990 and 1993 rate hikes were upper-income taxpayers. By contrast, during the 1990s the income tax burden on low-income Americans was greatly eased. Because of the widened income gap between low and high earners, the government took in much more revenue than it would have if the tax increases had been spread evenly across income brackets. The government taxed the winners during the 1990s, redistributing income while boosting its revenues. By design or accident, sound social policy coincided with responsible budget policy.

Will the Surplus Persist?

Anyone who has made or used budget projections during the 1990s should be exceedingly guarded in forecasting the budget future. Although the medium-term (five to ten years) outlook is cloudy, the longer-term forecast is clear. Under current policy, the budget will incur large and growing deficits when the surge in the over-65 population forces the Social Security fund to draw down the trillions of dollars of accumulated surpluses.

The sure prospect of resurgent deficits makes it urgent that policy mistakes not imperil the surpluses projected for the first decade of the new millennium. Last July CBO estimated that annual budget surpluses would rise from $161 billion in 2000 to $413 billion in 2009. If the forecasts are right, Washington would accumulate almost $3 trillion in surpluses during the next decade?two-thirds in Social Security funds, the rest in the general fund. Although the projected surpluses are enormous, the economic and revenue assumptions on which they are based are modest. The CBO does not build a recession into its forecast, but it assumes that the economy will grow only 2.4 percent a year over the next decade?much more slowly than it has in the recent past. It also expects federal revenues to rise only $75 billion a year during the next five years, as opposed to the almost $115 billion averaged during 1993?98.

The weakest part of the CBO projection is the assumption that discretionary spending (capped through fiscal 2002) will remain tightly in check. The recent actions of Congress in evading the caps for fiscal 2000 appropriations make it highly unlikely that this part of the budget scenario will play out according to the CBO script. Responding to real and imagined emergencies, boosting defense spending (something Democrats and Republicans alike support, though they differ as to how much), raising discretionary domestic appropriations in line with price increases, and adding billions here and there for national priorities such as education would consume almost three-quarters of the projected non?Social Security surpluses. If, as is likely, taxes are also cut, the remainder of the surplus would be at risk.

These possibilities counsel two prudent steps on the part of Washington politicians: do not spend the surplus before it is earned and do not repeat the policy mistakes of the early 1980s. Prudence in fiscal management cannot ensure that surpluses will persist, but it can guard against a return of runaway deficits.

The 2000 election may have much to say about the future budget health of the nation. Divided government has blocked Republican ambitions for large tax cuts and deterred Democrats from big increases in social spending. If either party were to win all the national political sweepstakes in 2000, it would have a clear field to pursue its pent-up budgetary agenda. Perhaps the surprising lesson of the conversion of deficits into surpluses is that fiscal prudence can reign when neither party can achieve its budgetary vision.