Budget Realities: Priorities & Politics

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

August 2, 2001

The mid-year budget revisions are now out. The administration is trumpeting the “second largest surplus in history.” They describe the tax cut as “modest” but characterize the projected long-term deficit in Social Security as “massive.” Democratic critics are claiming that the tax cut means that Social Security “lock box” will be broken and the Social Security trust fund will be “raided.”

What is a poor citizen to think? What follows is a guide for the perplexed in sorting out the conflicting claims of the political parties. Be warned, however: You cannot understand this debate unless you are willing to muck around in the numbers. That is what budgets are all about.

First, some background. Through a combination of plain good economic luck and sound budget policy, the United States converted large and persistent budget deficits of the 1980s and early 1990s into large budget surpluses in the late 1990s. Both parties deserve credit for this accomplishment. The first George Bush and a Democratic Congress fashioned the budget agreement of 1990. President Clinton and a Democratic Congress enacted additional deficit reducing measures in 1993. And a Republican Congress successfully pushed through more deficit reduction than President Clinton initially wanted in 1997.

These agreements constituted good fiscal housekeeping. More importantly, they created an opportunity for the government during a period of high employment to contribute powerfully to economic growth. By collecting more in taxes than it spent, the government could pay off the national debt.

An important shift in budget policy contributed to realization of this goal. Before 1999, the normal budget goal was balance in the budget for all operations of government. After 1999, both parties agreed to try to balance the budget for operations of government other than Social Security and to dedicate burgeoning Social Security to paying down the national debt. In 2001, for example, Social Security will take in $160 billion more than it will spend. Furthermore, these cash surpluses are projected to continue growing, reaching $345 billion in 2011. Eventually, the resulting reserves—and more—will be needed to pay pensions for baby-boomers.

Meanwhile, Social Security cash surpluses can be used to pay off public debt. The savings that would otherwise have gone into government bonds would be freed for investments in the United States or abroad. The added income from these investments can help the nation to pay for the large pension and health costs that will start with the imminent retirement of the baby-boomers.

The logic behind this policy shift is easy to understand. A family with small children is well advised to pay off the family’s home mortgage while the children are young so that it can better afford college tuition later on. The public debt is the nation’s mortgage. Paying it off would make it easier to face later pension and health costs because interest payments on the debt would be reduced. The same logic also calls for using cash surpluses in the Medicare Hospital Insurance Trust Fund should to pay down the public debt.

The principle is simple: save current cash surpluses; don’t consume them now.

Budget prospects were rosy as President Bush took office. Projections indicated that budget surpluses outside Social Security and Medicare Hospital Insurance would grow as far as the eye could see, totaling $3.2 trillion from 2001 through 2011. In addition, Social Security and Medicare Hospital Insurance Trust Funds would accumulate an additional $3.1 trillion over this period.

Rosy prospects have now turned bleak. Largely because of the tax cut, three quarters of the surplus outside Social Security and Medicare projected through 2011 has vanished. Deficits are anticipated until 2005. The tax cut accounts for most of the reduction (see inset). Increased spending accounts for only 5 percent of the decline. This statistic flatly refutes Republican claims that a spendthrift Congress bears responsibility for the worsened budget picture. And over the long-haul, the seventy-five year horizon used for computing Social Security’s solvency, the tax cut will reduce revenues by more than twice the amount necessary to close the projected long-term deficit in Social Security.

These projections tell only part of the story, however. Prospects are actually much worse. CBO does not project the effects of legislation that everyone of both parties understands is inevitable but has not yet been enacted.

Start with national defense. Members of both parties understand that defense equipment is aging fast and needs to be replaced. The administration is strongly committed to missile defense. The combined cost over the next decade will run $100-200 billion.

The alternative minimum tax, a hellacious provision to curb overly aggressive tax avoidance by high income filers, currently applies to about 1 million returns. But is not adjusted for inflation, and the tax cut bill will subject many filers to the AMT. If nothing is done, projections indicate that it will apply to 35 million filers by 2011. No one thinks that Congress will permit this to happen. But fixing this problem will cost an estimated $250-350 billion over the next decade.

CBO assumes that tax breaks scheduled to expire will be allowed to vanish even if Congress has renewed them repeatedly. The likely renewal of these provisions will cost another $70 billion.

Each of these changes will prevent the government from paying down the debt, boosting interest payments and adding an additional $50-90 billion to outlays.

The total tab for these all-but-certain items is $470-$710 billion. Under reasonable assumptions, the budget, apart from Social Security and Medicare Hospital Insurance, will be in deficit.

And this list omits any allowance for a medicare prescription drug benefit that would cost $190 billion according to the Administration and as much as $300 billion according to Congress. Nor does it include $70 billion for added farm subsidies that seem to be on a Congressional fast track. And the CBO projections assume continued drops in other non-defense discretionary spending, as a share of national output that recent Congressional actions supported by both parties make unlikely.

All these numbers add up to a few simple conclusions.

First, prospective budget surpluses outside Social Security and Medicare Hospital Insurance are gone.

Second, an excessive tax cut, not the growth of spending, is the reason why the budget climate has changed.

Third, this outcome is disturbing not so much because of deficits this year—the rebates most of us are now receiving may actually serve a constructive short-run purpose by shoring up consumer spending during a period of economic weakness. The real problem comes later. The ever-larger tax cuts mean a return to the era of deficits, which successive presidents and Congresses, both Republican and Democratic, struggled and, eventually, managed to end.

Finally, the tax cut has greatly complicated the task of restoring long-term financial balance to the Social Security system. Whether one favors continuation of the current system or its replacement with private accounts, the road would be smoothed by transfers from the general budget. Alas, there are no longer any funds to transfer.