First Things First: The Case for Developing New Budget Rules

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

April 27, 2001

After two decades of generally steady economic growth, the U.S. economy faces a short-term slowdown and a long-term financing problem relating to social security and medicare. At the same time, government reports predict budget surpluses totaling trillions of dollars over the next decade and a new Administration is armed with ambitious plans for tax cuts, entitlement reform and other issues. The confluence of these events has generated a frenzy of new policy proposals, with the three main alternatives being tax cuts, increases in government spending, and efforts to save the budget surplus via debt reduction.

But the best policy response would be none of the above—yet. Faced with historic opportunities but significant uncertainties, the single most important policy choice the Congress and Administration could make would be to develop a set of budget rules and procedures that do a better job of describing the government’s true fiscal status, comparing the costs and benefits of policy alternatives, and protecting against the uncertainties.

Admittedly, this sounds like a huge yawner—a policy only a wonk could love. But the case for better procedures is simple and straightforward: Current budget methods seriously distort the government’s true financial status; some very simple changes could resolve many of the biggest problems; and these changes would likely lead to better and more informed public policies.

I. What’s wrong with current budget methods?

The Congressional Budget Office and the Bush Administration estimate a baseline surplus of $5.6 trillion over the next 10 years. That sounds like—and is—a lot of money, but it is a very misleading basis upon which to make policy choices.

The first problem relates to how the budget counts retirement funds. About 60 percent of the so-called surplus is due to accumulations in trust funds for social security, medicare, and government pensions for military and civilian employees. Private firms are forbidden to spend their pension reserves on current operating expenses. State governments choose to separate their pensions from their operating budget. The federal government should do the same. Currently, though, the budget includes the annual surplus of the trust funds but omits the expected future spending. In principle, the right way to measure the government’s financial status would be to include both the current surpluses and future spending liabilities, but this raises a number of difficult issues. At the very least, though, if the liabilities are excluded, the assets should be too. Removing the retirement trust funds from consideration reduces the forecasted 10-year surplus to $2.3 trillion.

The second problem with current methods of budget accounting concerns how the budget projects the consequences of current policy. The forecast assumes that Congress will fail maintain current law. This is reasonable as an objective basis for making a projection that cannot be criticized as reflecting partisan judgments, but it is not realistic. The “current law” method assumes that Congress will fail to react while 21 million taxpayers become ensnared in the intricacies of the alternative minimum tax (AMT). It assumes that Congress will allow a series of temporary tax provisions to expire, even though the subsidies have been granted continuances every time they have expired in the past. The forecast also assumes that discretionary spending—on defense, education, health, infrastructure, the environment, and so on—will be allowed to fall by 10 percent per person over the next decade, after accounting for inflation. Making conservative adjustments for each of these items—along with the adjustment for the retirement trust funds above—reduces the available surplus to only $1.7 trillion over the next 10 years. Thus, two simple but sound adjustments—for retirement funds and for the projection of current policies—reduce the forecasted surplus by almost $4 trillion over the next decade.

The third problem is that the 10-year budget window tends to obscure the government’s longer-term financial situation. For public policies such as social security and medicare, the conventional planning horizon is 75 years. This horizon yields much different results than the 10-year horizon because an aging population and rapidly rising medical care costs will quickly increase the cost of these programs after 2011. Indeed, my own research with Professor Alan Auerbach of the University of California, as well as reports by government agencies, show that under current policies the government faces a long-term deficit—not a surplus—of about two-thirds of one percent of GDP over the next 75 years.

The fourth problem relates to uncertainty. Budget surplus or deficit estimates are particularly uncertain over the next decade and over the longer term, both because the economy itself is uncertain and because small proportional changes in the economy translate into large proportional changes in the budget surplus. The budget forecast does not adjust for this uncertainty in any way, and no budget rules exist to help guide choices in the presence of uncertainty. But if it is politically difficult to adjust policy, and in particular if it is more difficult, say, to raise taxes and reduce spending than the other way around, then either the forecast or the budget rules needs to adjust for uncertainty.

All of the issues above concern the formulation of baseline budget forecasts. Another problem is that current procedures can be exploited to misrepresent the costs or benefits of particular proposals. For example, by using slow phase-ins, politicians can reduce a proposal’s official cost even though the long-term cost might be huge. A proposal to leave the estate tax alone for 10 years and abolish it in year 11 would have significant long-term costs but would cost nothing in the budget window. Is this budget gimmick so transparent that it could never happen? Possibly, but earlier this year, the House of Representatives passed a bill to phase out and then abolish the estate tax, with a 10-year cost of $185 billion. Abolishing the tax immediately would cost $662 billion over the next decade. So the House has already gone 70 percent of the way toward the budget gimmick noted above. The key point is that the only reason to design a tax proposal like that is to hide the true costs. This very fact should exclude the proposal from public debate.

II. Better Rules

It is well known that government accounts do not accurately reflect the true costs and benefits of government programs or tax cuts. However, getting the costs and benefits exactly right would prove very difficult, as it would require highly detailed and technical calculations, a series of judgment calls, and considerable uncertainty. Nevertheless, a few simple and understandable rules could address the problems noted above and thus provide most of the benefits of an ideal accounting system—accurate measures of the government’s fiscal situation and of the costs and benefits of new programs—with few of the costs.

The first change involves the baseline budget calculation. Congress should remove accumulations in trust funds for social security, medicare and government pensions from the baseline budget, and reaffirm its commitment not to spend any of these resources on anything other than previously legislated benefits. The baseline could also provide more realistic and plausible projections of future policy by adjusting real discretionary spending for population growth rather than allowing it to fall on a per-person basis, assuming that temporary provisions will be extended and stipulating that the percentage of tax filers facing the AMT will be held fixed over time.

The second change would set some of the baseline surplus “off limits” for allocation to new tax and spending programs in case the underlying tax and spending projections are not realized. Robert Reischauer, currently the President of the Urban Institute and formerly the Director of the Congressional Budget Office, has proposed that Congress should commit only a given percentage of future surpluses to tax cuts or new spending, with the percentage lower for surpluses farther in the future. For example, Congress might commit 80 percent of surpluses projected for the first two years of the 10-year budget projection, 70 percent of surpluses in the next two, and so on, down to 40 percent in the last two years. The Reischauer rule essentially provides a reserve fund. The rule recognizes that budget projections and economic forecasts are subject to considerable uncertainty, that uncertainty rises with the time horizon, that new and unforeseen contingencies will arise, and that policy reversals may prove difficult.

The third change would improve estimates of the costs or benefits of new tax and spending initiatives to prevent manipulation of the 10-year budget estimates. Stipulating that all tax or spending programs must be scored as fully phased in within, say, five years would allow some time for gradual adjustment but would ensure that 10-year costs remain valid indicators of the long-term effects. Temporary tax or spending policies should be scored as permanent, and the costs of tax changes should include the cost of changes in the AMT to ensure that the tax cut does not raise the number of AMT filers. Finally, including the interest costs due to higher federal debt associated with higher spending or lower taxes would provide a truer measure of the cost of the plan.

Use of these rules would fundamentally alter the current budget and tax cut debate. The current debate starts from the premise that with a $5.6 trillion surplus, $3.1 trillion of which is outside the social security trust fund, the President’s tax cut, which is priced at $1.6 trillion, is easily affordable. But with the rules above, the numbers would be quite different. The baseline budget surplus would be $1.7 trillion over the next 10 years. The Reischauer rule would make about $900 billion of that available for new tax cuts or new spending to be legislated in 2001.

The President’s tax plan would be seen to include $400 billion in interest costs and $300 billion to ensure that the tax cut does not push people onto the AMT, bringing the total cost to $2.3 trillion. (The costs would go even higher if the phase-in of the tax cut were accelerated to fit into the five year phase-in rule, so that the long-term costs were more accurately represented in the 10-year budget window.)

A natural question would arise as to how a $1.7 trillion surplus could finance a $2.3 trillion tax cut. The answer would be clear: the Administration is using almost a trillion dollars of pension funds accumulations to finance current operating expenses. Over $500 billion would be taken from the medicare (part A) trust fund to pay for supplementary medicare insurance, which has traditionally been financed by general revenues and program fees. Likewise, $400 billion in government pensions reserves would be used to finance current expenses.

III. Discussion

It is useful to distinguish two points: the need for a new set of budgetary rules (which is the central thesis here), and the desirability of the particular set of rules motivated and examined above.

The need for changes in the budget rules seems clear. The example above shows that a few simple, plausible rules dramatically change the budget and tax picture. The current cash flow surpluses mask a much more troubling long-term financial picture. And the old budget rules, which required that any change in mandatory spending or taxes be financed by other changes in the same categories and which put caps on the growth of nominal discretionary spending, were designed for a period with short-term budget deficits. Although they appear to have been fairly successful in their time, they have been honored mainly in the breach in the last few years.

Other recently-discussed rules are less promising. The balanced budget amendment has received much attention over the past several years. But if the underlying budget has little economic significance, it is not at all clear why balancing it is a good idea. The recent proposal by Congressional moderates to tie tax cuts to a trigger mechanism, based on the prior year’s surplus, is well-intended but not useful. It would create uncertainty and invite budget gimmickry, it would attempt to determine whether future tax cuts are affordable by looking at last year’s—rather than projected—surpluses, and it would correct none of the problems noted above.

Other changes, while controversial, are worth further consideration. For example, currently the tax revenue baseline assumes that tax brackets are indexed only for inflation over the next 10 years, but for real wage growth and inflation for years 11 through 75. Adjusting the 10-year revenue baseline so that real wage growth did not result in increased tax revenues would be a significant change. An equally controversial proposal would attempt to adjust for the so-called dynamic effects of proposed tax or spending changes on the level of overall economic activity.

In the current political environment, both of these latter changes would lend support to Republican tax cut proposals, whereas most of the proposals above tend to cast doubt on the wisdom of such proposals. This highlights the importance of policy rules in setting a framework to analyze the options, and shows that careful attention to policy rules can and should be a bi-partisan concern.

Establishing a new set of rules might prove less exciting than pushing through everyone’s favorite tax or spending proposal under the cover of the surplus, but ultimately it would result in policy that is fiscally responsible with respect to the needs of future generations and fiscally responsive with respect to current generations.

The author thanks Samara Potter for outstanding assistance, and Henry Aaron, Eric Engen, Charles Schultze, and David Wilcox for helpful comments.