The Deficit That Didn’t Just Happen: A Sober Perspective on the Budget

It took the federal government 28 years (1970-98) to produce a budget surplus, but only 4 years to return to deficit. President Bush’s 2003 budget promises that the government will have a surplus in 2005, but the revenue and spending policies it pursues risk another long spell of red ink that may extend well into the next decade, when the front edge of the baby boom generation reaches retirement age and both health and pension costs escalate.

Why the asymmetry in budget cycles? Why is the vicious circle of deficits so much longer than the virtuous circle of balanced budgets? If economic weakness impels government to spend more than it takes in, shouldn’t the reverse also occur, that economic good times rescue the budget from red ink?

Part of the answer is that adverse budgetary effects of recession linger after the economy recovers. Recession lowers the trend line of economic growth, and it therefore takes a number of years to recover the lost output. Just a 1 percent drop-off in the 2002 growth rate would add $50 billion to the deficit a decade later, even if full growth were to resume in 2003.

This is the no-fault part of the deficit story that the Bush budget emphasizes. But it is far from the whole picture. In fact, the Congressional Budget Office has estimated that less than one-quarter of the $4 trillion in lost surpluses over the next decade is due to current economic difficulties. Most of the remainder is the result of political decisions to spend more and tax less. Two years ago in these pages, in “A Surplus, If We Can Keep It,” I argued that policy mistakes caused the deficit surge in the 1980s and policy corrections stabilized federal finances in the 1990s. Critical turning points in budgeting don’t just happen; they are the products of sound or flawed policies. No less than in the past, policy matters in budgeting. And policy mistakes are the reason why the fiscal outlook has rapidly deteriorated.

Policy mistakes are not simply matters of disagreement. They are inconsistent actions that cannot achieve purported objectives. Cutting taxes while steeply boosting defense spending in the early 1980s was mistaken because it generated huge deficits. Raising taxes in the early 1990s while constraining spending growth was sound policy because it enabled the government to successfully implement its deficit elimination strategy.

The government may now be at the cusp of another major policy error. It is not yet as big as the error two decades ago, but it risks becoming more damaging. The Bush budget story has three interlocking chapters: spending decisions, tax legislation, and White House attitudes concerning surpluses.

Spending Our Way Out of the Surplus

The arrival of a surplus a few years ago triggered a spending frenzy that vitiated the discretionary spending caps established by the 1990 Budget Enforcement Act and made a mockery of the BEA requirement that increased spending be offset by cuts in other spending or by revenue increases. In 2000 and 2001, discretionary spending soared more than $200 billion above the legal limits on annual appropriations. The caps expire at the end of 2002—which will at least enable politicians to be more honest about what they are doing. They no longer have to pretend that the census and other ongoing operations of government are national emergencies.

Defense is leading the spending parade, but it is not the only winner. In a replay of the policies of Ronald Reagan, Bush proposes to boost defense spending by $85 billion over three years, with additional tens of billions for homeland security. In dollar terms, this defense buildup is bigger than the one undertaken in the early 1980s, but it is a significantly smaller share of GDP or of total federal spending. The odds are, however, that defense costs are understated in the budget. On the one hand, the president’s State of the Union Address declares that “our nation is at war . . . and the civilized world faces unprecedented dangers.” On the other hand, his budget projects that defense spending will decline by mid-decade as a share of GDP. Military leaders have already complained that the additional money is insufficient; they will not have to wait long to get more.

Bush has not proposed the wholesale elimination of domestic programs, preferring instead to hold many to approximately the previous year’s spending level. This way, inflation does the cutting and the president can claim credit for some well-publicized increases. But the discretionary budget may be tighter than it appears, for it includes billions for homeland security and for the health care and pensions of federal employees, which have been shifted from the mandatory to the discretionary budget. The CBO’s baseline, which shows domestic spending keeping pace with GDP, would eat up most of the budget surplus promised by the president for the next decade.

Entitlements are also likely to add to budget pressures. Congress must reenact welfare and agriculture legislation during the 2002 session, and advocates are demanding hefty increases. The president’s Medicare numbers are $300 billion (over the next 10 years) below CBO’s baseline. He expects the rise in Medicare spending to decelerate despite the increase in the number of older Americans covered by Medicare.

Summing up the expenditure story, in the next decade the government will spend more than it did in the recent past and more than the president has projected in the budget. The era of big government may be over; the era of big spending is not. The question is, will government have the money to pay for it?

The Power Not to Tax

Judging from the Bush budget, the clear answer is “no.” George W. Bush may be the first president in American history to declare war and demand tax cuts. He wants almost $700 billion in tax cuts over the next 10 years, on top of the $1.3 trillion cut enacted last year. The true size of that cut was masked by artfully placed phase-ins and phase-outs. Some cuts were scheduled to take effect near the end of the 10-year period; most would phase out during or at the end of it. Fully implemented, over the course of a decade the cuts would subtract almost $2 trillion from federal revenue.

Despite its search and destroy mission to find and liquidate provisions of the tax code, the administration would allow the alternative minimum tax (AMT), which may be the most disliked feature of the tax code, to ensnare millions of Americans in coming years. The AMT was originally designed to curb aggressive tax avoidance, but because it is not indexed for inflation, increasing numbers of people will face the AMT in future years for reasons completely unrelated to tax sheltering. Last year’s tax cut granted taxpayers a temporary reprieve from the AMT, but that relief expires in 2004. Apparently, even the White House could not afford the $500 billion (over 10 years) price tag of fixing the AMT problem. An alternative take is that the president knows Congress will be pressured to act and that if he gets his additional tax cuts and Congress fixes AMT, the combined revenue loss would be even higher. A final spin on the administration’s oversight is that once millions of taxpayers have to pay AMT, they will be so angry as to undermine public support for taxes. Whatever the true motive, the downstream loss in revenue may be even higher than the administration has forecast.

One need not wait long to see the effects. The 2003 budget shows two consecutive years—2001 and 2002—of decline in federal revenues, the first time that has happened since the end of World War II, when the United States shifted from full mobilization to peacetime. Even if no new tax cuts are enacted beyond those already adopted, the federal government faces a structural imbalance that is being masked in the short run by Social Security surpluses but will become apparent less than a decade from now. The administration has ignored the dire future by departing from past budget practice and shortening the budget’s time horizon from 10 years to 5. Of course, this does not stop it from promoting permanent tax cuts whose budget impact will be fully felt after the foreshortened 5-year period has ended

The Political Logic of Unbalanced Budgets

The White House is not clueless as to the fiscal course it has charted. This is not a case of ignorance aforethought. The administration knows what it wants and is setting out to get it.

During the Reagan era, when serious policy mistakes led to a fivefold escalation in public debt from $700 billion to $3.5 trillion, Senator Daniel Patrick Moynihan accused the administration of creating the deficit to starve the government of revenue. Moynihan did not have a smoking gun to confirm his hypothesis, but George W. Bush has supplied one. Several weeks after taking office, the Bush White House published A Blueprint for a New Beginning, with a chart titled “Budget Surpluses Lead to Bigger Government.” If this is so, the prudent thing to do is to get rid of surpluses; otherwise, government will grow bigger. Many conservatives have accepted as an article of faith that government spends any money it has and that the only effective way to constrain spending is to take away the surplus. In their mind, it is better to have a smaller government with a bigger deficit than a bigger government with a smaller deficit.

The problem with this point of view is that even if the government is broke, it will spend more. One reason is that big government includes big defense. In an age of terrorism, the Pentagon will not spend less because the government has red ink. Another is that, as David Stockman, Reagan’s budget director, discovered two decades ago, Republicans also beat the drums for more spending. Stockman labeled this phenomenon “the triumph of politics,” which became the title of his surly memoirs on his service in the U.S. government.

The third, most compelling reason for more government spending is that higher spending is built into the demographics of American life. We are now two decades closer in time, but no closer in solution, to the baby boom surge. These costs will have to be faced, regardless of the government’s financial position. Some cynics think that the White House understands the mammoth costs that lie only a few years ahead, but that it is driven by the conviction that only a full-blown financial crisis will build support for privatizing all or a big portion of Social Security and Medicare. It believes that as long as Uncle Sam can afford to pick up the tab, there will be no pressure to fundamentally restructure these retirement programs.

We may, however, get only the crisis part of this scenario, in which case the administration is taking truly enormous risks with the future well-being of the United States. As the title of this article says, this deficit didn’t have to happen. And it shouldn’t.