The federal budget registered a surplus in fiscal year 1998, the first in 29 years.
The budget for the current fiscal year, 1999, will also end in surplus, producing the first back-to-back surpluses since 1956-57. OMB projects that, if tax and spending policies remain unchanged (the baseline projection), significant surpluses will persist for several decades. To ensure that this unexpectedly favorable fiscal outlook is neither squandered nor frittered away, President Clinton laid out in his fiscal year 2000 budget proposal a framework for dealing with the projected surpluses of the next 15 years. The president’s framework, which is multi-faceted and complex, has proven difficult for even seasoned budget analysts to explain.
The president’s framework
Assuming the economy performs as the Administration projects, that OMB’s estimates of future mandatory spending are correct, and that tax and spending policies are not changed, budget surpluses totaling $4.854 trillion will be realized over the fiscal 2000 to 2014 period (Table 1). Both Social Security and the government’s non-Social Security accounts will register sizeable surpluses over this period (Figure 1).
Under the president’s framework, 59 percent of this projected baseline surplus would be reserved to reduce debt held by the public.
The remaining 41 percent would be available to commit now to current and future needs. The president’s budget proposes using this portion of the surplus to increase discretionary spending, contribute to new personal retirement accounts for workers (USA accounts), and buy equities for the Social Security trust fund. Other policymakers have suggested that all of the surplus not devoted to debt reduction be used to cut taxes or expand discretionary and entitlement spending. This would be inconsistent with the allocation in the president’s framework because the portion of the surplus used to buy equities for the Social Security trust fund is equivalent to debt reduction. The equities would be liquid assets that could easily be sold, and the proceeds used to redeem debt. Thus, under the president’s framework, only 29 percent of the surplus is available for such initiatives.
Under the president’s framework, special Treasury securities equal in value to the amount by which debt held by the public is expected to be reduced over the 15 year period would be credited to the Social Security and Medicare HI trust funds (addendum, Table 1). These bonds would be in addition to the special Treasury securities the trust funds receive when Social Security and Medicare remit their annual surpluses to the Treasury. The additional securities credited to the trust funds would be registered as budget outlays under a change the president proposes to make in current budget accounting rules.
The exact amounts that will be credited to the trust funds each year will be specified in legislation enacted in 1999. Therefore, the actual reduction in debt held by the public under the president’s framework may end up being more or less than the value of the securities added to the trust funds.
The Baseline Surplus and the President’s Framework
(fiscal years 2000-2014)
*includes $5 billion from the Postal Service
The goals of the president’s framework
The president’s framework has at least four different broad objectives.
First, it is an effort to ensure that a large fraction—roughly 82 percent—of the baseline surplus projected for the next 15 years contributes to national saving by paying down debt held by the public, purchasing equities for the Social Security trust fund, and boosting the retirement saving of workers (USA accounts).
Second, it is an attempt to establish a budgetary environment in which debt reduction is politically sustainable. Many believe that, without some restraints, lawmakers will enact tax cuts and spending increases that dissipate the projected surpluses. To thwart this, the president has wrapped his policy of debt reduction in the protective armor of initiatives to strengthen Social Security and Medicare.
Third, the president’s framework is an initiative that shifts some of the burden for supporting future Social Security and Medicare benefits to the government’s general funds. This is accomplished by crediting the Social Security and Medicare HI trust funds with more Treasury securities than the funds’ surpluses warrant. These infusions of obligations mean that less of the long-run imbalances between future benefit costs and payroll tax receipts in Social Security and Medicare will be closed through payroll tax hikes and benefit cuts in those programs and more will be financed through slower growth in other program spending and higher levels of general taxes than otherwise would occur.
The equities purchased for the Social Security trust fund will reduce the adjustments that Social Security and the balance of government together will have to make in the future.
Fourth, the president’s framework is an effort to improve the prospect that Congress and the president can reach agreements on measures that address the long-run solvency problems facing Social Security and Medicare. It does this by reducing the programs’ funding shortfalls through the provision of additional bonds to the trust funds. Because the shortfalls will be smaller, fewer painful measures—payroll tax increases and benefit reductions—will be needed to close the remaining imbalances. For example, without the president’s infusion of extra bonds into the Social Security trust fund, benefit cuts and payroll tax increases equivalent to 2.19 percent of taxable payroll—a politically undigestible mouthful—would be required to close the program’s estimated 75 year imbalance. With his policy, the adjustments would shrink to a size that lawmakers might more readily swallow—about one percent of payroll.
Some critics have suggested that, by reducing the long-run shortfall, the president’s framework could undercut the pressure on policymakers to act. But the president has not claimed that his framework represents a full response to Social Security’s long-run financial problem. It buys time but does nothing to lower future Social Security benefit promises. The higher returns earned by equity investments and the interest earnings on the additional bonds will boost the program’s revenues modestly. But, as the president has acknowledged, other measures will be needed to complete the package.
The impact of the president’s framework on public debt and Social Security reserves
Under the president’s proposal, the level of the debt held by the public would fall from an estimated $3.670 trillion at the end of fiscal 1999 to $1.168 trillion at the end of 2014, or from 41.9 percent of GDP to 7.1 percent of GDP, the lowest share of GDP since 1917 (Table 2). Whether this represents a major or modest reduction depends critically on what one thinks would happen to the budget surpluses if the president’s framework were not adopted. Of the many possibilities, the following three scenarios encompass the range of plausible alternatives:
- Save Total Surplus. Under this scenario, all of the budget surplus would be “saved,” that is, used to pay down debt held by the public. If this happened, all of the debt held by the public would be retired by 2013.
- Save Social Security Surplus. Under this scenario, the surpluses in the Social Security accounts would be used to pay down debt held by the public.6 The surpluses in the non-Social Security accounts would be devoted to tax cuts and spending increases. Debt held by the public would amount to $1.149 trillion or about 7 percent of GDP by the end of fiscal 2014 under this scenario.
- Dissipate Surplus. Under this scenario, all of the unified budget surplus would be dissipated through tax cuts and spending increases. Debt held by the public would not decline, but rather would rise a bit to $3.849 trillion for reasons that relate to the way credit programs are treated under current budget accounting rules.
Debt Held by the Public and
Social Security Trust Fund Balances
End of Year 1999, 2004, 2009, and 2014)
Most analysts who are familiar with the pressures facing lawmakers consider the. “Dissipate Surplus” scenario to be the most likely. In other words, they believe that most, if not all, of the projected budget surplus will be dissipated if some enforceable framework for protecting the surplus is not enacted. Compared to this situation, the president’s framework is a model of fiscal prudence. Over the next five, ten, and fifteen years, the president’s plan would reduce the levels of public debt by $464 billion, $1.341 trillion and $2.681 trillion, respectively, compared to the levels that would exist if all of the surplus was dissipated on tax cuts and spending increases.
The president’s framework would reduce the level of debt held by the public marginally less than would be the case under the scenario in which all of the Social Security surpluses were devoted to debt reduction. Specifically, public debt in 2004, 2009, and 2014 would be higher by roughly $249 billion, $317 billion, and $19 billion, respectively, under the president’s framework. However, the equity investments provided to the Social Security trust fund under the president’s framework, which are functionally equivalent to debt reduction, would amount to $768 billion by the end of 2014. 7 Counting these assets, the net liabilities of the government under the president’s framework would be lower after 2008 than those under the scenario in which the Social Security surplus was devoted exclusively to debt reduction.
The president’s proposal would reduce the debt held by the public over the next five, ten, and fifteen years by about $364 billion, $1,068 billion and $1,168 billion less than would be the case if all of the total budget surplus were devoted to paying down federal debt.
Reserves in the Social Security trust fund would be larger under the president’s framework than under any of the alternative scenarios because additional Treasury securities and equities would be credited to the trust fund and these new assets would generate interest, dividends, and capital gains. By 2014, the trust fund balance would be augmented by about $3.752 trillion.
General fund support for Social Security and Medicare under the president’s framework
Some have argued that the president’s framework—which will credit the Social Security trust fund with equities and the Social security and Medicare HI trust funds with special Treasury securities in excess of those due them in return for their annual surpluses—represents a sharp break with past policy, which they interpret as requiring that these programs be financed exclusively through payroll tax receipts and interest earnings on the trust fund reserves that accumulate when payroll tax receipts exceed benefit costs.
The additional securities and the equity investments that the trust funds will receive represent general fund support for these social insurance programs. They will postpone the dates at which the trust funds become insolvent. The additional Treasury securities will not, however, reduce the size of the adjustments that the government will have to make in the future, nor will they affect the timing of these adjustments. Rather than forcing adjustments—tax increases or spending cuts—within the Social Security and Medicare programs, the trust funds will redeem their added securities; the Treasury will have to come up with the resources by increasing general revenues, reducing the growth of non-Social Security, non-Medicare spending, or borrowing from the public, which would push up debt service costs.
There are political, historical, and economic justifications for the president’s proposal to shift some of the burden for supporting future Social Security and Medicare benefits to general revenues. The political arguments were alluded to previously. One is that the transfer of securities to the trust funds, which creates a future general fund obligation, when combined with the proposed budget accounting change, will make a policy of debt reduction politically sustainable. A second argument is that by shifting some of the burden for adjustments onto the general funds the dimensions of the long run problems facing these two programs will be reduced to magnitudes that politicians may find more manageable.
The historical justification is that an infusion of general revenues represents compensation for the fact that, during the early years, Social Security and Medicare payroll taxes were used to support benefits that more appropriately should have been paid for out of general revenues because these benefits were more social welfare than social insurance.
The 1935 Social Security Act set pensions for those retiring during the program’s first few decades at very meager levels—ones that were commensurate with the modest payroll tax contributions the first cohorts of retirees were expected to make. The initial beneficiaries in 1942 would have received a maximum monthly pension of $25 (in 1998 dollars); the first workers to receive full pensions under the 1935 law—those turning 65 in 1979—would have received pensions of less than $250 a month (in 1998 dollars). Under this parsimonious approach, large trust fund balances would have accumulated and these reserves would have generated interest income that would have helped pay future pensions.
In 1939, Congress decided to begin paying benefits in 1940 rather than 1942, raise pensions, and add spouse and survivor benefits to the worker pensions established in the 1935 law. Benefits for these early cohorts were boosted periodically thereafter. These decisions were made to ameliorate a broad social problem—widespread poverty among the elderly whose earnings and savings had been decimated by the Great Depression. The 1939 and subsequent reforms reduced the amount of general revenues needed to support the welfare program for the aged. They provided income support to millions without the stigma of welfare or the inequities associated with the inter-state differences in welfare payment levels that characterized the Old Age Assistance program.
While the arguments for providing more generous pensions than the original Social Security Act called for to those turning 65 during the four decades after 1940 was certainly defensible, it imposed a burden on the Social Security system that would have been more appropriately placed on general revenues.
The implementation of Medicare followed a similar pattern. Starting in 1966, those age 65 and older who were eligible for Social Security benefits—and their spouses, if they were age 65 or older—became eligible for Medicare benefits even though they had not contributed a penny in Medicare payroll taxes to the HI trust fund. The first cohorts of workers who will have paid HI payroll taxes for their entire careers will become eligible for benefits only after 2005.
An economic justification for some general revenue contribution to the Social Security program arises from the difference between the benefit Social Security’s surpluses provide to the nation’s economy and the return that is earned by the trust fund on its reserves.
Additions to national saving generate a real return to the economy of at least 6 percent. Social Security surpluses, however, earn less because the trust fund is required to hold its reserves exclusively in special Treasury securities that, over the long run, are projected to pay an average real return that is under 3 percent. To provide workers with a fair return on the portion of their payroll taxes that bolsters the trust fund reserves, policymakers could allow Social Security to invest its reserves in higher yielding assets, agree to pay a higher rate of interest on the special Treasury securities held by the trust fund, or credit the trust fund with additional bonds. The president’s framework represents a mixture of the first and third of these alternatives.
The “double counting” issue
Many lawmakers and some analysts have criticized the president’s framework not only for its complexity but also because it engages in what they consider to be “double counting.” Specifically, they object to the fact that the president’s plan seems to commit 159 percent of the budget surplus—59 percent to pay down debt held by the public; 12 percent to buy equities for the Social Security trust fund; 29 percent for USA accounts, new discretionary spending, and associated debt service costs; and 59 percent to provide additional Treasury securities to the Social Security and Medicare HI trust funds (Figure 2). They charge that it is budget legerdemain to use the same dollar to both pay down debt and boost reserves in the Social Security and Medicare HI trust funds, as appears to be the case under the president’s framework.
But using budget surplus dollars to redeem debt is fundamentally different from devoting these surpluses to tax cuts or increased spending. In the latter situations, the benefit of the use is external?it flows to taxpayers or program beneficiaries. In the case of debt reduction, the government is reducing its external liabilities. In effect, it is strengthening its balance sheet by buying assets (government bonds held by the public). By crediting the trust funds with these assets, as is done under the president’s framework, the benefit of the improvement in the government’s balance sheet is directed towards preventing future payroll tax increases and benefit cuts rather than towards general tax cuts or spending increases for other government programs. The exchange, however, is not a wash?that is, the increase in the total liabilities of the non-Social Security, non-Medicare portion of the budget would be modestly larger than the reduction in the program adjustments necessary to meet future Social Security and Medicare benefit commitments.
The prospect of growing budget surpluses over the next several decades, together with the expiration of the discretionary spending caps and pay-as-you-go rules after fiscal year 2002, has created a need to establish some framework for dealing with the nation’s fiscal good fortune. Absent such a framework, fiscal discipline could break down and a feeding frenzy of tax cuts and spending increases could erupt. If so, the surpluses could be dissipated by addressing immediate needs that, in retrospect, could appear trivial when compared to the priorities that emerge over the next two decades.
The president has proposed one framework for dealing with the projected surpluses; other policy makers have put forward alternatives. Senator Domenici (R-NM), chair of the Senate Committee on the Budget, has recommended that all of the Social Security surpluses be reserved for debt reduction and that only the projected surpluses in the non-Social Security accounts be available for current commitment. Representative Kasich (R-OH), chair of the House Committee on the Budget, has suggested that commitments can be made now to cut taxes (or increase spending) as long as those initiatives (and the resultant financing costs) do not absorb more than 43 percent of the projected budget surplus for any year.
This percentage is the fraction of the aggregate fifteen year surplus that would remain, under the president’s framework, if the additional Treasury securities credited to the Social Security trust fund and the equity investments were excluded.
Over the next five years, the framework suggested by Senator Domenici would make much less available for current commitment than would the approaches of the president or Representative Kasich. This is because little of the expected surplus over the next few years is contributed by the non-Social Security portion of the budget (Table 3 and Figure 3). Over the 2009 to 2014 period, the Domenici framework is the most generous because well over half of the projected surpluses for that period arise from the non-Social Security accounts. In fact, Social Security surpluses peak in 2012 and decline thereafter. The president’s framework is the most restrictive over the entire 15 year period because it commits 71 percent of the projected surpluses to debt reduction and equity investments for Social Security.
Resources Available for Current Commitments under Alternative Frameworks for the Surplus
fiscal years 2000 to 2014 ($ billions)
Projections of federal revenues and spending, even under unchanged policy, are notoriously inaccurate. The economy can perform significantly better or worse than expected. The fraction of economic output represented by tax revenues can trend up or down for reasons that are difficult to predict. Similarly, spending on entitlement programs such as Medicare and Medicaid can speed up or slow down for reasons that are hard to explain even in retrospect. Figure 4 [not available], which illustrates the changes that have occurred over the last four years in the Congressional Budget Office’s baseline projections, after subtracting out the effects of policy changes, underscores this reality. While on balance the unexpected shocks of the past four years have acted to improve the fiscal outlook, the opposite was the case during the 1980s and early 1990s. That less fortunate pattern could be repeated in the future. Given this uncertainty, the economic benefits of debt reduction, and the challenges that the babyboomers’ retirement will pose for the nation, a framework like the president’s represents a prudent approach to fiscal policy for the first two decades of the 21st century.