Testimony

The Budget Outlook and Tax Policy

William G. Gale

Mr. Chairman and Members of the Committee:

Thank you for giving me the opportunity to discuss the challenges and opportunities presented by the current and projected fiscal situation. My testimony is divided into two sections. The first section provides a summary of the major conclusions. The second section provides the background analysis that supports these views.

1. The Budget Outlook

The most recent Congressional Budget Office baseline forecast projects cumulative surpluses of $5.6 trillion between 2002 and 2011. There is much less there, however, than meets the eye. To assess policy options accurately requires a measure of the surplus that would be available for tax cuts or new spending under responsible budgeting procedures, plausible assumptions about the maintenance of current policy, and appropriate time horizons. The adjustments required to meet those needs imply that the funding likely to be available for new tax cuts or spending programs is substantially less than the baseline forecast would suggest.

Over the next 10 years, almost 60 percent of the projected surplus is due to accumulations in retirement trust funds. No financially responsible firm would consider its pension reserves as a source of financing for current operating expenses, and neither should the federal government. Cordoning off social security reduces the available surplus to $3.1 trillion. Protecting the Medicare trust fund reduces the amount to $2.7 trillion. Protecting the pension reserves of government military and civilian workers would reduce the available surplus to $2.3 trillion.

Fixing problems with the alternative minimum tax and expiring tax provisions reduces the available funds to $2.1 trillion. Allowing real discretionary spending per person to remain constant reduces the amount of available funds to $1.7 trillion over the next 10 years.

There is nothing sacrosanct about a 10-year planning horizon. For public policies such as social security and medicare, the official planning horizon is 75 years. Looking beyond the 10-year horizon is particularly important for assessing the budget outlook because the rapid growth in entitlement programs driven by an aging population and rapidly rising medical care expenditures is not projected to begin until later dates. Despite current surpluses, estimates in this testimony show that the government continues to face a long-term financial shortfall. This fundamental fact counters claims that Americans are being “overcharged” for government currently.

2. President Bush’s Tax Proposals

President Bush’s tax proposal would reduce the highest income tax rates, abolish the estate tax, create a new 10 percent tax bracket, expand the child credit to high-income households, reduce the phase-out rate, double the credit amount, and allow a two-earner deduction, among other changes.

Author

The Joint Committee on Taxation has estimated that under Bush plan’s approximately 27 million taxpayers would be affected by the AMT by 2010. The Bush administration has acknowledged this problem, but the Bush campaign web site (where voters could calculate how much of a tax cut they would receive under Bush’s plan) did not allow for the AMT to reduce anyone’s tax cut, and thus implicitly assumed that an AMT fix was a de facto part of the Bush plan. For all of these reasons, I include adjustments so that no taxpayer’s tax cut would be affected by the AMT as part of the Bush plan.

3. Evaluating the President’s Tax Proposals

The Administration has had a very difficult time providing a coherent justification for its tax package. Notably, the President’s justifications for his tax proposal keep changing, but the proposal does not.

Over the next 10 years, Bush’s proposal would cut taxes by about $1.56 trillion, the AMT adjustments would total $242 billion, and the added interest payments on the federal debt caused by the reduction in federal revenues would cost another $345 billion. Thus, although the proposal is often referred to as a $1.6 trillion tax cut (by rounding the $1.56 trillion figure above), the real cost of the proposal would be about $2.15 trillion over the next 10 years. This is much larger than the “available surplus” noted above, and implies that many other important policy priorities could not be met unless Congress were willing to finance new programs with balances in the retirement trust funds.

The proposed tax cut would roughly triple the severity of the long-term fiscal problem. Properly adjusted, Bush’s tax cut is about as large as the net tax cut created by the 1981 and 1982 tax acts. But taxes on most families were much higher then than they are now, and tax rates had been rising steadily rising in years before that. In recent years, the tax burdens on most families have fallen.

Besides being too large, the Administration’s tax cut would be disproportionately tilted toward high-income taxpayers, who would receive a bigger percentage decline in tax payments, a bigger percentage increase in after-tax income, a bigger share of the total tax cut than their current tax share, and a gigantic cut in dollar amounts. The Administration’s rhetoric on distributional effects has been particularly misleading and disingenuous.

The President’s efforts to “take down the tollbooth to the middle class” and to address the marriage penalty leave out households with earnings below $20,000, who often face the highest effective tax rates and the largest marriage penalties.

One of the most puzzling and misleading aspects of the President’s defense of the tax cut is his claim that it would be an effective way to fight a brewing recession. It is not clear that a recession will emerge, and most economists (myself included) feel that tax policy is poor way to counter a recession. Even if tax policy were a good way to counter a recession, the President’s tax proposal is incredibly poorly designed for that purpose. It is so big it would raise interest rates, which would hurt the economy. It is delayed (no tax cuts in 2001 and only $20 billion in 2002), and so can not help fight a recession now. And it is geared toward high-income households, when it is low- and middle-income households that would be most likely to lose their job and most likely to spend the tax cut.

Another argument the president uses to justify tax cuts is that tax revenues are at historic highs and therefore that Americans are being crushed by overburdensome taxes. But if a high aggregate federal tax burden justifies tax cuts, it should justify cuts in a variety of taxes, not just the income and estate taxes. In fact, for most families, taxes are as low or lower than they have been in the past 20-30 years. Overall tax payments have risen because the rich have gotten richer at an impressive rate.

Some argue that tax cuts are needed to prevent government from going on a spending spree. There is clearly some validity to this concern, but the vast portions of existing surpluses have been allowed to accumulate, so the argument is weakened considerably. And it is Congress that has been willing to cordon off Medicare, not the Administration. Finally, even if this argument justifies a tax cut, it does not provide a rationale for why the tax cut should be focused on the highest-income households.

An argument put forth recently by Alan Greenspan, and quickly repeated by tax cut advocates, is that under current surplus projections, the government will pay off all available government debt by around 2006 or shortly thereafter. Greenspan and others argue that having the federal government hold such assets would raise a number of difficult issues. These issues are real, but the concerns are probably overstated. Currently, for example, state and local government pension funds hold private assets equal to 28 percent of GDP.

4. Policy Options

The current fiscal surpluses are a significant accomplishment, and should not be taken lightly or for granted. There is clearly room for a tax cut, for spending priorities, and for debt reduction. But I believe that the most important budgeting decision for the Congress is to establish a new set of budget rules, and that these rules should be established before making a significant set of tax and spending changes.

A. Budget rules

The fiscal accomplishments of the last decade should be preserved and enhanced, not squandered. The old rules are expiring. And the current budget situation has dangers associated with it, since there are short-run surpluses but long-term deficits. Consideration of policy rules should take several factors into account. First, there is a certain asymmetry in policy options. It is always easier to reduce taxes later than to raise them. Second, new and unforeseen policy priorities frequently arise, so prudent fiscal management would suggest the equivalent of a “reserve fund” of some sort. Third, both budget projections and economic forecasts are subject to considerable uncertainty, which suggests another reason not to commit all available resources immediately.

—Reaffirm the commitment to protect social security and medicare and extend the same treatment to government pension reserves.

—Adopt a proposal put forth recently by Robert Reischauer to cordon off increasing amounts of future surpluses from current commitments.

B. Tax Policy

Tax policy should be made inside of a budgetary framework that recognizes the importance of other public policy goals—such as education, health, defense, the refurbishing of social security and medicare and so on. In addition, fairness, efficiency, and simplicity remain the core principles of tax policy regardless of the size of the surplus.

—Create a new, lower tax bracket of 10-12 percent, covering a range of income broader than the 10 percent bracket proposed by proposed by President Bush.

—Combine or integrate interactions between the child credit, earned income credit, and personal exemption. This would simplify taxes, improve incentives to work and marry, and provide added resources to low-income households. A crucial element would be to increase the refundability of the child credit.

—Simplify the tax code by raising the standard deduction, providing a uniform exclusion for capital gains income rather than the complicated patchwork of capital gains tax rates we currently have.

—Provide tax cuts to high-income taxpayers and simplify the tax system further by removing the phaseout of personal exemptions and the limitations on itemized deductions. Either reform or abolish the alternative minimum tax.

—Reform the estate tax by raising the effective exemption, modestly reducing rates, indexing the tax for inflation, and closing down a number of egregious sheltering practices.

The Budget Outlook and Tax Policy

1. The Budget Outlook

After decades of deficits, the federal budget has recently yielded increasing annual surpluses. The most recent Congressional Budget Office baseline forecast, released in January projects cumulative surpluses of $5.6 trillion between 2002 and 2011, including $2.5 trillion in the social security trust fund (the “off budget” surplus) and $3.1 trillion in the rest of the budget (the “on-budget” surplus).

Just as perennial budget deficits dominated policy discussions in the 1980s and early 1990s, choices regarding how to use these surplus will shape fiscal debates for years to come.

Debates regarding these choices are almost always carried out in the context of CBO’s baseline forecast. However, while it provides a common and visible benchmark, CBO’s baseline is limited in several crucial ways and does not provide sufficient information to assess various policy options.

To assess policy options accurately requires a measure of the surplus that would be available for tax cuts or new spending under responsible budgeting procedures, plausible assumptions about the maintenance of current policy, and appropriate time horizons. To obtain these measures, it is necessary to adjust the baseline forecast for the treatment of retirement funds, the definition of “current policy;” and the time horizon employed. These adjustments provide different perspectives on the size of the available surplus and generally imply that the funding likely to be available for new tax cuts or spending programs is substantially less than the baseline forecast—and the current policy debate—would suggest.

A. The treatment of retirement trust funds

No financially responsible firm would consider its pension reserves as a source of financing for current operating expenses. Neither should the federal government. This simple but fiscally prudent observation has a significant impact on estimates of the available surplus.

As noted above, a substantial portion of currently project budget surpluses over the next 10 years occurs because the Social Security trust fund will take in about $2.5 trillion more in payroll tax revenues and interest received on its assets than it will pay out in benefits and administrative costs. Leaders of both political parties agree that accruing Social Security trust fund balances should contribute to improving that program’s long-term financial viability, and should not be used to finance tax cuts or other spending programs.

Medicare pays for health care for the elderly, and is divided into two parts. Part A, hospital insurance, covers hospital costs and is financed by payroll taxes. Part A is very similar in structure to social security. Workers contribute payroll taxes to a trust fund while working and receive promised benefits when they are elderly. Part B, supplementary medical insurance, is financed by a combination of user fees and general revenues. Over the next 10 years, the Medicare (Part A) trust fund is projected to run surpluses totaling $392 billion (CBO 2001, p. 19). Although Medicare is officially part of the on-budget surplus, both Houses of Congress voted last year to support measures that protected the Medicare trust fund from being used to finance other programs or tax cuts. The House of Representatives approved the measure by a vote of 420-2. The Senate passed two separate measures; 98 Senators voted in favor of one or both. The strong votes demonstrated overwhelming Congressional support for preserving the Medicare trust fund.

Notably, however, the Bush administration has not agreed to protect the Medicare trust fund. Indeed, the administration has moved in the opposite direction, and has proposed to use the hospital insurance surplus to replace a portion of the general revenues that currently finance supplementary medical insurance. This amounts to spending the Trust Fund on a program other than hospital insurance. As such, it would violate the measures passed by both Houses last year.

While the social security and Medicare trust funds have received significant attention in the budget debate, a third set of retirement funds has not. Trust funds holding pension reserves for federal military and civilian employees will accrue surpluses of $419 billion over the next 10 years (CBO 2001, p. 19). Under current budget procedures, these surpluses are a component of the on-budget surplus. Like Social Security and Medicare, however, these trust funds represent current accumulations intended to provide retirement benefits to future workers. Thus, the same economic logic that has led fiscally responsible leaders to protect Social Security and Medicare balances, implies that government pension reserves should be protected as well. Many states, in fact, already separate their pension reserves from funds available for tax cuts and other spending. A recent proposal (H. RES. 23) by Representatives Baron Hill (D-Indiana) and Gene Taylor (D-Mississippi) would protect the pension reserves owed to military workers. Fiscal responsibility requires that the same protections be accorded to civilian pensions as well.

B. The definition of current policy

In order to project future spending and tax revenues, assumptions must be made about how tax and spending programs will evolve. The CBO’s baseline forecast is intended only to measure the implications of maintaining “current policy.” But how one should project current policy into the future is not always obvious. The baseline forecasts project current policy subject to a variety of statutory requirements, which limit the scope of the forecast’s underlying assumptions and time horizons and can be at variance with reasonable expectations.

Mandatory spending—e.g., entitlements, such as Social Security—is generally assumed to continue as it is currently structured in the law. Discretionary spending, however, poses problems with regard to defining “current policy.” Unlike mandatory spending, discretionary programs—e.g., defense, education, the environment, or infrastructure—are not automatically included in the annual budget and thus require annual appropriations from Congress. As a result, no consensus exists about how to project current policy for discretionary programs. In light of this quandary, CBO simply assumes that real discretionary spending authority will remain constant at fiscal year 2001 levels (CBO 2001, p. 76).

This assumption is clear, but may not be very reasonable. Discretionary spending totaled 6.3 percent of GDP in 1999 and 2000, the lowest share since at least 1962. Under CBO’s baseline forecast, discretionary spending would fall to 5.1 percent of GDP. That is, it would fall by 20 percent relative to the size of the economy. It would also fall by over 10 percent in per capita terms. In a growing economy with large surpluses, growing defense needs, and other concerns, this seems to be a particularly draconian baseline.

At the very least, it would be more reasonable to have real discretionary spending grow at the same rate as the population (about 1 percent per year). This would hold real discretionary spending per person constant, but would still allow spending to fall to 5.6 percent of GDP by 2011. Incorporating this baseline would raise discretionary spending by $359 billion (CBO 2001, table 4-4) and, counting the added interest payments on federal debt that would be required, would reduce available surpluses by about $418 billion.

A more ambitious alternative baseline would have discretionary spending grow at the same rate as nominal GDP, thus keeping the ratio of discretionary spending to GDP constant. This would raise spending by $905 billion (CBO 2001, table 4-4) and reduce the available surplus by $1,055 billion between 2002 and 2011.

To put these figures in perspectives, note that in the campaign President Bush proposed new spending programs totaling $475 billion, along with cuts in government spending of $196 billion, for a net spending increase of $279 billion between 2001 and 2010 (table 1). This is virtually identical to the cost of having real discretionary spending grow by 1 percent over the same period (rather than over 2002-2011, see CBO table 4-4). Thus, this suggests that having real discretionary spending grow by 1 percent is a lower bound for the likely path of discretionary spending, both because Congressional Democrats and Republicans may have proposals of their own sometime over the next 10 years, and because President Bush may have more proposals for spending—especially on defense—after his initial round of proposals.

At least two aspects of current policy toward taxation merit consideration. The first regards the alternative minimum tax (AMT), one of the most complex areas of individual tax law. The AMT was implemented as a sort of backstop confronting the small number of taxpayers who are considered to be too aggressive in creating shelters and claiming deductions to avoid paying taxes.

In practice, the AMT has affected few taxpayers. In 2000, for example, only 1.3 percent of taxpayers faced the levy. Under current law, however, the Treasury projects that by 2010, 15 percent of taxpayers will be affected by the AMT. The main reason why is that the AMT exemption is not indexed for inflation. CBO’s surplus forecasts assume that the dramatic rise in AMT taxpayers will occur. However, the increase would be fought fiercely by the affected groups. Indeed, the problem has already received significant attention, even though only a small portion of taxpayers currently face the tax.

“Current policy” would be better represented by indexing the AMT for inflation. This would keep the number of taxpayers on the AMT limited to about 1.9 percent by 2010. The lost tax revenue from this policy would total $113 billion over the next 10 years. Counting the added interest, the net cost would be $130 billion.

A second tax issue relates to temporary tax provisions, a number of which are scheduled to expire over the next decade. For all taxes other than excise taxes dedicated to trust funds, CBO assumes that legislated expirations occur as scheduled. In the past, however, the temporary provisions have typically been extended another few years each time the expiration dates approached. In light of this practice, current policy is more aptly viewed as assuming that these so-called “extenders” will be granted a continuance. Extending the provisions – except the one relating to AMT, which is addressed above – through the 10-year horizon would cost a net of $69 billion in lost revenues (CBO 2001, table 3-12), plus an estimated additional $13 billion in interest costs.

C. Implications for the available surplus over the next 10 years

Table 2 shows that these adjustments have a profound effect on the amount of funds that should be considered to be available for tax cuts or new spending. (Appendix table 1 provides year-by-year estimates of the alternative surplus measures.) The total 10-year projected surplus of $5.6 trillion is shown in the first line. Removing the social security trust fund surplus generates an “on-budget” surplus of $3.1 trillion. Removing Medicare trust funds reduces the surplus to $2.7 trillion. Protecting government pension funds from invasion for other purposes reduces the available surpluses to $2.3 trillion. That is, almost 60 percent of the projected 10-year surpluses are due to the retirement trust funds.

Adjusting for the issues regarding the AMT and expiring tax provisions reduces the available surplus to $2.1 trillion. If real discretionary spending were held constant on a per capita basis—or if President Bush’s spending plans were implemented—the net available surplus for other programs would be just under $1.7 trillion. In contrast, if discretionary spending were held constant as a share of GDP, the remaining available surplus would be about $1 trillion (table 3).

Thus, depending on what is considered the most reasonable assumption regarding current policy toward discretionary spending, the available surplus is between $1.0 trillion and $1.7 trillion. This represents between 18 and 30 percent of the total surplus, and roughly one-third to one-half of the on-budget surplus over the 10 year period. The Center on Budget and Policy Priorities (CBPP) has made a similar set of adjustments and estimated an available surplus of about $2 trillion over the next 10 years (Greenstein and Kogan 2001).

D. Looking beyond the 10-year horizon

There is nothing sacrosanct about a 10-year planning horizon. For public policies such as social security and medicare, the official planning horizon is 75 years. Indeed, an analysis of social security’s finances that focused only on the next 10 years would not pass a laugh test. Likewise, many important private economic decisions, such as how an investor values a firm’s stock, or how a family sets the parameters of a financial plan, also typically depend on perceptions of events that will occur more than 10 years into the future. Looking beyond the 10-year horizon is particularly important for assessing the budget outlook because the rapid growth in entitlement programs driven by an aging population and rapidly rising medical care expenditures is not projected to begin until later dates.

To take these and other factors into account, previous research (Auerbach 1994 and 1997, Auerbach and Gale 1999, 2000) estimates the long-term “fiscal gap” under different policies. The fiscal gap is the size of the permanent increase in taxes or reductions in non-interest expenditures (as a constant share of GDP) that would be required now to keep the long-run ratio of government debt to GDP at its current level. The fiscal gap gives a sense of the current budgetary status of the government, taking into account long-term influences.

These estimates use the current CBO 10-year forecast through 2011 and CBO long-term budget forecasts through 2070. In subsequent time periods, all revenues and non-interest expenditures are assumed to remain a constant share of GDP. Social Security and Medicare outlays follow the intermediate projections in the reports released by the trustees of the funds. Discretionary spending, federal consumption of goods and services, and all other government programs, with the exception of net interest, are assumed to grow with GDP after 2010. Tax revenues are a constant share of GDP, except for supplementary medical insurance premiums collected for Medicare, which grow relative to GDP.

Table 4 shows that different measures of current policy can have a significant impact on the long-term fiscal status of the federal government, if these policies establish levels of spending or taxes that are preserved (relative to GDP) after 2011. Under the CBO baseline assumptions about discretionary spending, the fiscal gap through 2070 is projected to be 0.67 percent. That implies that a permanent tax increase of 0.67 percent of GDP, which would currently be about $67 billion, would be required to restore fiscal balance through 2070. The fiscal balance on a permanent basis is currently 3.33 percent of GDP. Allowing discretionary spending outlays to remain constant as a share of GDP raises the fiscal gap further, to 1.45 percent of GDP over the next 70 years and 4.14 percent on a permanent basis.

In light of the recent political pressure to raise spending and/or cut taxes, it seems highly unlikely that there will be any immediate action to reduce the fiscal gap. But delaying the implementation of necessary tax increases or spending cuts will raise the required fiscal correction at the time of implementation.

All of the calculations above show that systematically incorporating longer horizons implies that the government faces significant financial shortfalls. This, of course, significantly damages the case for large-scale tax cuts today. Remarkably, however, some tax cut advocates try to use horizons (slightly) longer than 10 years to justify large tax cuts. They argue that when the 10-year projection period changes next year to 2003 to 2012 (from the current 2002 to 2011), the 10-year projected surplus will rise dramatically because adding the surplus projected for 2012 will far outweigh the loss of the surplus projected for 2002. Their claim is correct as far as it goes, but is misleading. It is essentially arguing for an 11-year perspective, which completely ignores the long-term fiscal shortfall.

E. Uncertainty

It is difficult to predict the course of the economy over a period as short as 6 to 9 months. Thus, it should not be surprising that all of the estimates above are subject to a considerable amount of uncertainty. A few comments on the uncertainty of the forecasts are warranted.

First, CBO’s underlying economic assumptions do not appear to be unreasonable. Their forecast for GDP growth over the next two years—2.4 percent in 2001 and 3.4 percent in 2002—is in the middle of the Blue Chip forecasters. Notably, CBO does not foresee a recession in 2001, just a slowdown. Just as notably, CBO projects that the economy will turn around and growth will accelerate in 2002, even without any changes in tax or spending policy. CBO predicts a growth rate of about 3.1 percent for the rest of the decade, which does not seem out of line with reasonable expectations. CBO (2001, p. 60) points out that its forecast does not depend on a continuation of high capital gains revenues or high stock market values and in fact projects a decline in the share of revenues from capital gains.

Second, there is simply a huge amount of uncertainty regarding the evolution of the economy and the surplus. CBO (2001, p. 99) reports optimistic and pessimistic scenarios for the economy, where the 10-year surpluses range from $8.8 trillion to $1.6 trillion. In the latter case, there is an on-budget deficit of about $525 billion over the 10 years. CBO (2001, p. 96) also notes that on average their revenue forecast has been off by 11 percent of revenues after 4 years. If revenues were 11 percent higher or lower than forecast over the next 10 years, the surplus would differ from baseline by about $3.9 trillion. Interestingly, CBO (2001, p. 102) estimates that a mild recession followed by higher-than-trend growth would have little effect on the 10-year surplus, but that does not preclude a deeper, longer recession or a change in the long-term growth rate from having a significant impact.

Third, an important source of uncertainty stems from the fact that the surpluses are expected to rise over time. Only 12 percent of the projected total surplus and 10 percent of the projected on-budget surplus occurs in the first two years. Likewise, only 36 percent of the projected total surplus and 32 percent of the projected on-budget surplus occur in the first five years.

Fourth, other things equal, long-term estimates are inherently more uncertain than short-term estimates. But the added uncertainty should not lead us to ignore long-term issues, for at least two reasons. First, the serious consequences of a relatively bad long-term outcome should spur a precautionary response from policymakers now (Auerbach and Hassett 2000). Second, over the next 10 years, the primary factor affecting surpluses will be the course of the economy, which as noted above, is uncertain. In contrast, in the longer-term, the demographic pressures that are due to an aging population are far more certain to occur.

F. Implications for the tax policy debate

These findings suggest some useful lessons for the current debate about how to allocate the surplus. The virtually exclusive emphasis given to baseline 10-year budget projections in current fiscal policy debates is inappropriate. The baseline forecast suggests the availability of trillions of dollars for tax cuts or new spending, but is based on a particular set of views of what constitutes current policy. Fiscal responsibility and plausible notions of current policy reduce the available 10-year surplus to between $1.0 and $1.7 trillion.

Despite the recent strong improvement in the government’s fiscal position, there is still a long-term imbalance. This imbalance is a “future” problem only insofar as our budget accounting rules ignore the existence of liabilities already accrued.

Given this long-term imbalance, the fiscal climate may be more troubling now than in previous years. The short-ter