How to Get the Deficit Under $100 Billion
By Martin Feldstein
Martin Feldstein, who wrote the Essay that follows, served from September 1982 to July 1984 as chairman of the Council of Economic Advisers in the Reagan Administration. One of the leading conservative economists, he nonetheless differed with the White House on several key budget and tax issues, in particular, what he saw as the grave danger posed by large deficits.
There is now widespread agreement in the U.S. that the budget deficit is the most serious problem facing the American economy. This year it will exceed $200 billion, nearly $1,000 for every man, woman and child in the nation. Without tough legislative action, the deficits will continue to increase and will reach nearly $300 billion a year by the end of the decade. If the U.S. is to continue to enjoy a healthy economic recovery and a rising standard of living, these huge deficits must be eliminated.
A $200 billion deficit this year means that the Government is adding $200 billion to our national debt--an increase that some day must be repaid or that we and our children and our children's children will have to pay interest on forever. The deficits projected for the next several years would increase the national debt by more than $1 trillion between now and the end of the decade. If this is allowed to happen, the increase in this decade alone will be greater than the entire rise in the 200 years since this nation began.
Any addition to the national debt increases the Government's future annual interest costs, even if the interest rates remain unchanged. A $200 billion increase in the national debt raises the Government's annual interest cost by some $20 billion a year. That makes the one-year increase in the Government's annual interest bill more than the entire cost of the food-stamp program. The interest that the Government pays on the national debt has soared from less than $130 per person in 1960 to more than $500 per person this year, and is heading to an annual total of almost $750 per person by 1989 even when expressed in constant 1985 dollars.
By raising interest costs on the national debt, large budget deficits make future tax increases inevitable. By 1989 nearly half of the income taxes that we pay will be used to finance interest payments on the Government debt.
Continued large deficits will also mean a slower rate of economic growth and a reduction in our future standard of living. Experience shows that the key to raising living standards is investment. New factories, offices and stores and new machinery and equipment increase the output produced by each employee. This higher productivity then permits the noninflationary increases in wages and salaries that enable employees to afford a higher standard of living. Budget deficits undermine such increases because they require the Government to borrow funds that would otherwise be available to finance investments in plant and equipment and in housing. The projected annual deficits of 5% of G.N.P. mean that Government borrowing would absorb more than half of these funds.
The competition for money between the Government and private borrowers inevitably raises the level of inflation-adjusted or real interest rates. Despite the recent fall in market interest rates, the real rates on home mortgages and corporate bonds today are about 10%--or more than three times the level in the 1970s. The principal reason for this increase has been the rise in the federal budget deficit. The high real interest rates caused by the budget deficit are also the direct source of the overwhelming trade deficit now hurting American exporters and those U.S. firms competing with imports. The rates have attracted funds to the U.S. from around the world, and the increased demand for dollars has raised the dollar's value by more than 60% since 1980.
The funds attracted to the U.S. from abroad add to the pool of funds available to finance investment in the country. This year the capital inflow will be enough to offset half of the Government's borrowing. But the current level of capital inflow cannot be sustained. Foreign assets in the U.S. have increased 50% since 1980. Even if U.S. interest rates remain high, foreign investors will eventually become saturated with dollar securities. When the inflow of funds shrinks or stops, investment in the U.S. will decline, and real interest rates here will rise even higher--unless Government borrowing has by then been brought under control.
The final major adverse effect of sustained large budget deficits is to increase the risk of an inflationary monetary policy. We already hear occasional calls for an easier monetary policy that its advocates incorrectly claim will stimulate growth, increase tax revenue and reduce future deficits. But experience shows that an excessive monetary expansion would not only fail to achieve an increase in growth or a sustained reduction in real interest rates but would instead cause a rise in the rate of inflation.
The deficits that now loom so large were unimaginable just a few years ago. The U.S. had a balanced budget in 1960 and again in 1970. How did we get to a deficit of nearly 5% of G.N.P. in 1984? The answer in short is that Government spending has increased sharply without a corresponding increase in taxes to pay for it. But this short answer hides four important facts about the way that the composition of spending and taxes has changed.
First, the jump in spending on Social Security and Medicare--from 2.3% of G.N.P. in 1960 to 6.6% in 1984--accounts for virtually all of Government spending's increased share of G.N.P. Second, there has been an absolutely unprecedented cut of 12% since 1980 in the real outlays on all other nondefense programs. More specifically, spending on all such nondefense programs fell from 9.3% of G.N.P. in 1980 to 7.3% in 1984, and will decline to 6.2% by 1989 even if there are no further changes in the law. Third, the defense-spending share of G.N.P. fell by one-third between 1960 and 1980, and has only begun to recover its previous level. Defense spending took 9.7% of G.N.P. in 1960 and declined to only 5.3% of G.N.P. by 1980. Since then it has increased to 6.5% of G.N.P. Fourth, there has been a sharp decline in income taxes as a share of G.N.P. and a rapid rise in the payroll taxes used to finance Social Security and Medicare. While payroll taxes rose from 2.1% of G.N.P. in 1960 to 5.7% in 1984, all other taxes fell from 16.4% of G.N.P. to 13%.
The Reagan Administration inherited a deficit equal to 2% of G.N.P., but predicted that this could be eliminated in four years by a combination of reductions in Government spending and the increased tax revenue that it calculated would result from a much improved rate of economic growth. President Reagan did cut total nondefense spending other than Social Security and Medicare by a very substantial $43 billion, measured in 1984 dollars. But these cuts were not enough to offset the continued rapid rise in Social Security and Medicare benefits, the sharp increase in defense outlays and the jump in interest on the national debt. Moreover, the 1981 and 1982 tax bills reduced total tax revenues by $90 billion in 1984 and by a projected $173 billion in 1987.
The President and his Cabinet budget group now recognize that growth alone cannot solve the deficit problem, and have called for very tough spending cuts aimed at shrinking the deficit to 2% of G.N.P. by 1988, or roughly $100 billion. The President's targets for budget savings properly include subsidy payments to affluent farmers, medical care for middle-class veterans, subsidized loans to small- and medium-size businesses and grants to states and local governments with budget surpluses. Nevertheless, the President's proposals cannot reduce the deficit adequately because they are restricted to a small part of total Government outlays.
To achieve the needed deficit reductions, every part of the budget will have to play a part. Congressional leaders in both parties have made it clear that their first change in the Administration's budget will be to slow the growth of defense spending. By 1989 currently projected defense outlays will be reduced by between $30 billion and $50 billion. But the combination of defense cuts that Congress will require and nondefense cuts that the Administration can achieve is not likely to reduce total spending on Government programs in 1989 by more than $100 billion. Although that would certainly be a major achievement, it would still leave an unacceptable deficit of nearly $200 billion at the end of the decade. To reduce the deficit to the Administration's target level of 2% of G.N.P. in 1988 and to achieve a balanced budget by early in the next decade, it will be necessary to go beyond these cuts in defense and nondefense programs.
Government outlays for Social Security benefits tripled in the past decade to exceed $175 billion in 1984, and are currently slated to reach $250 billion a year by 1989. During the 1970s, Social Security benefits per retiree rose 50% after adjusting for inflation, while the average earnings per employee did not increase at all after taking inflation into account. Social Security benefits are paid without regard to financial need, and most of the $175 billion of current Social Security benefits goes to individuals who are certainly not poor. Under current law, Social Security beneficiaries also receive an annual cost of living adjustment (COLA) that completely offsets the rise in consumer prices.
A simple way to reduce the future growth of Social Security benefits would be to modify the annual cost of living adjustment, restricting the automatic increase to the excess of inflation over 3%. Such a 3% threshold on the COLA would mean that benefits would rise by 1% if the inflation rate were 4%, by 2% if the rate were 5% and so forth. This would slow the growth of total benefits without denying anyone a Social Security benefit and without reducing the size of any retiree's monthly check.
Although each retiree would experience only a small reduction in the increase of monthly benefits, the cumulative effect on total benefit outlays would be very substantial. A 3% indexing threshold would reduce 1989 Social Security outlays by about $35 billion. And if the same principle for limiting indexing were extended to all other Federal Government retirement programs, the savings would rise to $50 billion a year by 1989.
A tough rethinking of the major domestic programs and a significant slowing of defense spending and of Social Security benefits can reduce total 1989 outlays--including interest on the national debt--by as much as $160 billion. But even with such savings, the deficit would still be more than $100 billion. There is thus no politically feasible way to achieve the Administration's own goal without increasing tax revenue. After the Congress has completed its search for spending cuts, it will be time to turn to the problem of raising revenue.
It is important that any revenue increase be achieved with as little damage to economic incentives and long-term growth as possible. That means that the current incentives to save and to invest should be preserved and strengthened. It also means that further increases in already high tax rates should be avoided.
Although there is never a good way to raise tax revenue, there are three ways that are better than other alternatives. The first would be a 3% threshold on the indexing of the income tax brackets. Taxes would continue to be adjusted every year to offset the effects of inflation but only to the extent that inflation exceeds 3%. This would parallel the 3% threshold on the indexing of Social Security benefits and would be a natural basis for a political trade between those who oppose any reduction in the growth of Social Security benefits and those who oppose any tax increase. By 1989 such a change in tax indexing would increase annual revenues by $35 billion.
A second source of additional revenue would be a tax on energy. The price of oil has declined more than 20% in the past three years, and is likely to go on falling. Even a relatively small 5% excise tax on energy could produce some $15 billion a year by the end of the decade. And an extra 10 cents-per-gal. tax on gasoline--which would offset only half of the 20 cents-per-gal. price decline that has occurred over the past four years--would raise $10 billion a year.
Finally, tax reform of the type the Treasury recently proposed provides a framework within which revenue can be raised, the incentives for good economic performance strengthened and overall tax fairness improved. I disagree with many specific features of the Treasury's proposal, particularly those that would hurt incentives for saving and business investment. But I believe that there is substantial virtue in the basic notion of changing the tax rules in a way that permits reducing currently high tax rates and simplifying compliance for the vast majority of taxpayers. It should not be difficult to design a tax reform that by changing some of the current tax deductions and special tax rules, keeps the distribution of tax payments unchanged, lowers the current high tax rates and raises as much as $50 billion a year more revenue.
In short, the economically desirable reductions in the budget deficit can be achieved politically by a comprehensive reduction in spending and a well- structured change in the tax rules. The combination of slower growth of defense spending and of Social Security benefits and actual reductions in a wide range of over-size, nondefense programs can lower outlays by $160 billion in 1989. But to reduce the deficit to less than 1% of G.N.P. and bring a balanced budget into sight will also require tax changes that raise 1989 tax revenues by $75 billion to $100 billion.
We are now at a critical point for the future of the American economy. Substantial progress has been made in the past four years in putting the economy on a path that can provide a rising standard of living for everyone. Inflation has been brought under control, incentives for saving and investment have been strengthened, and the burden of the Government on the private economy has been lightened. But that progress and the current bright prospects for the future can easily be destroyed by fiscal irresponsibility. The next six months will test whether our political system can produce the tough fiscal legislation that is now required if we are to sustain the progress that has been made and realize the full potential of our economic future.
QUOTE: "There is no politically
feasible way to achieve
the Administration's own
goal without increasing
tax revenue."
"The current bright
prospects for the
future can easily
be destroyed by fiscal
irresponsibility."