[Budget of the U.S. Government]
[III. Putting the Building Blocks in Place]
[From the U.S. Government Publishing Office, www.gpo.gov]
III. PUTTING THE BUILDING BLOCKS IN PLACE
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To reclaim our future, we must strive to close both the budget deficit and the investment gap.
Governor Bill Clinton
Senator Al Gore
Putting People First
1992
With regard to Congress, if I could do one thing, I would pass a balanced budget that would open the doors of
college to all Americans and continue the incremental progress we've made in health care reform.
President Clinton
November 10, 1996
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President Clinton has pursued a disciplined but fair budget policy,
working with Congress to make the tough choices that have dramatically
cut the deficit while protecting the values that Americans share. He has
cut wasteful and lower-priority spending while protecting safety net
programs and investing in the future.
The results are clear: The deficit has fallen by a whopping 63
percent--from $290 billion in 1992, the year before the President took
office, to $107 billion last year. Now, with this budget, the President
proposes to build on that progress by balancing the budget for the first
time since 1969.
Why must we finish the job?
What the Administration Inherited
Large budget deficits damage the economy, hurting taxpayers and
discouraging businesses. The sharply higher deficits that began in 1981
have been a serious drag on the Nation's economic performance ever
since.
The Debt and What It Means for the Average Citizen: The budget deficit
is the annual amount that the Government spends in excess of what it
receives in revenues. The Federal debt, by contrast, is the total of the
accumulated deficits that have not been offset by surpluses over the
years.
At first blush, deficits may appear painless; they allow the Nation's
leaders to avoid the hard choices needed to bring spending in line with
revenues. But the Government must finance the debt that it accumulates,
and the cost of doing so prevents the Nation from meeting future
spending needs or cutting taxes.
The Government finances the deficit mainly by borrowing from the
public, including foreign investors. The large deficits of the 1980s and
early 1990s quadrupled the Federal debt. At the end of 1980, Federal
debt held by the public was $710 billion. By the end of 1992, it had
grown by $2.289 trillion--to $2.999 trillion.\1\ Because the deficit has
fallen under this Administration, the debt has risen more slowly, and,
in fact, the ratio of the debt to our Gross Domestic Product (GDP) has
declined. But until we balance the budget, the debt will keep growing.
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\1\ This measure excludes the debt held in Federal trust funds. It
counts only the debt held directly by private investors and the Federal
Reserve System.
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In a sense, today's deficits are the legacy of the much larger
deficits of the years from 1981 to 1992. The budget would be
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balanced today if not for the interest that we pay on the deficits accumulated in those 12 years.
The Federal Government paid $241 billion in interest last year--$241
billion that it could have spent in far more productive ways. If the
Government were not paying interest at all, it could have used those
funds to have a balanced budget and still have $134 billion left over--
which equals half of the military budget, or about 40 percent of Social
Security payments, or about 20 percent of income taxes.
How Deficits Have Damaged the Economy: The economy did not perform as
well from 1980-1992 as before, partly due to the rise in Federal debt
that marked the period. As this experience shows, persistent deficits
reduce saving, raise interest rates, stifle investment, and cut the
growth of productivity, output, and incomes.
During recessions, when private consumption and investment declines,
Government borrowing to finance unemployment and other benefits and to
make up for reduced income taxes maintains demand and helps to turn the
economy around. But if deficits become ``structural''--that is, they
persist even in good times--they can cause harm. That's what happened in
the 1980s.
A structural deficit--especially when sustained for a long time, as in
the 1980s--depletes the Nation's pool of saving. Saving provides the
resources to build the new factories and machinery that generate
tomorrow's incomes. National saving has two components:
private saving (by individuals and businesses--the net result
of millions of savings decisions); and
public saving (by Federal, State, and local governments,
which save when they run surpluses and dis-save when they run
deficits). \2\
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\2\ Recently, the Commerce Department's Bureau of Economic Analysis
modified the national income accounts to measure more accurately how
government at all levels contributes to saving.
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If the Government taps the savings pool to finance its deficit, that
borrowed saving is not available to make productive private investments.
With its massive deficits in the 1980s, the Government drained much of
the pool. Worse, as Federal deficits were rising, private saving was
falling, exacerbating the overall saving problem.
In each year of the 1960s, net national saving \3\ totaled at least 10
percent of GDP (see Chart III-1). Since then, net saving has fallen
substantially. After averaging about eight percent of GDP in the 1970s,
the net national saving rate fell to five percent of GDP in the 1980s,
and hit a low point of just 2.4 percent of GDP in 1992.
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\3\ That is, gross saving minus depreciation of the Nation's capital
stock.
With less saving, interest rates remained high in the 1980s, choking
off demand for private investment. Why? Because lower saving shrinks the
pool of available funds. The Federal Government taps the pool first by
selling its bills, notes, and bonds at auction, leaving private
borrowers to compete for what's left. With so many would-be borrowers,
and so little left to borrow, the competition forces interest rates
higher.
Real interest rates--that is, the portion of the rate that exceeds
inflation--were markedly higher in the 1980s than in the prior three
decades. In real terms, short-term rates had actually been negative for
much of the 1970s, but they averaged almost four percent in the 1980s;
long-term real interest rates were as much as much as two to three
percentage points higher than in the prior three decades (see Chart III-
2).
Under this Administration, saving has rebounded, mainly due to lower
deficits. In the first three quarters of calendar 1996, net national
saving averaged 5.4 percent of GDP. In fact, over 90 percent of the
improvement in the net saving rate in the last four years is
attributable to lower deficits.
Higher real interest rates in the early 1980s attracted foreign
capital into the United States, driving up the dollar in foreign
exchange markets. The foreign capital helped offset some of the fall in
domestic saving and helped to cushion U.S. investment. But it came at a
price. The higher dollar pushed up the U.S. trade deficit significantly,
causing competitive problems for American manufac-
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turers and industrial workers. The Nation entered the 1980s as the world's largest creditor; it left as the largest debtor.
Thus, big deficits unsettle potential investors--they raise interest
rates, increase the risk of ballooning future Government credit demands
and higher inflation, and create uncertainty in the currency markets. In
response, business decision makers and other investors will likely buy
safer, shorter-term securities rather than risk their money in long-term
commitments for new factories, machines, and other productive
investments. As a result, investment declines, and the economy is poorer
for the foreseeable future.
And, in fact, despite the increase in borrowing from abroad, net
investment \4\ fell in the 1980s. The share of net private domestic
investment (including residential and nonresidential spending) fell from
over seven percent to five percent of GDP (see Chart III-3). By 1992,
the ratio of net investment to GDP had dropped to just 2.5 percent.
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\4\ That is, gross investment minus depreciation of the Nation's
capital stock.
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With the rise in net saving since then, net investment has rebounded.
Equipment investment, which includes computer purchases, has risen
especially rapidly--with the increases averaging 11 percent a year in
inflation-adjusted terms.
The economy grew much slower in the 1980s than in prior decades,
partly due to the fall in saving and investment. From the business cycle
peak in 1960 to the peak in 1980, real economic growth averaged 3.7
percent a year--compared to 2.6 percent during the business cycle of the
1980s. By reducing national saving, the 1980s-era deficits held down
capital formation enough to cut real potential GDP at the end of the
decade by an estimated 2.5 to 3.5 percent. If incomes had been three
percent higher in 1996, the average person would have had $600 more in
disposable income to spend.
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Growth has improved in the past four years, compared to 1988-1992. In
fact, private-sector GDP has grown since 1992 faster than in either of
the two previous Administrations. Because the government component of
GDP is shrinking now, whereas it rose rapidly in the 1980s, the overall
numbers do not fully reflect this strength.
Still, several factors continue to hold the economy back. First, the
stagnant saving and low investment of the 1980s and early 1990s are
still having an effect. Only years of higher investment will offset the
capital that was not put in place over the preceding 12 years. Second,
the labor force is growing more slowly. And third, the recent slow
growth of the major European economies and Japan has constrained the
exports of even the newly revitalized and competitive U.S. economy.
What the Administration Has Accomplished
When the President took office, the deficit was high and rising. It
had reached almost five percent of GDP in 1992, and projections
suggested that it would not fall below four percent of GDP even during
the anticipated economic recovery over the following four years. Then,
according to the projections, the deficit would rise again, and continue
rising without limit in the future.
The President took action.
The Omnibus Budget Reconciliation Act of 1993 (OBRA 1993): Upon taking
office, the President proposed a five-year deficit reduction program
that was largely enacted later that year as OBRA 1993.
The law was designed to cut projected deficits from 1994 to 1998 by a
total of $505 billion, cutting spending and raising revenues about
equally. Of the spending cuts, about $100 billion came in entitlement
programs, mostly in health care programs (although expanded health
coverage offset some of the savings); other cuts came in discretionary
spending and interest costs. All income tax rate increases fell on the
top 1.2 percent of families. At the same time, the plan cut taxes for 15
million working families by expanding the Earned Income Tax Credit.
But, largely because the economy has performed better than expected,
the Administration now projects that the plan will cut the 1994-98
deficits by $924 billion (see Chart III-4). Specifically, the plan
helped cut interest rates and spur growth, thereby generating more
Federal revenues and less spending on unemployment compensation and
other social benefits. Lower interest rates also helped to cut Federal
costs for deposit insurance and for servicing the debt. Meanwhile, the
Administration's push for health care reform helped to slow the rise in
health care inflation, thus helping to slow the growth in Medicare and
Medicaid.
While cutting the deficit, the President's plan also shifted resources
toward Administration priorities in education and training, the
environment, science and technology, and law enforcement. These
investments were intended to raise living standards and the quality of
life, both now and in the future.
Budget Cuts Since OBRA 1993: The President has continued to cut the
budget the right way--eliminating wasteful and lower-priority spending
while preserving key investments. The President and Congress have
scrapped over 200 programs and projects entirely, while cutting hundreds
more. Spurred by the Vice President's National Performance Review,
departments and agencies also have cut their workforces, streamlined
programs, reduced paperwork, and overhauled their procurement systems.
The Economic Benefits: The President's success in cutting the deficit
is paying huge dividends.
Falling deficits enabled the Federal Reserve to hold short-term
interest rates low in 1993. In addition, the markets also reacted
favorably, cutting long-term rates. Just as rising deficits increase
investor uncertainty about credit demands, inflation, and currency
fluctuations, the prospect of continually falling deficits into the
future eases uncertainty, prompting investors to risk their money on the
new factories and equipment that enhance productivity and, thus, make
the economy grow.
Short-term rates stayed low through the President's first year in
office. As for long-
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term rates, the yield on 10-year Treasury notes fell
below six percent in 1993--the first time since 1972 that the rate was
this low. Lower long-term rates helped to stimulate investment in
housing and business equipment, spurring the recovery.
Interest rates later rose somewhat as the economy expanded, but they
remained at very low levels for a rapidly growing economy with such low
unemployment. In fact, the last time the economy had unemployment as low
as today, the rate on the 10-year Treasury bond was about two percentage
points higher.
Future interest rates likely will depend on the success of efforts to
balance the budget over the next five years. A bipartisan agreement this
year would greatly foster chances of further cuts in both short- and
long-term rates.
What have we learned? That, contrary to some views, deficit cutting
can go hand-in-hand with economic growth--if the deficit cutting allows
the Federal Reserve to maintain low interest rates, and if it's credible
in the financial markets. In the months between the announcement and
enactment of the President's 1993 economic plan, economic activity
picked up. As shown in the monthly employment reports, job gains
accelerated, and over the next four years, the economy created over 11
million new jobs--about 93 percent of them in the private sector (see
Chart III-5).
The job gains occurred without an increase in inflation, which has
been remarkably stable for several years. Although the Consumer Price
Index (CPI) rose a bit more last year, the increase was due to faster
increases in volatile food and energy prices, which experts do not
expect to see again this year. If anything, the underlying rate of
inflation has fallen (see Chart III-6).
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Family Incomes, Poverty, and Inequality: More jobs, low inflation, and
steady growth can foster a widely shared rise in living standards, as
witnessed by the last two years. After many years of, at best, modest
gains in median family income, 1995 witnessed one of the largest real
gains in two decades--1.8 percent. Moreover, people in all kinds of
households gained. Poverty fell for the second straight year (see Chart
III-7), and groups at the bottom of the income distribution actually
enjoyed larger percentage gains than those at the top.
The stronger investment climate also sent stocks much higher. The Dow-
Jones Industrial Average has risen an average of 18 percent a year from
December 1992 to December 1996--more than half again as fast as in the
prior 12 years. Corporate profits, the underpinning for the value of
stocks, also have soared. Just as important, the profit gains have not
come at the expense of wages, which have risen in this period, but are
mainly due to falling corporate interest payments and a slowdown in
employers' health insurance costs.
To be sure, the strong economy is not due to the President's budget
policy alone. But just as surely, his policies have contributed to a
stronger financial climate, enabled the Federal Reserve to maintain low
interest rates, released extra saving for private investment, and showed
skeptics that the Nation's leaders could cut the deficit. These
successes have played their part in revitalizing the economy in the last
four years.
What Remains To Be Done
The best way to preserve and strengthen the current economic expansion
is to cut the deficit further. This budget reaches balance in 2002--a
goal widely shared by Congress and the public. The President is
committed to achieving it, and his previous success in cutting the
deficit puts it well within reach.
But the goal of reaching balance is not without controversy. Some
observers would
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balance the budget every year--no matter what the
circumstances; they even would enshrine the goal in the Constitution by
passing an amendment to that effect. Others argue that further deficit
cutting is unnecessary, if not economically harmful. Both of these
visions are misguided.
A Balanced Budget Requirement: A requirement to reach balance every
year is potentially harmful. Virtually all taxes, and many spending
programs, respond automatically to changing economic conditions. That
is, when the economy is weak and incomes fall, income tax revenues fall
as well; unemployment compensation and other benefits also cushion the
effect of the downturn on consumer buying power. Without these
``automatic stabilizers,'' economic downturns would be much worse.
Consider what could happen under a balanced budget amendment. A weak
economy would mean fewer tax revenues and more spending on unemployment
and other programs. As a result, a balanced budget requirement could
force a tax increase or spending cuts--or both--in the middle of a
recession. Those steps would make a weak economy even weaker.
Nor are any ``escape hatches'' from the budget-balancing requirement--
for times of economic distress--guaranteed to work. One reason is that
economists are notoriously slow to recognize economic downturns.
Consequently, by the time they saw the slowdown and Congress acted to
ease the balanced-budget requirement, the economic damage would be done.
The better practice is to aim for balance, but to adjust budget policy
according to circumstances.
A Reversal of Course: Allowing the deficit to begin rising again would
be economically damaging. Admittedly, as some analysts argue, continued
economic growth and low interest rates could keep Federal debt growing
more slowly than the economy as a whole, and that would help to keep
Federal interest costs under control. The problem is, the Nation faces
some important challenges in the not-so-distant future for which we
should begin to prepare. A balanced budget would be a good first step.
Today, the Nation is benefitting from its demography. Its largest
population group--the ``baby-boom'' generation, born between 1946 and
1964--is entering its highest-earning years. They pay much more to the
Government than they receive in direct benefits. But the situation will
begin to change in about 12 years.
At that point, the oldest baby-boomers will become eligible for early
retirement under Social Security. Because the next generation of
taxpayers is smaller in size, they will contribute relatively less to
the Government in revenues, making it harder to support the baby-boomers
in their retirement. The President has already called for a bipartisan
process to address that problem. But if we don't balance the budget
beforehand, the challenge of supporting the baby boomers will only grow
larger.
A balanced budget by 2002 will add a margin of safety into the budget
to absorb the coming demographic burden--and any unforeseen problems
before then. As illustrated in Chart III-8, if Congress enacts the
President's budget and continues his proposed limits on Medicaid while
controlling discretionary spending beyond 2002, the Government should be
able to avoid an explosion of debt when the baby-boomers retire. (See
Chapter 2 of Analytical Perspectives for a full discussion of the
methodology underlying these projections.)
The Administration's Economic Assumptions
This budget, like the Administration's previous budgets, is based on
prudent assumptions about economic growth, interest rates, inflation,
and unemployment for the foreseeable future. As with the previous
budgets, the assumptions are close to the consensus among private
forecasters. While the Administration believes that, with sound
policies, our economy can do even better, we also believe that we should
use prudent, mainstream economic assumptions for budget planning.
The Congressional Budget Office (CBO) also prepares economic
assumptions with which to evaluate budget proposals. In the past four
years, CBO's assumptions generally have
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been quite close to this Administration's, although small differences can generate large gaps in budget projections over five to seven years.
In recent years, the economy generally has performed somewhat better
than either the Administration or CBO had projected, showing faster
growth and lower unemployment and inflation.
The Administration's assumptions include the following:
Growth: Real growth will dip slightly below the trend for the
next two years, averaging two percent on a fourth quarter over
fourth quarter basis. Later, real GDP growth will average 2.3
percent per year--the Administration's estimate of its
potential growth rate.
Interest rates: If Congress enacts the President's budget
plan, interest rates will fall as the budget approaches
balance. The yield on 10-year Treasury notes, 6.3 percent at
the end of 1996 and higher earlier in the year, will decline
to 5.1 percent and then stabilize; on a discount-basis, the
90-day Treasury bill rate will drop to four percent, from
around 5.1 percent. The long-term real rate will be about 2.5
percent, and the short-term real rate about 1.5 percent. These
real interest rates are consistent with U.S. experience during
past periods of steady growth and low inflation.
Inflation: Inflation will remain fairly stable. The CPI will
rise an average of 2.7 percent a year from 1997 through 2002,
down slightly from the 3.3 percent increase in 1996 (which was
aggravated by special factors). The price index for GDP
(measured on a chain-weighted basis) will rise at a 2.6
percent annual rate--somewhat faster than in 1996. The gap
between these two measures of inflation, which has been large
in the past, will narrow due to recent and forthcoming changes
to the methodology underlying both indexes--including improved
measures of health care
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inflation (due later this year) and an
update of the CPI market basket (effective in 1998).
Unemployment: Civilian unemployment will be 5.5 percent by the
start of 1998, very near the current rate, and the average
level will remain there.
The Administration does not forecast the economy's cyclical pattern
beyond the next few quarters; within that horizon, it sees no sign of an
impending downturn. If the economy continues to grow for the entire
forecasting period, the current expansion would become the longest in
this century.
In some years, growth may exceed 2.3 percent; in others, it may fall a
bit short. But, the Administration's assumptions should be, on average,
close to correct for this period, and should provide a sound basis for
reaching balance by 2002.
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Table III-1. ECONOMIC ASSUMPTIONS \1\
(Calendar years; dollar amounts in billions)
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Projections
Actual --------------------------------------------------------------
1995 1996 1997 1998 1999 2000 2001 2002
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Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars..................... 7,254 7,577 7,943 8,313 8,717 9,153 9,610 10,087
Real, chained (1992) dollars........ 6,743 6,901 7,056 7,197 7,355 7,525 7,699 7,877
Chained price index (1992 = 100),
annual average..................... 107.6 109.9 112.7 115.7 118.7 121.8 125.0 128.2
Percent change, fourth quarter over
fourth quarter:
Current dollars..................... 3.8 5.0 4.6 4.7 5.0 5.0 5.0 5.0
Real, chained (1992) dollars........ 1.3 2.8 2.0 2.0 2.3 2.3 2.3 2.3
Chained price index (1992 = 100).... 2.5 2.3 2.5 2.6 2.6 2.6 2.6 2.6
Percent change, year over year:
Current dollars..................... 4.6 4.5 4.8 4.7 4.9 5.0 5.0 5.0
Real, chained (1992) dollars........ 2.0 2.3 2.2 2.0 2.2 2.3 2.3 2.3
Chained price index (1992 = 100).... 2.5 2.2 2.5 2.6 2.6 2.6 2.6 2.6
Incomes, billions of current dollars:
Corporate profits before tax........ 599 652 676 714 757 796 816 849
Wages and salaries.................. 3,431 3,628 3,808 3,982 4,168 4,374 4,590 4,810
Other taxable income \2\............ 1,532 1,612 1,684 1,748 1,809 1,882 1,967 2,068
Consumer Price Index (all urban): \3\
Level (1982-84 = 100), annual
average............................ 152.5 156.9 161.2 165.5 170.0 174.6 179.3 184.1
Percent change, fourth quarter over
fourth quarter..................... 2.7 3.1 2.6 2.7 2.7 2.7 2.7 2.7
Percent change, year over year...... 2.8 2.9 2.7 2.7 2.7 2.7 2.7 2.7
Unemployment rate, civilian, percent:
Fourth quarter level................ 5.5 5.3 5.4 5.6 5.5 5.5 5.5 5.5
Annual average...................... 5.6 5.4 5.3 5.5 5.5 5.5 5.5 5.5
Federal pay raises, January, percent:
Military............................ 2.6 2.6 3.0 2.8 3.0 3.0 3.0 3.0
Civilian \4\........................ 2.6 2.4 3.0 2.8 NA NA NA NA
Interest rates, percent:
91-day Treasury bills \5\........... 5.5 5.0 5.0 4.7 4.4 4.2 4.0 4.0
10-year Treasury notes.............. 6.6 6.5 6.1 5.9 5.5 5.3 5.1 5.1
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NA=Not Available.
\1\ Based on information available as of mid-November 1996.
\2\ Rent, interest, dividend and proprietor's components of personal income.
\3\ CPI for all urban consumers. Two versions of the CPI are now published. The index shown here is that
currently used, as required by law, in calculating automatic adjustments to individual income tax brackets.
Projections reflect scheduled changes in methodology.
\4\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after
1998 have not yet been determined.
\5\ Average rate (bank discount basis) on new issues within period.
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