The Deficit and the Economy: An Update of Long-Term Simulations (Letter
Report, 04/26/95, GAO/AIMD/OCE-95-119).

This report updates a 1992 GAO study (GAO/OCG-92-2) on the long-term
economic impact of the deficit, which concluded that deficit reduction
was the key to America's long-term economic health. GAO noted that a
path of inaction could not be sustained over the long run.  If
policymakers failed to take the initiatives, the economic consequences
would force action.  GAO identified three forces driving the long-term
growth of budget deficits: health spending, interest costs, and--after
2010--Social Security.  In its current report, GAO uses a long-term
economic growth model to simulate three possible fiscal paths through
the year 2025: (1) no action on the deficit; (2) "muddling through" with
deficits at three percent of gross domestic product, roughly
approximating deficits of recent years; and (3) reaching a balanced
budget in 2002 and sustaining it.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD/OCE-95-119
     TITLE:  The Deficit and the Economy: An Update of Long-Term 
             Simulations
      DATE:  04/26/95
   SUBJECT:  Deficit reduction
             Budget cuts
             Fiscal policies
             Economic analysis
             Balanced budgets
             Economic growth
             Budget deficit
             Budget surplus
             Econometric modeling
             Future budget projections
IDENTIFIER:  Social Security Program
             Medicare Program
             Medicaid Program
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on the Budget, U.S.  Senate, and
the Chairman, Committee on the Budget, House of Representatives

April 1995

THE DEFICIT AND THE ECONOMY - AN
UPDATE OF LONG-TERM SIMULATIONS

GAO/AIMD/OCE-95-119

The Deficit and the Economy


Abbreviations
=============================================================== ABBREV

  CBO - Congressional Budget Office
  FRBNY - Federal Reserve Bank of New York
  GDP - gross domestic product
  HCFA - Health Care Financing Administration
  NIPA - National Income and Product Account
  OASDI - Old Age Survivors' and Disability Insurance
  OBRA - Omnibus Budget Reconciliation Act of 1993

Letter
=============================================================== LETTER


B-259450

April 26, 1995

The Honorable Pete V.  Domenici
Chairman, Committee on the Budget
United States Senate

The Honorable John R.  Kasich
Chairman, Committee on the Budget
House of Representatives

As you requested, this report updates our simulations of the
long-term economic impacts of deficits we first published in our 1992
report.\1 In 1992 we examined the role of fiscal policy in promoting
or inhibiting long-term economic growth and concluded that deficit
reduction was key to our nation's long-term economic health.  We
observed that a path of "no action" could not be sustained over the
long run.  If policymakers did not take the initiative, the economic
consequences would force action.  We identified three forces driving
the long-term growth of budget deficits:  health spending, interest
costs, and--after 2010--Social Security. 

In our current work, we used a long-term economic growth model to
simulate three of the many possible fiscal paths through the year
2025:  (1) a path that takes no action on the deficit, (2) a path
that "muddles through" with deficits at 3 percent of gross domestic
product (GDP), roughly approximating deficits of recent years, and
(3) a path that reaches balance in 2002 and sustains it.\2 To suggest
some of the trade-offs facing policymakers in choosing among fiscal
policies, we examined some long-term economic and fiscal outcomes of
these paths.  We also simulated how some types of early action on the
deficit, including early action on health, might affect the long-term
deficit outlook.  Finally, we examined the prospects for sustaining
budget balance over the long term.  While this report discusses the
consequences of alternative fiscal paths, it does not suggest any
particular course of action, since only the Congress can resolve the
fundamental policy question of choosing the fiscal policy path most
appropriate for the nation. 

In our simulations, we employed a model originally developed by
economists at the Federal Reserve Bank of New York (FRBNY) that
relates long-term GDP growth to economic and budget factors.  (For
details of the model's assumptions, see table I.1.) Simulations are
useful for comparing the potential outcomes of alternative policies
within a common economic framework but should not be interpreted as
forecasts of the level of economic activity 30 years in the future,
given the broad range of uncertainty about future economic changes. 
Simulation results provide qualitative illustrations, not
quantitative forecasts, of the budget or economic outcomes associated
with alternative policy paths. 


--------------------
\1 Budget Policy:  Prompt Action Necessary to Avert Long-Term Damage
to the Economy (GAO/OCG-92-2, June 5, 1992). 

\2 The "balance" path takes unspecified cuts beginning in 1996 in all
types of federal spending to achieve total deficit reduction of no
more than 0.5 percent of GDP per year until balance is reached in
2002, after which balance is maintained in the same manner.  The
"muddling through" path follows Congressional Budget Office deficit
projections through 1999, then moves to a constant deficit of 3
percent of GDP by taking unspecified cuts. 


   BACKGROUND
------------------------------------------------------------ Letter :1

Economic growth--which is central to almost all our major concerns as
a society--requires investment, which, over the longer term, depends
on saving.  Since the 1970s, nonfederal saving\3 has declined while
federal budget deficits have consumed ever-higher levels of these
increasingly scarce savings.  The result has been to decrease the
amount of national saving potentially available for investment.\4
(See figure 1.) Since we last reported on this issue in 1992, overall
national saving has remained low.  These conditions--less nonfederal
saving and a greater share of this saving absorbed by deficits--do
not bode well for the nation's future productive capacity and future
generations' standard of living.  The surest way to increase the
resources available for investment is to increase national saving,
and the surest way to increase national saving is to reduce the
federal deficit. 

   Figure 1:  Effect of the
   Federal Budget Deficit on Net
   National Saving (1960-1994)

   (See figure in printed
   edition.)

Note 1:  Entire bar represents nonfederal saving net of capital
depreciation.  Nonfederal saving is comprised of private saving and
the aggregate state and local government surplus/deficit. 

Note 2:  Shaded portion of bar represents net national saving, which
is comprised of total private and public sector saving. 

Source:  U.S.  Department of Commerce. 

Our 1992 analysis showed that an indefinite continuation of
then-current federal budget policy was not sustainable.  Without
policy change, the continuation of large increases in health care
costs, a jump in Social Security costs after 2010 as the baby boom
generation retires, and escalating interest costs would fuel
progressively larger deficits.  Growing deficits and the resulting
lower saving would lead to dwindling investment, slower growth, and
finally a decline of real GDP.  Living standards, in turn, would at
first stagnate and then fall.  Our view was that a "no action" path
with respect to the deficit was not sustainable.  Action on the
deficit might be postponed, but it could not be escaped. 

Our simulation of several hypothetical deficit reduction paths
further showed that the timing and magnitude of deficit reduction
would affect both the amount of sacrifice required and the economic
benefits realized.  Acting sooner would reduce future interest costs
and therefore total deficit reduction required from other sources. 
Achieving and sustaining balance or surplus would yield long-term
benefits in the form of higher national saving, higher investment,
and more rapid economic growth.  By promoting economic growth,
deficit elimination would give future generations more resources to
finance the baby boom's retirement. 

Since our 1992 report, the Congress and the President have taken
action on the deficit.  According to Congressional Budget Office
(CBO) estimates, the Omnibus Budget Reconciliation Act of 1993 (OBRA
93) will reduce the federal deficit cumulatively for fiscal years
1994 through 1998 by over $400 billion.  Despite this short-term
progress, however, OBRA 93 did not fundamentally alter the growth of
the major entitlement programs driving the long-term deficit problem. 
The Bipartisan Commission on Entitlement and Tax Reform, created in
late 1993, highlighted the nation's vulnerability to the growth of
these programs and their potential fiscal effects.  Currently, the
Congress and the administration are again considering proposals which
could reduce future deficits. 


--------------------
\3 Nonfederal saving consists of the savings of state and local
governments and the private sector. 

\4 The depressing effect of deficits on growth might have been
mitigated had they financed higher levels of public investment. 
However, as we noted in our 1992 report, this is not what happened. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

Some progress has been made on deficit reduction since our 1992
report, but the long-term deficit outlook remains a pressing national
problem.  Our updated simulation results confirm that not taking
additional action to reduce deficits remains an unsustainable
approach in the long term.  Given continuation of current budget
policies, federal spending would grow faster than revenues, driven in
part by escalating health costs and, in later years, Social Security
costs.  Rising interest costs would compound the deficit problem and
take up an increasing share of the federal budget.  Left unchecked
through 2025, growing deficits would result in collapsing investment,
a declining capital stock, and, inevitably, a declining economy.  If
timely policy action were not taken, these economic consequences
would force belated and more painful policy changes at some point
before the end of our simulation period.  Accordingly, our "no
action" simulation is not a forecast of what would happen but rather
underscores that, as in 1992, the question is not whether to reduce
the deficit, but when and how. 

Our updated simulations confirm the long-term economic and fiscal
benefits of deficit reduction.  A fiscal policy of balance--or, as we
previously reported, of surplus--would yield a stronger economy in
the long term than a policy of "muddling through." A budget balance
reached in 2002 and sustained until 2025 would, over time, lower the
amount of real national debt per capita, lead to increased investment
and a larger capital stock, and yield higher real GDP per capita than
less austere fiscal policies. 

A balance path would also shrink the share of total federal spending
required to pay interest costs, thereby reducing the long-term
programmatic sacrifice necessary to attain deficit reduction targets. 
Although an alternative path of "muddling through" with deficits
maintained at 3 percent of GDP would prevent deficits from rising,
the continuing deficits under this policy would exact a price through
higher interest costs and thus require progressively harder fiscal
choices to maintain the deficit at desired levels. 

The way deficits are reduced also influences the long-term deficit
outlook.  While our simulations cannot project the long-term effects
of specific program cuts, they suggest that, dollar-for-dollar, an
early reduction in fast-growing areas, such as health programs, would
contribute more to the elimination of long-term deficits than other
types of spending reductions.  Moreover, since fiscal pressures on
the federal budget will grow as the population ages, program changes
generating growing savings over time might both help mitigate these
longer term pressures and give affected populations more time to
adjust. 

While deficit reduction would improve the long-term economic outlook
and better prepare the nation for addressing future demographic
pressures, it would require painful budget adjustments, and the
higher saving achieved would mean foregoing some economic consumption
in the short term.  The decisions that the Congress faces thus
involve difficult tradeoffs between the short- and long-term economic
costs and benefits of deficit reduction, as well as hard budgetary
choices among competing programs and priorities. 


   INACTION ON THE DEFICIT IS NOT
   SUSTAINABLE
------------------------------------------------------------ Letter :3

As in our 1992 work, our updated simulation results show that
continuing current spending and taxation policies unimpeded over the
long term would have major consequences for economic growth.  A
fiscal policy of "no action" through 2025 implies federal spending of
nearly 44 percent of GDP and a deficit of over 23 percent of GDP. 
(See figure 2.) By drastically reducing national saving, rising
deficits would shrink private investment and eventually result in a
declining capital stock.  Given our labor force and productivity
growth assumptions, GDP would inevitably begin to decline.  These
negative effects of rapidly increasing deficits on the economy would,
we believe, force action at some point before the end of the
simulation period.  If policymakers did not take the initiative,
external events--for example, the unwillingness of foreign investors
to sustain a deteriorating American economy--would compel action. 
While the "no action" simulation is not a prediction of what would
actually happen, it illustrates the pressures to change the nation's
current fiscal course. 

   Figure 2:  Deficit Path in "No
   Action" Simulation (1995-2025)

   (See figure in printed
   edition.)


The shift in the composition of federal spending by the end of the
simulation period shows that, under a long-term "no action" path,
health care, interest costs, and--after 2010--Social Security
spending drive increasingly large and unsustainable deficits.  (See
figure 3.)\5

  As federal spending in the simulation heads toward 44 percent of
     GDP in 2025, the major federal health care programs--Medicare
     and Medicaid--would become the major programmatic driver of
     budget deficits.  Their share of the economy would more than
     triple between 1994 and 2025.  Health care cost inflation and
     the aging of the population work together to produce this rapid
     growth. 

  At the same time, simulated interest spending increases
     dramatically.  Escalating deficits resulting from the increased
     spending add substantially to the national debt.  Rising debt,
     in turn, raises spending on interest, which compounds the
     deficit problem, driving a vicious circle.  The effects of
     compound interest are clearly visible, as interest spending
     rises from about 3 percent of GDP in 1994 to over 13 percent in
     2025. 

  Social Security also grows, but its rise is much slower than health
     care.  Its expansion occurs mainly after 2010 as the baby boom
     generation retires. 

The expansion of the three forces fueling budget deficits means that
the federal government would find it increasingly difficult to fund
other needs. 

   Figure 3:  Long- Term Change in
   Composition of Federal Spending
   Under the "No Action"
   Simulation

   (See figure in printed
   edition.)

Source:  1994 data from U.S.  Department of Commerce. 


--------------------
\5 In general, CBO's forecasts are used, along with our GDP levels,
in the simulations through 1999 and, where practicable, through 2004. 
The Health Care Financing Administration (HCFA) and Social Security's
long-term assumptions are used for their respective programs.  After
1999, tax revenue is held constant as a percentage of GDP.  (See
appendix I for more details on our budget assumptions.)


   DEFICIT REDUCTION WOULD PROMOTE
   ECONOMIC GROWTH IN THE LONG
   TERM
------------------------------------------------------------ Letter :4

The economic benefits of deficit reduction are illustrated by the
three fiscal paths we simulate in our model.  (See table 1.) As
discussed above, a fiscal policy of "no action" is not economically
sustainable over the long term.  The "muddling through" and "balance"
paths show that the further away fiscal policy moves from a path of
"no action," the better the outlook for the economy in the long term. 



                                     Table 1
                     
                     The Economic and Fiscal Position in 1994
                          (Actual) and 2025 (Simulated)

                      (All data in per capita 1995 dollars)


                        2025--       2025--
                           "No    "Muddling      2025--         "No    "Muddling
              1994     Action"     Through"   "Balance"     Action"     Through"
------  ----------  ----------  -----------  ----------  ----------  -----------
Real       $26,300     $27,900      $35,100     $37,400          34            7
 GDP
Debt       $13,500     $60,200      $21,400      $4,800         -92          -78
Nonfar      $3,100          $0       $4,200      $5,100         N/A           21
 m
 busin
 ess
 inves
 tment
Nonfar     $23,700     $11,600      $30,100     $36,600         216           22
 m
 capit
 al
 stock
--------------------------------------------------------------------------------
The differences in GDP per capita at 2025 reflect major differences
in the underlying capacity of the economy in our illustrative
simulations to generate growth.  Our "no action" simulation, when
maintained unimpeded through 2025, portrays the potential long-term
economic impact of a declining national saving rate.  Under a policy
of "no action" on the deficit, investment would peak in the next
decade and then decline steadily due to the lack of national saving. 
Shortly thereafter, capital depreciation would outweigh investment,
and the capital stock would actually begin to decline.  Given our
assumptions about labor force and productivity growth, the declining
capital stock would lead inevitably to a decline in GDP.  By 2025,
investment would be entirely eliminated, the capital stock would have
declined to less than half of its 1994 level, and per capita
GDP--only about 5 percent greater in real terms than at the start of
the 30-year period--would be poised for a precipitous drop.\6

Compared to a policy of "no action," more stringent fiscal policies
would result in greater economic growth.  Tighter fiscal policies can
promote greater private investment in the long term, a larger capital
stock, and therefore a larger future GDP.  The "muddling through"
simulation shows such GDP growth but because of persistent deficits,
debt increases well above current levels.  In the model, the larger
debt requires increased foreign capital inflows.  Our "balance"
simulation, compared to "muddling through," achieves greater deficit
reduction and a larger GDP with lower debt and, accordingly, less
reliance on foreign capital.  And as we stated in 1992, a strongly
growing economy will be needed to support present commitments to the
future elderly and a rising standard of living for the future working
population. 

In actuality, the differences between alternative fiscal policies
would likely be even greater than our simulation results suggest. 
Our model incorporates conservative assumptions about the
relationship between savings, investment, and GDP growth that tend to
understate the differences between the economic outcomes associated
with alternative fiscal policies.  For example, in our model,
interest rates, productivity, and foreign investment all hold steady
regardless of economic change.  In the "no action" simulation, we
assumed that they all remain constant in the face of a collapsing
U.S.  economy; this is unlikely to be true.  Similarly, under our
"balance" simulation, interest rates, productivity, and foreign
investment do not respond favorably to increased national savings and
investment.  While the magnitude of any response is difficult to
predict, some change could be expected.  To the extent that our
assumptions are conservative, differences between a "balance" path
and the other two paths would be larger than simulated. 

We recognize that deficit reduction would have costs in the short
term.  The deficit reduction necessary to achieve beneficial
long-term economic outcomes and reduced interest costs would entail
difficult budgetary reductions and require a greater share of
national income to be devoted to saving, thus foregoing some
consumption in the short term.  The greater the fiscal austerity, the
more consumption would need to be sacrificed.  However, more
stringent deficit reduction measures mean correspondingly larger
increases in consumption in the long term.  The decision policymakers
face, then, involves a trade-off between the immediate sacrifice of
deficit reduction and the deferred but more severe economic costs
associated with continued deficits. 


--------------------
\6 If capital were perfectly mobile, foreign capital inflows could
fully offset a decline in U.S.  savings although a portion of the
income generated would flow abroad.  The evidence continues to
suggest, however, that a nation's investment is correlated with its
own saving.  Accordingly, we retained our 1992 assumption that net
foreign capital inflows rise by one-third of any decrease in the
national saving rate. 


   DEFICIT REDUCTION WOULD REDUCE
   INTEREST COSTS
------------------------------------------------------------ Letter :5

The share of the federal budget devoted to interest costs would be
reduced through deficit reduction, freeing up scarce resources to
satisfy other public needs.  This will be particularly important for
future budgets when the aging of the population will prompt greater
spending pressures. 

The dynamics of compound interest which, given no action on the
deficit, lead inexorably to spiralling deficits, yield dividends
under a balance simulation.  The more rapidly real debt is reduced
and real interest costs brought down, the less long-term programmatic
sacrifice required.  Action taken to achieve balance by 2002 and to
sustain it shrinks interest as a percent of total outlays from 12
percent in 1994\7 to less than 5 percent in 2025, assuming a constant
interest rate.\8 (See figure 4.) In contrast, higher interest costs
would approach 18 percent of outlays by 2025 under the "muddling
through" path because the deficit is maintained at 3 percent of GDP,
resulting in higher debt.  Moreover, due to growing pressures from
health and Social Security commitments, the "muddling through" path
requires progressively greater spending reductions just to keep the
deficit from growing above 3 percent of GDP. 

   Figure 4:  Net Interest as a
   Share of Total Expenditures in
   2025 Under GAO's Three Fiscal
   Policy Simulations

   (See figure in printed
   edition.)


--------------------
\7 For comparability with our model, this percentage is calculated
using National Income and Product Account (NIPA) definitions.  The
figure would be higher if budget definitions were used. 

\8 Our interest rate assumptions are based on CBO through 1999 and
then move to a fixed rate. 


   THE TYPE OF SPENDING REDUCTION
   MATTERS
------------------------------------------------------------ Letter :6

Not all spending cuts have the same impact over the long run. 
Decisions about how to reduce the deficit will reflect--among other
considerations--judgments about the role of the federal government
and the effectiveness of individual programs.  In our 1992 work, we
drew particular attention to federal investment in physical capital,
human capital, and research and development.  Such public investment
plays a key role in economic growth, directly and by creating an
environment conducive to private sector investment.  Accordingly, in
addition to the overall level of deficit or surplus, the proportion
of the budget devoted to investment spending will also affect
long-term growth. 

The extent to which deficit reduction affects spending on
fast-growing programs also matters.  Although a dollar is a dollar in
the first year it is cut--regardless of what programmatic changes it
represents--cutbacks in the base of fast-growing programs generate
greater savings in the future than those in slower-growing programs,
assuming the specific cuts are not offset by increases in the growth
rates of the programs.\9

Figure 5 illustrates this point by comparing the long-run effects of
a $50-billion cut in health spending with those of the same dollar
amount cut from unspecified other programs.  For both paths the cut
occurs in 1996 and is assumed to be permanent but, after 1996,
spending is assumed to continue at the same rates of growth as those
shown in the "no action" simulation.We used the simple assumption
that a reduction either in health or in other programs would not
alter the expected growth rates simply to illustrate the point that a
cut in high-growth areas of spending will exert greater fiscal
effects in the future than the same size cut in low-growth areas. 

   Figure 5:  Comparison of
   Deficit Path With an Early Cut
   in Health to Deficit Path With
   an Equal Cut in Other Spending

   (See figure in printed
   edition.)

Because the 1996 cuts are equal dollar amounts, the two simulations
appear very similar in the early part of the period.  A gap develops
between them as time passes, however, and by 2025 the difference
between the two paths has widened to nearly 4 percent of GDP.  The
gap appears and then widens because health spending grows much faster
than other areas of spending.  A cut in this spending area reduces
the proportion of the budget growing quickly, thereby reducing the
total budget growth.  The effects of compound interest, discussed
earlier in this report, magnify the difference. 


--------------------
\9 We did not simulate the effect of reducing growth rates.  If
cutting the base also had the effect of slowing the rate of growth,
the action would have an even greater impact on the long-term
deficit.  Of course, if cutting the base raised the growth rate, the
actions could raise the deficit in the long term. 


   FISCAL PRESSURES WILL CONTINUE
------------------------------------------------------------ Letter :7

Even if a balanced budget is achieved early in the next century,
deficits could reemerge as the coming demographic changes continue to
exert fiscal pressures.  Depending upon the types of spending
reductions adopted, future growth in health, Social Security, and
interest costs--the deficit drivers--will continue to place demands
on federal budgetary resources.  As the Bipartisan Commission on
Entitlement and Tax Reform recently observed,\10 the decreasing ratio
of the labor force to retirees will exacerbate the fiscal effects of
the growing elderly population. 

In addition to the effects of the known demographic shift,
uncertainties about the growth of health care costs also promise to
complicate future budget policy.  Recent budgetary history has shown
that health care costs have proven very difficult to predict. 
Experts we contacted agreed on only one thing--long-range cost
projections made today will be wrong.  Whether they are too high or
too low is unclear, although historically health projections have
nearly always been too low.  For these reasons, sustaining a balanced
budget over the long term could be an ongoing challenge. 

Rather than discouraging efforts to reduce the deficit, an awareness
of future fiscal pressures might instead be used to help inform
current fiscal policy choices.  For example, some program changes, if
made today, would generate little in immediate savings but would
exert large future outlay reductions.  Program changes with such
"wedge-shaped" savings paths might be important elements of a
strategy to mitigate the longer-term spending pressures, as they were
in several other nations that reduced fiscal deficits.\11 Phasing in
such changes over a longer time frame would give affected populations
more time to adjust to these changes.  Moreover, other nations found
that phasing in program changes strengthened prospects for public
support of needed fiscal policy changes. 


--------------------
\10 Bipartisan Commission on Entitlement and Tax Reform, Final Report
to the President, 1995. 

\11 For a more detailed discussion of this approach to deficit
reduction, see Deficit Reduction:  Experiences of Other Nations
(GAO/AIMD-95-30, Dec.  13, 1994). 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :8

The analysis presented in this report of the long-term economic and
fiscal implications of these alternative fiscal policy paths relies
in substantial part on an economic growth model that GAO adapted from
a model developed by economists at the Federal Reserve Bank of New
York.  The model reflects the interrelationships between the budget
and the economy over the long term and does not capture their
interaction during short-term business cycles. 

The main influence of budget policy on long-term economic performance
is through the effect of the federal deficit on national saving. 
Conversely, the rate of economic growth helps determine the overall
federal deficit or surplus through its effect on revenues and
spending.  Higher federal budget deficits reduce national saving
while lower deficits increase national saving.  The level of saving
affects investment and, in turn, GDP growth. 

Budget assumptions in the model rely upon CBO estimates through 2004
to the extent practicable.  These estimates are used in conjunction
with our model's simulated levels of GDP.  For Medicare, we assumed
growth consistent with CBO's projections and HCFA's long-term
intermediate projections from the Medicare Trustees' April 1995
report.  For Medicaid through 2004, we similarly assumed growth
consistent with CBO's projections.  For 2005 and thereafter, in the
absence of long-range Medicaid projections from HCFA, we used
projections developed in 1994 by the Bipartisan Commission on
Entitlement and Tax Reform.  For Social Security, we use the April
1995 intermediate projections from the Social Security Trustees
throughout the simulation period.  Other mandatory spending is held
constant as a percentage of GDP after 1999, the last year in which
CBO projections are available in a format usable by our model. 
Discretionary spending is held constant as a percentage of GDP after
2005.  Receipts are held constant as a percentage of GDP after 1999. 
Our interest rate assumptions are based on CBO through 1999 and then
move to a fixed rate.  (See appendix I for a more detailed
description of the model and the assumptions we used.)

We conducted our work from June 1994 through April 1995.  We received
comments from experts in fiscal and economic policy and have
incorporated them as appropriate. 

We are sending copies of this report to the President of the Senate
and the Speaker of the House of Representatives and to the Ranking
Minority Members of your Committees.  We are also sending copies to
the Director of the Congressional Budget Office, the Secretary of the
Treasury, and the Director of the Office of Management and Budget. 
Copies will be made available to others upon request. 

This report was prepared under the direction of Paul L.  Posner,
Director for Budget Issues, and James R.  White, Acting Chief
Economist.  They may be reached at (202) 512-9573.  Major
contributors to this report are listed in appendix II. 

Charles A.  Bowsher
Comptroller General
of the United States


THE ECONOMIC MODEL AND ASSUMPTIONS
=========================================================== Appendix I

This updated analysis\1 of the long-term economic and budgetary
implications of alternative fiscal policy paths relies in substantial
part on an economic growth model that GAO adapted from a model
developed by economists at the Federal Reserve Bank of New York
(FRBNY).  The model represents growth as resulting from labor force
increases, capital accumulation, and the various influences affecting
total factor productivity.  To allow a closer analysis of the
long-term effects of fiscal policy, we added a set of relationships
describing the federal budget and its links to the economy.  The
relationships follow the definitions of national income accounting,
which differ slightly from those in the budget. 

The model is helpful for exploring the long-term implications of
policies and for comparing alternative policies within a common
economic framework.  The results provide qualitative illustrations,
not quantitative forecasts, of the budget or economic outcomes
associated with alternative policy paths.  The model reflects the
interrelationships between the budget and the economy over the long
term and does not capture their interaction during short-term
business cycles. 

OVERVIEW OF THE MODEL

Figure I.1 illustrates the core relationships of the model.  The main
influence of budget policy on long-term economic performance is
through the effect of the federal deficit on national saving.  Higher
federal budget deficits reduce national saving while lower deficits
increase national saving.  The level of savings affects investment
and, hence, GDP growth. 

   Figure I.1:  Key Model
   Relationships and Budget
   Assumptions

   (See figure in printed
   edition.)

Gross domestic product (GDP) is determined by the labor force,
capital stock, and total factor productivity.\2 GDP in turn
influences nonfederal saving, which consists of private saving and
state and local government surpluses or deficits.  Through its
effects on federal revenues and spending, GDP also helps determine
the federal budget deficit or surplus.  Nonfederal and federal
savings together comprise national saving, which influences private
investment and the next period's capital stock.  Capital combines
with labor and total factor productivity to determine GDP in the next
period, and the process continues. 

There also are important links between national saving and investment
and the international sector, not shown in figure I.1 in order to
keep the overview simple.  In an open economy such as the United
States, a decrease in saving due to, for example, an increase in the
federal budget deficit, does not require an equal decrease in
investment.  Instead, part of the saving shortfall may be filled by
foreign capital inflows.  A portion of the net income that results
from such investments flows abroad. 

If capital were perfectly mobile, foreign capital inflows could fully
offset the effect on domestic investment of a decline in U.S. 
saving.  The evidence continues to suggest, however, that a nation's
investment is correlated with its own saving.  Hence, we retained our
1992 assumption (based on the work of FRBNY) that net foreign capital
inflows rise by one-third of any decrease in the national saving
rate. 

Table I.1 lists the key assumptions incorporated in the model.  The
assumptions used tend to provide conservative estimates of the
benefit of deficit reduction and the harm of deficit increases.  The
interest rate on the national debt is held constant, for example,
even when deficits climb and the national saving rate plummets. 
Under such conditions, the more likely result would be a rise in the
rate of interest and a more rapid increase in federal interest
payments than our results display.  Another conservative assumption
is that the rate of total factor productivity growth is unaffected by
the amount of investment.  Productivity is assumed to advance 1
percent each year even if investment collapses.  Such assumptions
suggest that deficit changes could have greater effects than our
results indicate. 

We have made several modifications to the model since the 1992
report, but its essential structure remains the same.  The model
incorporates the National Income and Product Accounts (NIPA) shift
from 1982 to 1987 as the base year, and the switch from gross
national product to GDP as the primary measure of overall economic
activity. 

The more recent data prompted several parameter changes.  For
example, the inflation rate is now assumed to be 3.4 percent, down
from 4.0 percent in our previous work, while the average interest
rate is reduced to 7.2 percent from 7.8 percent.  Our work also
incorporates the CBO projection that deficits in the next few years
will be somewhat lower than was foreseen in 1992. 

The distinction between the mandatory and discretionary components of
the budget is important.  Our approach has been modified to
accommodate this distinction by reclassifying budget data based on
the NIPA framework as mandatory or discretionary spending.  From 1995
through 1999, CBO data were used for this reclassification.  For the
years from 2000 through 2005, we adopted CBO's assumption that
discretionary spending would increase at the rate of inflation, and,
thereafter, we assumed it would keep pace with GDP growth. 

Mandatory spending includes Health, Old Age Survivors' and Disability
Insurance (OASDI, or Social Security), and a residual category
covering other mandatory spending.  For the first 9 years, health
spending incorporates CBO's Medicare and Medicaid assumptions. 
Thereafter, Medicare follows the Trustees' 1995 Alternative II
projections.  We smoothed the path of Medicaid spending from 2005
through 2011 in order to link CBO's spending assumptions to those of
the Bipartisan Commission on Entitlement and Tax Reform.  OASDI
reflects the April 1995 Social Security Trustees' Alternative II
projections. 

Other mandatory spending is a residual category consisting of all
nonhealth, non-Social Security mandatory spending.  It equals CBO's
NIPA projection for Transfers, Grants, and Subsidies less Health,
OASDI, and other discretionary spending.  Through 1999, CBO
assumptions are the main determinant of other mandatory spending,
after which its growth is linked to that of GDP. 

The interest rates for 1994-1999 are consistent with the average
effective rate implied by CBO's interest payment projections.  We
assume that the average rate then moves to 7.2 percent by 2003, where
it remains for the rest of the simulation period. 

Receipts follow CBO's dollar projections to 1999.  Thereafter, they
continue at 20.3 percent of GAO's simulated GDP, which is the percent
the model projects for 1999. 

As these assumptions differ somewhat from those used in our earlier
report, the results are not directly comparable.  An appendix to the
1992 report provides additional detail on the model's structure. 



                          Table I.1
           
                       Key Assumptions

                      Assumptions         Comments
--------------------  ------------------  ------------------
Saving rate: private  16.5% of GDP        Same as 1992
savings plus state
and local surplus/
deficit


Labor: growth in      Follows the
hours worked          Trustees'
                      Alternative II
                      projections

Total factor          1% per year         Same as 1992
productivity growth

Inflation rate        3.4% per year       Revised; was 4% in
                                          1992

Interest rate         7.2% per year       Revised; was 7.8%
(average on           after 2002;         in 1992
the national debt)    in earlier years,
                      interest rates are
                      consistent with
                      the average
                      effective rate
                      implied by CBO's
                      interest payment
                      assumptions

Surplus/Deficit       2.5% for 1995       Deficit is on a
1995-99               2.7% for 1996       NIPA basis and
(% of GDP)            2.7% for 1997       follows CBO
                      2.6% for 1998       projections of
                      2.8% for 1999       deficit's dollar
                                          values, GAO's GDP



Discretionary categories
------------------------------------------------------------
1995-1998             Follows caps

1999-2005             Spending rises at
                      the rate
                      of inflation

After 2005            Spending rises at
                      the rate of
                      economic growth


Health
------------------------------------------------------------
1995-2004             Grows at the rate
                      CBO assumes

After 2004            Medicare follows
                      HCFA; Medicaid
                      follows
                      assumptions of the
                      Bipartisan
                      Commission on
                      Entitlement and
                      Tax Reform


OASDI
------------------------------------------------------------
1995-2025             Follows the
                      Trustees'
                      Alternative II
                      projections



Other mandatory spending
------------------------------------------------------------
1995-1999             CBO's assumed
                      levels

After 1999            Spending rises at
                      the rate
                      of economic growth


Receipts
------------------------------------------------------------
1995-1999             CBO's assumed
                      levels

After 1999            Receipts equal
                      20.3 percent of
                      GDP (1999 ratio)
------------------------------------------------------------

--------------------
\1 Budget Policy:  Prompt Action Necessary To Avert Long-Term Damage
to the Economy (GAO/OCG-92-2, June 5, 1992). 

\2 Total factor productivity reflects sources of growth not captured
in aggregate labor and capital measures, including technological
change, labor quality improvements, and the reallocation of resources
to more productive uses. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION, WASHINGTON,
D.C. 

Barbara D.  Bovbjerg, Assistant Director (202) 512-5491
Andrew D.  Eschtruth, Evaluator-in-Charge
Linda F.  Baker, Senior Evaluator
Eric Rollins, Intern

OFFICE OF THE CHIEF ECONOMIST

Richard S.  Krashevski, Senior Economist

RELATED GAO PRODUCTS

Addressing the Deficit:  Budgetary Implications of Selected GAO Work
for Fiscal Year 1996 (GAO/OCG-95-2, Mar.  15, 1995). 

Deficit Reduction:  Experiences of Other Nations (GAO/AIMD-95-30,
Dec.  13, 1994). 

Budget Policy:  Issues in Capping Mandatory Spending
(GAO/AIMD-94-155, July 18, 1994). 

Budget Issues:  Incorporating an Investment Component in the Federal
Budget (GAO/AIMD-94-40, Nov.  9, 1993). 

Federal Budget:  Choosing Public Investment Programs (GAO/AIMD-93-25,
July 23, 1993). 

Budget Policy:  Long-Term Implications of the Deficit
(GAO/T-OCG-93-6, Mar.  25, 1993). 

Budget Policy:  Prompt Action Necessary to Avert Long-Term Damage to
the Economy (GAO/OCG-92-2, June 5, 1992). 

The Budget Deficit:  Outlook, Implications, and Choices
(GAO/OCG-90-5,
Sept.  12, 1990). 

*** End of document. ***