Budget Issues: Analysis of Long-Term Fiscal Outlook (Letter Report,
10/22/97, GAO/AIMD/OCE-98-19).

Pursuant to a congressional request, GAO updated its previous
simulations of the long-term economic impact of federal budget policy
following passage of the Balanced Budget Act of 1997.

GAO noted that: (1) the balanced budget or surpluses that are projected
in the Balanced Budget Act of 1997 would represent an enormous
improvement in the federal government's fiscal position through the next
10 years; (2) the improvements in national saving and reduced debt and
interest costs can be expected to produce tangible gains in economic
growth and budgetary flexibility over the longer term as well; (3) as a
result, the emergence of unsustainable deficits is substantially delayed
under recently enacted fiscal policy; (4) if no further action were
taken, GAO's simulations indicate that federal spending would grow
faster than revenues soon after the baby boom generation begins to
retire in 2008; (5) these higher spending levels would be driven would
be driven by escalating health and Social Security costs; (6) rising
interest costs would compound the deficit problem and take up an
increasing share of the federal budget; (7) growing deficits, if
unchecked, would eventually result in declining investment and capital
stock and, inevitably, falling living standards; (8) over the long term,
the "no action" scenario is unsustainable and timely policy action can
avoid these economic consequences; (9) while a "no action" simulation is
not a forecast of what will happen, it illustrates the nature of future
fiscal challenges; (10) the alternative simulations illustrate the
potential fiscal and economic benefits of achieving a sustainable budget
policy; (11) a fiscal policy of balance through 2050 or extended periods
of surplus, for example, could shrink the burden of federal interest
costs considerably and also result in a larger economy over the long
term; (12) all of these alternative policies would increase per capita
GDP in 2050 by more than 35 percent over a "no action" policy, but they
would require additional fiscal policy changes; (13) some changes would
be difficult to achieve, but over the long term they would strengthen
the nation's economy and overall living standards; (14) early action
would permit changes in, for example, Social Security or health care
benefits, time to adjust; (15) in considering what fiscal adjustments to
make, policymakers need to be presented with more complete information
on the costs of the government's existing long-term commitments; (16)
the budget's current structure and reporting mechanisms have not focused
attention on such commitment, nor has the budget process facilitated
their explicit consideration; and (17) options to change budget
reporting and process to improve recognition of these commitments and
prompt early action warrant further exploration.

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

 REPORTNUM:  AIMD/OCE-98-19
     TITLE:  Budget Issues: Analysis of Long-Term Fiscal Outlook
      DATE:  10/22/97
   SUBJECT:  Economic analysis
             Budget surplus
             Future budget projections
             Budget deficit
             Deficit reduction
             Balanced budgets
             Entitlement programs
             Fiscal policies
             Budget cuts
             Economic growth
IDENTIFIER:  Old Age Survivors and Disability Insurance Program
             Medicare Program
             Hospital Insurance Trust Fund
             Social Security Program
             Medicaid Program
             Social Security Trust Fund
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


Cover
================================================================ COVER


Report to Congressional Requesters

October 1997

BUDGET ISSUES - ANALYSIS OF
LONG-TERM FISCAL OUTLOOK

GAO/AIMD/OCE-98-19

Long-Term Fiscal Outlook

(935248)


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
  BBA - Balanced Budget Act of 1997

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


B-278394

October 22, 1997

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 previous simulations of the
long-term economic impact of federal budget policy.  In 1992, we
first used a macroeconomic model to simulate the effects of
alternative fiscal policy paths in promoting or inhibiting long-term
economic growth and the results supported the view that deficit
reduction was key to our nation's long-term economic health.\1

In 1995, our updated simulations indicated that a path of "no
action," under which current policies remain unchanged, could not be
sustained over the long run.\2 We identified three forces driving the
long-term growth of the budget deficit--health spending, Social
Security, and interest costs.  Since our 1995 report was issued, the
Congress and the President have taken additional fiscal action to
eliminate the annual deficit, culminating in the recent passage of
the Balanced Budget Act of 1997 (BBA).  The Congressional Budget
Office (CBO) projects that these actions, along with the recent
strong performance of the economy, will eliminate the deficit by 2002
and achieve several years of budget surpluses. 

In this report, we have updated our work to address the long-term
budget outlook following passage of BBA to help the Congress assess
the long-term consequences of current policies and alternatives.  We
used our long-term economic growth model to simulate the path
resulting from the BBA through the year 2050 assuming no further
policy changes ("no action").  For this path, we adopted CBO's
10-year budgetary and economic projections, under which the federal
government would run budget surpluses from 2002 through 2007, the end
of CBO's forecast period.\3

In addition to simulating the long-term results of current fiscal
policy, we also developed several alternative fiscal policy paths to
illustrate how overall fiscal policy changes can affect future
budgetary and economic outcomes.  While this report discusses the
consequences of alternative fiscal paths, it does not suggest any
particular course of action, since the choice of the most appropriate
fiscal policy path is a policy decision to be made by the Congress
and the President.  As discussed with your office, three alternatives
were chosen to represent different degrees of fiscal restraint.  Two
of these alternatives follow the "no action" path in the early years
of the simulation period but then shift direction once deficits
reemerge in the second decade of the 21st century by maintaining
either a budget balance or modest deficits through the remainder of
the simulation period.  A third alternative path would run larger
surpluses than the "no action" path in the near term and for a longer
period of time. 

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 50
years in the future given the range of uncertainty about future
economic changes and the responses to those changes.\4 Simulation
results provide qualitative illustrations, not quantitative
forecasts, of the budget or economic outcomes associated with
alternative policy paths.  In our simulations, we employed a model
originally developed by economists at the Federal Reserve Bank of New
York (FRBNY) that relates long-term gross domestic product (GDP)
growth to economic and budget factors.  All models require the use of
assumptions to permit extrapolations to be made.  For details of the
model's assumptions, see appendix I. 


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

\2 The Deficit and The Economy:  An Update of Long-Term Simulations
(GAO/AIMD/OCE-95-119, April 26, 1995). 

\3 CBO's budget projections, and thus our simulations using CBO data,
reflect the net effect of the Balanced Budget Act of 1997 as well as
the Taxpayer Relief Act of 1997. 

\4 The impact of federal spending reduction on aggregate national
saving and investment depends on how consumers respond to such
reductions.  For example, a reduction in federal Medicaid spending
may result in greater private spending on nursing home care thereby
diminishing the effect on total national saving. 


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

Economic growth--which is central to many of our major concerns as a
society--requires investment, which, over the longer term, depends on
saving.  The nation's saving consists of the private saving of
households and businesses and the saving or dissaving of all levels
of government.  In general, government budget deficits represent
dissaving--they subtract from national saving by absorbing funds that
otherwise could be used for investment.  Conversely, government
surpluses add to saving. 

Since the 1970s, private saving has declined while federal budget
deficits have consumed a large share of these increasingly scarce
savings.  The result has been to decrease the amount of national
saving potentially available for investment.\5

Since we last reported on this issue in 1995, private saving has
remained low.  However, federal budget deficits have declined
significantly from the levels of the 1980s and early 1990s, freeing
up some additional funds for investment.  (See figure 1.)
Nevertheless, total national saving and investment remain
significantly below the levels experienced in the 1960s and 1970s. 
Economists have noted that these low levels of saving and investment
raise concerns for the nation's future productive capacity and future
generations' standard of living.  As we have said in our earlier
reports, the surest way to increase the resources available for
investment is to increase national saving, and the most direct way
for the federal government to increase national saving is to achieve
and maintain a balanced federal budget.  Running budget surpluses
would further increase saving and allow the government to reduce the
level of federal debt held by the public. 

   Figure 1:  Effect of the
   Federal Budget Deficit on Net
   National Saving (1970-96)

   (See figure in printed
   edition.)

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

   (See figure in printed
   edition.)

   Source:  GAO analysis of U.S. 
   Department of Commerce data.

   (See figure in printed
   edition.)

Our earlier work concluded that without further policy action,
commitments in federal retirement and health programs would together
become progressively unaffordable for the nation over time, and the
economic consequences would force belated and painful policy choices. 
Growing deficits and the resulting lower saving would lead to
dwindling investment, slower growth, and finally a decline in real
GDP.  Living standards, in turn, would at first stagnate and then
fall.  These findings supported our conclusion that action on the
deficit might be postponed, but it could not be avoided. 

The results of our past work have been very similar to the
conclusions reached by other government entities and private
analysts.  Most notably, CBO published analyses based on its
long-term model work in 1996 and 1997 that corresponded with our main
findings.\6 Also, in 1994-95, the Bipartisan Commission on
Entitlement and Tax Reform reached similar conclusions in its study
of future fiscal trends. 

Since our 1995 report, robust economic growth and policy action have
combined to sharply reduce the deficit and are projected by CBO to
result in budget surpluses in the near term.  This report addresses
the outlook for the budget over the longer term.  We will explore how
recent progress affects this outlook and the fiscal and economic
impacts associated with alternative long-term fiscal policy
strategies. 


--------------------
\5 The depressing effect of deficits on growth might have been
mitigated had they financed higher levels of public investment. 
However, as a share of GDP, federal investment spending has actually
declined over the past two decades. 

\6 Congressional Budget Office, The Economic and Budget Outlook: 
Fiscal Years 1997-2006, May 1996, and Long-Term Budgetary Pressures
and Policy Options, March 1997. 


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

Major progress has been made on deficit reduction in the past several
years, culminating in the passage of the Balanced Budget Act of 1997. 
The balanced budget or surpluses that are projected would represent
an enormous improvement in the federal government's fiscal position
through the next 10 years.  Moreover, the improvements in national
saving and reduced debt and interest costs can be expected to produce
tangible gains in economic growth and budgetary flexibility over the
longer term as well.  As a result, the emergence of unsustainable
deficits is substantially delayed under recently enacted fiscal
policy.  While our 1995 simulations showed deficits exceeding 20
percent of GDP by 2024 if current policies were not changed, our
updated model results show that this point would not be reached until
nearly 2050. 

Notwithstanding this progress, if no further action were taken, (a
"no action" scenario), our simulations indicate that federal spending
would grow faster than revenues soon after the baby boom generation
begins to retire in 2008.  These higher spending levels would be
driven by escalating health and Social Security costs.  Rising
interest costs would compound the deficit problem and take up an
increasing share of the federal budget.  Our simulations show that
growing deficits, left unchecked, would eventually result in
declining investment and capital stock and, inevitably, falling
living standards.  Over the long term, the "no action" scenario is
unsustainable.  Timely policy action can avoid these economic
consequences.  While a "no action" simulation is not a forecast of
what will happen, it illustrates the nature of future fiscal
challenges. 

The alternative simulations illustrate the potential fiscal and
economic benefits of achieving a sustainable budget policy. 
According to our simulations, a fiscal policy of balance through 2050
or extended periods of surplus, for example, could shrink the burden
of federal interest costs considerably and also result in a larger
economy over the long term.  All of these alternative policies would
increase per capita GDP in 2050 by more than 35 percent over a "no
action" policy, but they would require additional fiscal policy
changes.  Some of these changes may be difficult to achieve, but over
the long term they would strengthen the nation's economy and overall
living standards.  Early action would permit changes to be phased in
and so give those affected by changes in, for example, Social
Security or health care benefits, time to adjust. 

In considering what fiscal adjustments to make, policymakers need to
be presented with more complete information on the costs of the
government's existing long-term commitments.  The budget's current
structure and reporting mechanisms have not focused attention on such
commitments, nor has the budget process facilitated their explicit
consideration.  Financial statements are beginning to provide some of
this information.  Options to change budget reporting and process to
improve recognition of these commitments and prompt early action to
address potential problems warrant further exploration. 


   POLICY ACTION CONTRIBUTES TO
   IMPROVED FISCAL OUTLOOK
------------------------------------------------------------ Letter :3

In recent years, the federal deficit has declined substantially from
$290 billion in fiscal year 1992--4.7 percent of GDP--to a CBO
projected level of $23 billion in fiscal year 1997--0.3 percent of
GDP, which would be the lowest level since 1974.  This improvement is
due, in part, to deficit reduction initiatives enacted in 1990 and
1993 as well as to subsequent spending restraint.\7 The Balanced
Budget Act of 1997, coupled with the strong recent performance of the
economy,\8 is expected to extend this recent progress by achieving a
balanced budget in 2002 followed by several years of budget surpluses
on a unified budget basis.\9 The decline in the deficit has
significantly slowed growth in the federal debt held by the public. 
As a share of GDP, this commonly used measure of federal debt is
projected by CBO to decline from about 50 percent in fiscal year 1993
to 30 percent in 2007. 

The improving fiscal outlook over the near term carries longer term
benefits as well, as illustrated by comparing our current "no action"
simulation with our 1992 and 1995 modeling results.  (See figure 2.)
Our initial modeling work in 1992 indicated that even in the short
term, prospective deficits would fuel a rapidly rising debt burden. 
Intervening economic and policy developments led to some improvement
by the time we issued our 1995 report, as shown by a modest shift
outward of the "no action" deficit path.  Nonetheless, both our 1992
and 1995 "no action" simulations indicated that deficits would have
reached 20 percent of GDP in the 2020s.  In contrast, the 1997 "no
action" path--which follows CBO's 10-year forecast--indicates small
and shrinking deficits over the next few years, followed by a decade
of surpluses.  Following the enactment of the BBA in 1997, our
simulation indicates that deficits would not reach the 20-percent
level until nearly 2050.  For purposes of comparison, the highest
deficit level reached since World War II was 6.1 percent of GDP in
1983.  Figure 3 illustrates the improvement in the long-term outlook
for the federal debt as a share of GDP stemming from recent policy
actions and economic developments. 

   Figure 2:  Deficit Paths Under
   GAO's Past and Present "No
   Action" Simulations

   (See figure in printed
   edition.)


--------------------
\7 Recent legislation attempting to control the deficit included the
Omnibus Budget Reconciliation Act of 1990, the Budget Enforcement Act
of 1990, and the Omnibus Budget Reconciliation Act of 1993. 

\8 Policy action accounted for about 25 percent of the recent
improvement in CBO's budget estimates.  The remainder of the
improvement was due primarily to economic factors. 

\9 The unified budget includes annual Social Security trust fund
surpluses.  These surpluses are expected to be temporary, peaking at
$140 billion (including interest) in 2009 before declining and
eventually turning to deficits in the following decade.  For
additional information, see Federal Debt and Interest Costs, CBO, May
1993, and Federal Debt:  Answers to Frequently Asked Questions
(GAO/AIMD-97-12, November 27, 1996). 


   LONG-TERM IMPLICATIONS OF
   CURRENT FISCAL POLICY PATH
------------------------------------------------------------ Letter :4

These recent fiscal improvements represent substantial progress in
the near term toward a more sustainable fiscal policy.  However,
longer term problems remain.  As in our earlier work, a "no action"
policy remains unsustainable over the long term.  (See figure 2.)
While the federal budget would be in surplus in the first decade of
the 21st century, deficits would reemerge in 2012, soon after the
baby boom generation begins to retire.  These deficits would then
escalate, exceeding 6 percent of GDP before 2030 and exceeding 20
percent of GDP by 2050. 

A comparison of federal debt to the size of the economy tells a
similar story--near-term improvement followed by potentially
unsustainable growth as the baby boomers retire.  (See figure 3.) In
the early years of the simulation period, budget surpluses produce a
substantial reduction in the absolute size of the debt as well as in
the relationship of debt to GDP, from today's level of around 50
percent to about 20 percent in 2015.  However, at that point, the
debt to GDP ratio begins to rise rapidly, returning to today's levels
in the late 2020s and growing to more than 200 percent by 2050. 

   Figure 3:  Debt-to-GDP Ratios
   Under GAO's Past and Present
   "No Action" Simulations

   (See figure in printed
   edition.)

Such levels of deficits and debt imply a substantial reduction in
national saving, private investment, and the capital stock.  Given
our labor force and productivity growth assumptions, GDP would
inevitably begin to decline.  These negative effects of rapidly
increasing deficits and debt on the economy would force action at
some point before the end of the simulation period.  Policymakers
would likely act before facing probable consequences such as rising
inflation, higher interest rates, and the unwillingness of foreign
investors to invest in a weakening American economy.  Therefore, as
we have noted in our past work, the "no action" simulation is not a
prediction of what will happen in the future.  Rather, it underscores
the need for additional action in the future to address the nation's
long-term fiscal challenges. 

The primary causes of the large deficits in the "no action"
simulation are (1) the aging of the U.S.  population, which
corresponds to slower growth in the labor force and faster growth in
entitlement program spending, and (2) the rising costs of providing
federal health care benefits.  In 2008, the first baby boomers will
be eligible for early retirement benefits.  As this relatively large
generation retires, labor force growth is expected to slow
considerably and, eventually, stop altogether.  These demographic
changes mean fewer workers to support each retiree.  Between 1997 and
2025, the number of workers per Social Security beneficiary is
projected to drop by 33 percent.  Without a major increase in
productivity, low labor force growth will inevitably lead to slower
growth in the economy and in federal revenue.  As slow growth in the
labor force constrains revenue growth, the large retired population
will place major expenditure demands on Social Security, Medicare,
and Medicaid.  In just 15 years, the Social Security trustees
estimate that the program's tax revenue is expected to be
insufficient to cover current benefits.  While the recent Balanced
Budget Act included some actions to restrain growth in Medicare
spending and increase income from beneficiary premiums, the program
is still expected to grow faster than the economy over the next
several years.  According to CBO estimates, the Hospital Insurance
Trust Fund portion of Medicare will be depleted in 2007, even before
retiring baby boomers begin to swell the ranks of Medicare
beneficiaries.\10 Medicaid spending will also be under increasing
pressure as the population ages because a large share of program
spending goes to cover nursing home care. 

In the "no action" simulation, Social Security spending as a share of
GDP increases by nearly 50 percent between now and 2030.  By 2050, it
approaches twice today's level.  Health care spending, fueled by both
an increased number of beneficiaries and (in the early years of the
simulation period) rising per beneficiary costs, would grow even more
rapidly--doubling as a share of GDP by 2030 and tripling by 2050.  As
Social Security and health spending rise, their share of federal
spending grows tremendously.  (See figure 4.) By the mid-2040s,
spending for these programs alone would consume more than 100 percent
of federal revenues. 

   Figure 4:  Long-Term Change in
   Composition of Spending as a
   Percentage of GDP Under "No
   Action" Simulation

   (See figure in printed
   edition.)

After initially declining, interest spending also increases
significantly in the "no action" simulation.  In the early years of
the simulation period, budget surpluses reduce the burden of interest
spending on the economy.  However, when the surpluses give way to
deficits, this decline is reversed.  Growing deficits add
substantially to the national debt.  Rising debt, in turn, raises
spending on interest, which compounds the deficit problem, resulting
in a vicious circle.  The effects of compound interest are clearly
visible in figure 5, as interest spending rises from about 3 percent
of GDP in 1997 to over 12 percent in 2050. 

   Figure 5:  Net Interest as a
   Percentage of GDP Under "No
   Action" Simulation

   (See figure in printed
   edition.)


--------------------
\10 Congress and the President have recognized the need for further
changes in Medicare by establishing a National Bipartisan Commission
on the Future of Medicare as part of the BBA. 


   ALTERNATIVE FISCAL POLICIES
   WOULD CHANGE LONG-TERM ECONOMIC
   OUTCOMES
------------------------------------------------------------ Letter :5

Alternatives to a "no action" policy illustrate the fiscal and
economic benefits associated with maintaining a sustainable course. 
According to one definition, under a sustainable fiscal policy,
existing government programs can be maintained without a continual
rise in the debt as a share of GDP.\11 Under an unsustainable policy,
such as "no action," the debt continually rises as a share of GDP. 
As illustrated in our past reports and CBO's work,\12 a number of
different policy paths could be sustained over the long term.  In our
current work, we tested three different long-term fiscal strategies,
one that would allow for modest deficits, one that would maintain a
balanced budget, and one that would include an extended period of
surpluses.  (See figure 6.)

   Figure 6:  Alternate
   Deficit/Surplus Paths

   (See figure in printed
   edition.)

   Note:  Overlapping lines
   enhanced for clarity.  As
   discussed in the text, these
   lines represent identical
   paths.

   (See figure in printed
   edition.)

   *Debt-GDP ratio is maintained
   at lowest level reached in "no
   action."

   (See figure in printed
   edition.)

   **Social Security surpluses
   (including interest) are saved
   from 2000-2018, then balance is
   maintained.

   (See figure in printed
   edition.)

The "constant debt burden" simulation follows the "no action" path
through 2015.  From this point on, the debt is held constant as a
share of GDP, rather than increasing as in the "no action"
simulation.\13 To prevent the debt burden from rising from its 2015
level of about 20 percent of GDP, the federal government would have
to hold annual deficits to roughly 1 percent of GDP.  While not
insignificant, this deficit level is relatively small compared to the
federal deficits of recent years or to deficits in other industrial
nations.  For example, the European Union has established a deficit
target of 3 percent of GDP for countries participating in the common
currency arrangement. 

The "maintain balance" simulation also follows the "no action" path
for the early part of the simulation period.  In 2012--the year that
deficits reemerge under "no action"--a balanced unified budget would
be achieved.  Balance would then be sustained through the remainder
of the simulation period. 

Going beyond balance by running larger budget surpluses for a longer
period of time than in the other simulations would yield additional
economic benefits by further raising saving and investment levels. 
For our "surplus" simulation, we chose as a goal ensuring that annual
Social Security surpluses (including interest that is credited to the
fund) add to national saving.  To achieve this goal, the federal
government would run unified budget surpluses equal in size to the
annual Social Security surpluses--which the Social Security Trustees
estimate will peak at $140 billion in 2009.  Such a policy means that
the rest of the federal government's budget would be in balance. 
Social Security's surpluses (including interest income) are projected
to end in 2018.  Beginning in 2019, our simulation follows a unified
budget balance identical to the path in our balance simulation. 

Figure 7 shows the debt-to-GDP paths associated with the various
simulations.  Under the "constant debt burden" simulation, the
debt-GDP ratio remains around 20 percent, which is the lowest point
reached in "no action." Under both the "balance" and "surplus"
simulations, the debt-GDP measure would decline to less than 10
percent of GDP--levels that the United States has not experienced
since before World War I. 

   Figure 7:  Debt-to-GDP Ratios
   Under GAO's Four Fiscal Policy
   Simulations

   (See figure in printed
   edition.)

   *Debt-GDP ratio is maintained
   at lowest level reached in "no
   action."

   (See figure in printed
   edition.)

   **Social Security surpluses
   (including interest) are saved
   from 2000-2018, then balance is
   maintained.

   (See figure in printed
   edition.)

Each of the alternative simulations would require some combination of
policy or program changes that reduce spending and/or increase
revenues.  We make no assumptions about the mix of those changes in
our analysis.  We recognize that such actions would not be taken
without difficulty.  They would require difficult choices resulting
in a greater share of national income devoted to saving.  While
consumption would be reduced in the short term, it would be increased
over the long term.  Early action would permit changes to be phased
in and so give those affected by changes in, for example, Social
Security or health care benefits, time to adjust. 

For both the federal government and the economy, any of the three
alternative simulations indicates a vast improvement over the "no
action" path.  Sharply reduced interest costs provide the most
striking budgetary benefit from following a sustainable policy. 
Currently, interest spending represents about 15 percent of federal
spending, a relatively large share that is a consequence of the
deficits of the 1980s and early 1990s.  As noted above, after
shrinking in the early years of the "no action" simulation, interest
costs increase sharply over the long term.  In contrast, under the
alternative simulations, the interest burden shrinks dramatically. 
(See figure 8.) By 2050, under either a balance or surplus policy,
interest payments would represent 1 percent or less of total
spending.  Even under the less austere "constant debt burden"
simulation, interest would account for only about 5 percent of
spending. 

   Figure 8:  Net Interest as a
   Share of Total Spending in 2050
   Under GAO's Four Fiscal Policy
   Simulations

   (See figure in printed
   edition.)

   *Interest spending equals less
   than 1 percent of total
   spending.

   (See figure in printed
   edition.)

The economic benefits of a sustainable budget policy include
increased saving and investment levels and faster economic growth,
which results in higher living standards.  For example, under any of
our alternative simulations, per capita GDP would nearly double
between 1996 and 2050.  In contrast, under "no action," growth in
living standards would slow considerably and living standards
themselves would actually begin to decline around 2040.  By 2050,
they would be nearly 40 percent lower than under the balance
simulation.  This difference results from a wide gap in private
investment.  Under "no action," large deficits eventually drive
private investment spending down to zero while, for example, a
balanced budget policy could produce a doubling of investment, as
shown in table 1.\14 In the "no action" simulation, capital
depreciation would outweigh investment, resulting in a diminishing
capital stock and, eventually, contributing to a falling GDP. 



                                Table 1
                
                The Economy and Fiscal Position in 1996
                     (Actual) and 2050 (Simulated)

                      (In per capita 1997 dollars)

                                                               Percent
                                                            difference
                                                           between "no
                                    2050--    2050--       action" and
                                       "No  "Balance      "balance" in
                            1996   action"         "              2050
--------------------------  ----  --------  --------  ----------------
Real GDP                    $29,   $40,900   $56,500               38%
                             300
Debt Held by the Public     $14,  $107,100    $2,400              -98%
                             500
Nonfarm business            $3,0        $0    $6,700               N/A
 investment                   00
Nonfarm capital stock       $29,   $17,400   $59,900              244%
                             400
----------------------------------------------------------------------
Note:  Based on Social Security Administration population
projections. 

Figure 9 compares the path of per capita GDP under "no action" to a
balanced budget policy.  This difference graphically shows the
emerging gap in long-term living standards that results from shifting
fiscal policy paths.  Although the "maintain balance" path would lead
to higher living standards, the rate of growth would be significantly
lower than that experienced over the past 50 years.  Such a rate
would be extremely difficult to attain given the slowdown in
productivity growth that has occurred in recent decades. 

   Figure 9:  GDP per Capita
   Projected Under the "No Action"
   and "Balance" Simulations

   (See figure in printed
   edition.)

   Source:  GAO analysis of
   1946-1996 historical data,
   GAO's GDP simulations, and
   Social Security Administration
   population projections.

   (See figure in printed
   edition.)


--------------------
\11 For a detailed analysis of sustainability, see Olivier Blanchard,
Jean-Claude Chouraqui, Robert P.  Hagemann, and Nicola Sartor, "The
Sustainability of Fiscal Policy:  New Answers to an Old Question,"
OECD Economic Studies, no.  15 (Autumn 1990).  See also The Canadian
Institute of Chartered Accountants, Indicators of Government
Financial Condition, April 1997. 

\12 Congressional Budget Office, Long-Term Budgetary Pressures and
Policy Options, March 1997. 

\13 Prior to 2016, the debt declines as a share of the economy due to
the improved fiscal outlook for the near term. 

\14 Long-range simulations are quite sensitive to underlying
assumptions and involve a large range of uncertainty.  Hence, the
amounts in table 1 should not be viewed as precise "point" estimates. 
Rather, they indicate the general magnitude of the differences that
might result from different fiscal policy paths. 


   LONG-TERM COMMITMENTS NOT
   ADEQUATELY REFLECTED IN BUDGET
   REPORTING AND PROCESS
------------------------------------------------------------ Letter :6

Long-term economic simulations are a useful tool for examining the
balance between the government's future obligations and expected
resources.  This longer term perspective is necessary to understand
the fiscal and spending implications of key government programs and
commitments extending over a longer time horizon.\15

The future implications of current policy decisions reflected in our
simulations and in other financial reports are generally not captured
in the budget process.  The budget is generally a short-term,
cash-based spending plan focusing on the short- to medium-term cash
implications of government obligations and fiscal decisions. 
Accordingly, it does not provide all of the information on the longer
term cost implications stemming from the government's commitments
when they are made.  While the sustainability of the government's
fiscal policy is driven primarily by future spending for social
security and health care commitments, the federal government's
commitments and responsibilities extend far beyond these programs. 
These commitments may, themselves, result in large costs that can
encumber future fiscal resources and unknowingly constrain the
government's future financial flexibility to meet all its commitments
as well as any unanticipated or emerging needs. 

Information about the cost of some of these commitments will be
increasingly available as agencies produce audited financial
statements.  We anticipate that they will provide additional
information on long-term commitments, including such items as
environmental cleanup and insurance.  For example, in its 1996
financial statements, the Department of Energy reported a cost of
$229 billion to clean up its existing contaminated sites.  The
Department of Defense will also be developing and reporting cleanup
costs in financial statements.  The Office of Management and Budget
has estimated that the government is likely to have to pay $31
billion in future claims resulting from the federal government's
insurance commitments.  The first audited governmentwide financial
statements will be issued for fiscal year 1997.  This represents a
key step in the government's efforts to improve financial management
and provide greater transparency and accountability for the costs of
government commitments and programs. 

The key challenge facing budget decisionmakers is to integrate this
information into the budget process.  A range of options can be
considered.  A logical first step would be to include understandable
supplemental financial information on the government's long-term
commitments and responsibilities in the budget.  For example, in a
recent report we concluded that supplemental reporting of
accrual-based costs of insurance programs would improve recognition
of the government's commitments.\16 Other options to refine the
budget process or budget reporting to improve the focus on these
commitments and prompt early action to address potential problems can
be explored.  For example, long-term simulations of current or
proposed budget policies could be prepared periodically to help the
Congress and the public assess the future consequences of current
decisions.  Another option, which would supplement the current
practice of tracking budget authority and outlays, would be to
provide information to permit tracking the estimated cost of all
long-term commitments created each year in the budget. 


--------------------
\15 Budget Process:  Evolution and Challenges (GAO/T-AIMD-96-129,
July 11, 1996). 

\16 See Budget Issues:  Budgeting for Federal Insurance Programs
(GAO/AIMD-97-16, September 30, 1997). 


   OBJECTIVES, SCOPE AND
   METHODOLOGY
------------------------------------------------------------ Letter :7

In this report, the analysis of alternative fiscal policy paths
relies in substantial part on an economic growth model that we
adapted from a model developed by economists at the FRBNY.  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.  Federal deficits reduce national saving while federal
surpluses increase national saving.  The level of saving affects
investment and, in turn, GDP growth. 

Budget assumptions in the model rely, to the extent practicable, upon
the baseline projections in CBO's September 1997 report, The Economic
and Budget Outlook:  An Update, through 2006, the last year for which
CBO projections are available in a format usable by our model.  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 the Health Care Financing Administration's long-term
intermediate projections from the Medicare Trustees' April 1997
report.  For Medicaid through 2006, we similarly assumed growth
consistent with CBO's budget projections.  For 2007 and thereafter,
we used estimates of Medicaid growth from CBO's March 1997 report,
Long-Term Budgetary Pressures and Policy Options.  For Social
Security, we used the April 1997 intermediate projections from the
Social Security Trustees throughout the simulation period.  Other
mandatory spending is held constant as a percentage of GDP after
2006.  Discretionary spending and revenues are held constant as a
share of GDP after 2006.  Our interest rate assumptions are based on
CBO through 2006 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 September to October 1997 in accordance
with generally accepted government auditing standards.  We received
comments from experts in fiscal and economic policy on a draft of
this report and have incorporated them as appropriate. 


---------------------------------------------------------- Letter :7.1

We are sending copies of this report to the Ranking Minority Members
of your Committees, interested congressional committees, the Director
of the Congressional Budget Office, and the Director of the Office of
Management and Budget.  We will make copies available to others upon
request.  The major contributors to this report are listed in
appendix II.  If you have any questions concerning this report,
please call me at (202) 512-9573. 

Paul L.  Posner
Director, Budget Issues


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

This update of GAO's work\1

on the long-term economic and budget outlook relies in large part on
a model of economic growth developed by economists at the Federal
Reserve Bank of New York (FRBNY).  The major determinants of economic
growth in the model include changes in the labor force, capital
formation, and the growth in total factor productivity.  To analyze
the long-term effects of fiscal policy, we modified the FRBNY's model
to include a set of relationships that describe the federal budget
and its links to the economy.  The simulations generated using the
model provide qualitative illustrations, not quantitative forecasts,
of the budget or economic outcomes associated with alternative policy
paths.  The model depicts the links between the budget and the
economy over the long term, and does not reflect their
interrelationships during short-term business cycles. 

The main influence of budget policy on long-term economic performance
in the model is through the effect of the federal deficit or surplus
on national saving.  Higher federal deficits reduce national saving
while lower deficits or surpluses increase national saving.  The
level of saving affects investment and, hence, gross domestic product
(GDP) growth. 

GDP is determined by the labor force, capital stock, and total factor
productivity.\2 GDP in turn influences nonfederal saving, which
consists of the saving of the private sector 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 saving together
constitute 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 are also important links between national saving and investment
and the international sector.  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 equivalent 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.  In this update, we retained the
assumption in our prior work 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 reducing deficits or running surpluses and of the harm of
increasing deficits.  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 changes in deficits or surpluses could
have greater effects than our results suggest. 



                               Table I.1
                
                            Key Assumptions

Model inputs                        Assumptions
----------------------------------  ----------------------------------
Saving rate: gross saving of the    17.5% of GDP
private sector and state and local
government sector

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

Total factor productivity growth    1%

Inflation rate                      Follows CBO through 2007; 2.7%
                                    thereafter

Interest rate (average on the       Average effective rate implied by
national debt)                      CBO's interest payment projections
                                    through 2006; 5.1% thereafter
                                    (CBO's 2006 implied rate)

Surplus/deficit                     Follows CBO's budget surplus/
                                    deficit as a percentage of GAO's
                                    GDP through 2006; GAO simulations
                                    thereafter

Discretionary spending              CBO through 2006; increases at the
                                    rate of economic growth thereafter

Medicare                            CBO through 2006; increases at
                                    HCFA's projected rate thereafter

Medicaid                            CBO's projections

OASDI                               Follows the Social Security
                                    Trustees' Alternative II
                                    projections

Other mandatory spending            CBO's assumed levels through 2006;
                                    increases at the rate of economic
                                    growth thereafter

Receipts                            CBO's assumed levels through 2006;
                                    in subsequent years, receipts
                                    equal 19.9% of GDP (2006 ratio)
----------------------------------------------------------------------
Note:  In our work, all CBO budget projections were converted from a
fiscal year to a calendar year basis.  The last year of CBO's
projection period is fiscal year 2007, permitting the calculation of
calendar year values through 2006. 

We have made several modifications to the model, but the model's
essential structure remains the same as in our previous work.  We
have incorporated the change in the definition of government saving
in the National Income and Product Accounts (NIPA) adopted in late
1995 by adding a set of relationships determining government
investment, capital stock, and the consumption of fixed capital. 

The more recent data prompted several parameter changes.  For
example, the long-term inflation rate is now assumed to be 2.7
percent, down from 3.4 percent in our 1995 report and 4.0 percent in
our 1992 report.  In this update, the average federal borrowing rate
steadily declines to 5.1 percent, compared to our assumption of 7.2
percent in 1995 and 7.8 percent in 1992.  Our work also incorporates
the marked improvement in the budget outlook stemming from the
Balanced Budget Act of 1997 reflected in the 10-year budget
projections that CBO published in September 1997. 

The distinction between the mandatory and discretionary components of
the budget remains important.  We adopted CBO's assumption from their
most recent 10-year forecast that discretionary spending equals the
statutory caps from fiscal years 1998 through 2002 and increases at
the rate of inflation from fiscal years 2003 through 2007.  We
assumed it would keep pace with GDP growth thereafter. 

Mandatory spending includes Health (Medicare and Medicaid), Old Age
Survivors' and Disability Insurance (OASDI, or Social Security), and
a residual category covering other mandatory spending.  Medicare
reflects CBO's assumptions through 2006 and increases at HCFA's
projected rate in subsequent years.  Medicaid is based on CBO's
September 1997 assumptions; thereafter, it increases at the rates
embodied in CBO's March 1997 report on the long-term budget outlook. 
OASDI reflects the April 1997 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 2006, CBO
assumptions are the main determinant of other mandatory spending,
after which its growth is linked to that of GDP. 

The interest rates for 1997 through 2006 are consistent with the
average effective rate implied by CBO's interest payment projections. 
We assume that the average rate remains at the 2006 rate of 5.1
percent for the rest of the simulation period. 

Receipts follow CBO's dollar projections through 2006.  Thereafter,
they continue at 19.9 percent of GAO's simulated GDP, which is the
rate projected for 2006. 

As these assumptions differ somewhat from those used in our earlier
reports, only general comparisons of the results can be made. 


--------------------
\1 Budget Policy:  Prompt Action Necessary to Avert Long-Term Damage
to the Economy (GAO/OCG-92-2, June 5, 1992) and The Deficit and The
Economy:  An Update of Long-Term Simulations (GAO/AIMD/OCE-95-119,
April 26, 1995). 

\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. 

Christine E.  Bonham, Assistant Director
Andrew D.  Eschtruth, Evaluator-in-Charge
James R.  McTigue, Jr., Senior Evaluator
MaryLynn Sergent, Senior Evaluator

OFFICE OF THE CHIEF ECONOMIST

Richard S.  Krashevski, Economist

RELATED GAO PRODUCTS

Budget Issues:  Budgeting for Federal Insurance Programs
(GAO/AIMD-97-16, September 30, 1997). 

Retirement Income:  Implications of Demographic Trends for Social
Security and Pension Reform (GAO/HEHS-97-81, July 11, 1997). 

Addressing the Deficit:  Budgetary Implications of Selected GAO Work
for Fiscal Year 1998 (GAO/OCG-97-2, March 14, 1997). 

Federal Debt:  Answers to Frequently Asked Questions (GAO/AIMD-97-12,
November 27, 1996). 

Budget Process:  Evolution and Challenges (GAO/T-AIMD-96-129, July
11, 1996). 

Deficit Reduction:  Opportunities to Address Long-standing Government
Performance Issues (GAO/T-OCG-95-6, September 13, 1995). 

The Deficit and the Economy:  An Update of Long-Term Simulations
(GAO/AIMD/OCE-95-119, April 26, 1995). 

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

Budget Issues:  Incorporating an Investment Component in the Federal
Budget (GAO/AIMD-94-40, November 9, 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, September 12, 1990). 

*** End of document. ***