Long-Term Budget Issues: Moving From Balancing the Budget to Balancing
Fiscal Risk (Testimony, 02/06/2001, GAO/GAO-01-385T).

GAO discussed the fiscal policy challenges facing Congress and the
nation. The focus of tax administration and budgeting are shifting due
to current and projected budget surpluses. GAO spoke of need for fiscal
responsibility when using surplus projections to design tax and spending
policies. These projections are based on a set of assumptions that may
or may not hold. They are not a precise prediction of the future and
should be used as a reference point when making policy decisions. While
the projections can provide an opportunity to respond to the demands
that were temporarily suspended during the era of fiscal restraint,
Congress must balance those demands with the nation's long-term economic
health.

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

 REPORTNUM:  GAO-01-385T
     TITLE:  Long-Term Budget Issues: Moving From Balancing the Budget
	     to Balancing Fiscal Risk
      DATE:  02/06/2001
   SUBJECT:  Budget surplus
	     Budget outlays
	     Financial management
	     Balanced budgets
	     Federal debt
	     Economic analysis
	     Tax administration
	     Fiscal policies
	     Risk management
	     Future budget projections
IDENTIFIER:  Social Security Trust Fund
	     Medicare program
	     Medicaid Program
	     Hospital Insurance Trust Fund
	     Federal Thrift Savings Plan
	     Old Age and Survivors Insurance Trust Fund
	     Supplementary Medical Insurance Trust Fund

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GAO-01-385T

For Release on Delivery Expected at 10: 30 a. m. Tuesday, February 6, 2001

GAO- 01- 385T

LONG- TERM BUDGET ISSUES

Moving From Balancing the Budget to Balancing Fiscal Risk

Statement of David M. Walker Comptroller General of the United States
Testimony

Before the Committee on the Budget, U. S. Senate

United States General Accounting Office

GAO

Page 1 GAO- 01- 385T

Chairman Domenici, Ranking Member Conrad, and other Senators, I am pleased
to be here today to present GAO's perspective on the long- range fiscal
policy challenges facing this Congress and our nation. In recent testimony
before this committee, Federal Reserve Chairman Alan Greenspan observed that
the new, larger surplus projections have reshaped the choices and
opportunities before us. 1 That is true. As I have noted before, this
Administration and this Congress enter the 21st Century facing new
opportunities- and new challenges. You have the opportunity to respond to
many of today's wants, but also the obligation to prepare for the long term.

As you face budget choices in a time of projected surpluses, I'd like to hit
a few points:

First, as the Congressional Budget Office (CBO) notes these projections are
based on a set of assumptions that may or may not hold- no one should design
tax or spending policy pegged to the precise numbers in any 10- year
forecast.

Higher 10- year surplus projections provide room to address pent- up demands
for some tax cuts and/ or additional spending kept in abeyance during years
of fighting deficits. It is important to remember, however, that while
projections for the next 10- year period look better, the long- term outlook
looks worse. Without a change in entitlement programs, demographics will
overwhelm the surplus and drive us back into escalating deficits and debt.

The rapid increase in surplus projections brings closer the time at which
the surplus is expected to generate cash above that needed to redeem debt
held by the public. Congress and the President face new challenges in saving
for the future as we approach a time when there will be almost no publicly
held debt.

Budget choices should be viewed in terms of a balanced portfolio of options.
In the aggregate, choices should be balanced across different levels of
fiscal risk to the long- term outlook by using a portfolio approach.
Attention must be paid not only to responding to current needs but also to
making choices that increase the capacity of future generations to make
their own choices by promoting long- term growth and reducing the relative
future burden of entitlement programs.

1 Alan Greenspan, Testimony before the Committee on the Budget, U. S. Senate
(January 25, 2001).

Page 2 GAO- 01- 385T

Before looking ahead, I think it is useful to take a moment to remind
ourselves of how we got where we are today. We face burgeoning surplus
projections not only because of sustained strong economic growth but also as
a result of many difficult decisions made by earlier Congresses. These
decisions, taken at different times and maintained over time, ultimately
helped us to slay the deficit dragon. They included a budget control regime
that imposed caps on discretionary spending and a pay- asyou- go (PAYGO)
process on mandatories and revenues. They included the difficult spending
and tax decisions that implemented this process. Fiscal discipline was
enforced. As these processes and measures took hold, little by little
deficits receded. As the unified budget went into surplus, a bipartisan
consensus emerged on saving the Social Security surpluses, and this
consensus has also played an important part in today's favorable fiscal
outlook and reduced levels of debt held by the public.

Both the Office of Management and Budget (OMB) and CBO now show not only
Social Security surpluses but also increasing levels of non- Social
Security, or on- budget, surpluses over the next 10- year period. It is
these projected surpluses that have changed the budget landscape
dramatically from even a year ago. The surpluses offer a welcome opportunity
to address the legitimate pent- up demands held in abeyance during the era
of deficits. At the same time the surplus estimates imply that, absent
policy or economic change, debt held by the public could be virtually
eliminated before the end of this decade. As Chairman Greenspan recently
emphasized in testimony before this Committee, the possible elimination of
debt held by the public is an unexpected aspect of the new budgetary
environment. In modern times, it is unprecedented. As you know, Mr. Chairman
and Senator Conrad, GAO has done and is doing some work on debt management,
and later in this testimony I will discuss some of the emerging issues in
this area we have identified in our ongoing work.

The question before this Congress is how to balance today's wants and needs
against our long- term challenges. The advent of actual and projected
surpluses provides a window to respond to a wide range of demands held in
abeyance during years of restraint. The surplus does not, however, eliminate
our obligation to be prudent in dealing with the taxpayers' funds. As we
noted recently in the Performance and Accountability Series 2 the newfound
budget surpluses provide an opportunity- to move from a focus on annual
budget deficits to a reexamination of what government does and how the
government does business.

2 Major Management Challenges and Program Risks: A Governmentwide
Perspective (GAO- 01- 241, January 2001).

Page 3 GAO- 01- 385T

Further, while we can rejoice in the prospect of burgeoning surpluses, at
the same time we need to proceed with a measure of caution. It is important
also to remember that only a few years ago OMB and CBO projected deficits as
far as the eye could see. I do not say this to question the new projections
but simply to remind us of their limitations and how they are meant to be
used. These new projections, like the ones before them, are a “what-
if”- not a precise prediction of the future. The projections are
useful because they quantify the likely future budgetary consequences if we
continue current federal policies without change. As such, they serve as a
reference point and are a key tool for policymakers in choosing between
alternative policy courses. At the same time they are built on a complex set
of assumptions, and I want to talk a little about those later because we
need to understand these assumptions if we are appropriately to understand
the baseline projections.

Clearly, these new surplus projections present us with different- but not
necessarily easier- issues and trade- offs than was the case in the era of
large and persistent deficits. Indeed, in my view these surpluses present
both opportunity and obligation as well. While much of the discussion will
properly concern the opportunities the surpluses afford, I believe it is
important to remember that they bring with them a stewardship obligation. By
stewardship obligation, I mean that today's budget decisions need to be made
with the future in mind. We must not only respond to the legitimate needs of
today but also take into account the longer term fiscal pressures that loom
ever larger in coming decades as the nation ages and the baby- boom
generation retires. Our long- term simulations, updated using CBO's new
budgetary estimates, show that spending for federal health and retirement
programs eventually overwhelms even today's projected surpluses. This is
true even assuming no additional spending for defense, education, or a
Medicare prescription drug benefit- i. e., even if the entire unified
surplus were saved. The aging of our nation, which will truly begin to
affect the budget just after the 10- year budget window ends, is one key
backdrop for the choices this Congress will make.

These long- term pressures which cast a shadow on today's budgetary
deliberations are a kind of fiscal risk. Budget policy actions may be seen
in terms of their impact on the long term. Our work on budget choices in
states and other nations suggests an array of fiscal actions that may serve
as a framework for thinking about budget choices in a surplus environment.
No one factor is likely to dominate and the allocation of these surpluses
among debt reduction, new or increased spending, and tax cuts is inherently
a matter for political choice. However, these choices can be made in the
context not only of today's needs but also of the future realities.
Policymakers might think in terms of a portfolio of actions in

Page 4 GAO- 01- 385T

which a balanced approach may spread and moderate any related fiscal risk.

In using baseline budget projections, we need to understand what assumptions
they incorporate and how realistic these assumptions may be. Intended as a
neutral reference point for comparing alternative policies, baseline
projections make no assumptions about future policy change. The overarching
assumption is that current laws concerning tax policy and spending continue
unchanged. The conventions governing baseline projections are appropriate
and understandable in the context of budget enforcement purposes. However,
in using these projections as a basis for policymaking, it is important to
remember what they are and what are they are not. The baseline is just that-
a baseline from which to estimate the impact of policy actions; one would
expect the ultimate outcomes to be different- particularly over a decade.

Some analysts have suggested that baseline projections may understate likely
future discretionary spending while overstating likely future revenues.
Where current law does not provide a determinative rule- as is the case for
discretionary spending after expiration of the caps- both CBO and OMB must
make some assumptions. CBO's most commonly used projection for discretionary
spending- and the one we use for the first 10 years of our long- term
simulations- is the baseline under which discretionary spending grows with
inflation. A number of observers of the federal budget, including former CBO
directors Robert Reischauer and Rudolph Penner, have suggested that this
inflated discretionary assumption is unrealistic. One analysis has pointed
out that a growth rate no higher than inflation would mean that future per-
capita discretionary spending would decline in real terms during an era of
budget surpluses. 3 In addition, projections based on current- law
assumptions may overstate likely future revenues. For example, the baseline
projections assume expiration of a set of about 20 tax credits- including
the research and experimentation tax credit- which have been routinely
extended in the past. The baseline projections also assume no change to the
alternative minimum tax, which is expected to affect an increasing number of
middleclass taxpayers.

3 Robert Greenstein, “Can the New Surplus Projections Accommodate a
Large Tax Cut?” Center on Budget and Policy Priorities (January 2001).
See also the Concord Coalition's “The Surplus Field of Dreams”
(October 11, 2000), and Alan Auerbach and William G. Gale,
“Perspectives on the Budget Surplus,” NBER Working Paper 7837
(August 2000). Current- Law Budget

Projections May Understate Future Spending and Overstate Future Revenues

Page 5 GAO- 01- 385T

All projections are surrounded by uncertainty. In using budget estimates, we
need to keep in mind that budget estimates are not- and are not meant to be-
a crystal ball. CBO itself has warned against attributing precision to its
projections, stating that actual budgetary outcomes will almost certainly
differ from the baseline projections- even absent any policy changes. 4 CBO
notes that its estimate of the 2006 surplus could vary by as much as $400
billion in either direction. As CBO has said, the value of the 10- year
estimates is that they allow Congress to consider the longer- term
implications of legislation rather than focus only on the short- term
effects. 5 No policy should assume the exactness of baseline projections;
relatively small shifts can lead to large year- to- year differences.

While considerable uncertainty surrounds both short- and long- term budget
projections, we know two things for certain: the population is aging and the
baby boom generation is approaching retirement age. In addition demographic
trends are more certain than budget projections! Although the 10- year
horizon looks better in CBO's January 31 projections than it did in July
2000, the long- term fiscal outlook looks worse. In the longer term- beyond
the 10- year budget window of CBO's projections- the share of the population
over 65 will begin to climb, and the federal budget will increasingly be
driven by demographic trends.

4 CBO, The Budget and Economic Outlook: Fiscal Years 2002- 2011 (January
2001). 5 CBO, The Budget and Economic Outlook: An Update (July 2000), p. 22.
Despite Today's

Outlook for Large and Growing Surpluses, in the Long Term Deficits Will
Reemerge

Page 6 GAO- 01- 385T

Figure 1: Aged Population as a Share of Total U. S. Population Continues to
Grow

Note: Projections based on the Trustees' intermediate assumptions. Source:
The 2000 Annual Report of the Board of Trustees of the Federal Old- Age and
Survivors Insurance and Disability Insurance Trust Funds.

As more and more of the baby boom generation enters retirement, spending for
Social Security, Medicare, and Medicaid will demand correspondingly larger
shares of federal revenues. Federal health and retirement spending will also
surge due to improvements in longevity. People are likely to live longer
than they did in the past, and spend more time in retirement. Finally,
advances in medical technology are likely to keep pushing up the cost of
providing health care. In contrast to the improvement in the 10- year
projections, our updated simulations- shown in figure 2- show a worsening in
the long- term fiscal outlook since July. This worsening is largely due to a
change in the assumptions about health care costs over the longer term.

0% 5%

10% 15%

20% 25%

1950 1975 2000 2025 2050 2075 Percent of total population

Population aged 65 and over

Page 7 GAO- 01- 385T

Figure 2: Comparison of Unified Deficits as a Share of GDP Under the Save
the Social Security Surpluses Simulation, July 2000 Update and January 2001
Update

*Data end when deficits reach 20 percent of GDP. Source: GAO's January 2001
analysis.

In recent months there has been an emerging consensus that the long- term
cost growth assumption traditionally used in projecting Medicare and
Medicaid costs in the out- years is too low. A technical panel advising the
Medicare Trustees stated this conclusion in its final report. Charged with
reviewing the methods and assumptions used in the Trustees' Medicare
projections, the panel found that the methods and assumptions were generally
reasonable with the exception of the long- term cost growth assumption.
Basing its finding on recent research and program experience, the panel
recommended that in the last 50 years of the 75- year projection period,
per- beneficiary program costs should be assumed to grow at a rate one
percentage point above per- capita gross domestic product (GDP) growth. 6
CBO made a similar change to its Medicare and Medicaid longterm cost growth
assumptions its October 2000 report on the long term. 7 Given this
convergence of views, we have incorporated higher long- term

6 Technical Review Panel on the Medicare Trustees Reports, Review of
Assumptions and Methods of the Medicare Trustees' Financial Projections
(December 2000), p. 27. The panel stated that it believes that the long-
term forecasts should reflect the impact of changes in per- beneficiary
spending in addition to the impact of demographic change (p. 28). A more
detailed rationale for the recommendation can be found in chapter III of the
final report (pp. 27- 42).

7 CBO, The Long- Term Budget Outlook (October 2000), pp. 3 and 19. See also
the Medicare technical panel's discussion of CBO's similar assumption (p.
38).

-5 0

5 10

15 20

2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070
2075 Percent of GDP

July 2000 Save the Social Security Surpluses* January 2001 Save the

Social Security Surpluses*

Page 8 GAO- 01- 385T

health care cost growth consistent with the Medicare technical panel's
recommendation into our January update. 8

The message from our long- term simulations, which incorporate CBO's 10-
year estimates, 9 remains the same as it was a year ago. Indeed, it is the
same as when we first published long- term simulations in 1992. 10 Even if
all projected unified surpluses are saved and used for debt reduction,
deficits reappear in 2042. If only the Social Security surpluses are saved,
unified deficits emerge in 2019. (See figure 3.) In both scenarios deficits
would eventually grow to unsustainable levels absent policy changes.

8 It is not known at this time whether the panel's recommendation on
Medicare's long- term cost growth will be adopted by the Trustees and
incorporated into the 2001 Hospital Insurance and Supplementary Medical
Insurance estimates.

9 These simulations are based on the projections CBO released last week. As
is our standard practice, we use CBO's estimates for the 10- year budget
window. Beyond the 10- year window, we assume that all current- law benefits
in entitlement programs are paid in full (i. e., we assume that all promised
Social Security benefits are paid including after projected exhaustion of
the OASDI Trust Funds in 2037) and that discretionary spending grows at the
same rate as the economy.

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

96- 66, March 13, 1996), Budget Issues: Analysis of Long- Term Fiscal
Outlook (GAO/ AIMD/ OCE- 98- 19, October 22, 1997), Budget Issues: Long-
Term Fiscal Outlook (GAO/ TAIMD/ OCE- 98- 83, February 25, 1998), and Budget
Issues: July 2000 Update of GAO's Long- Term Simulations (GAO/ AIMD- 00-
272R, July 26, 2000).

Page 9 GAO- 01- 385T

Figure 3: Unified Deficits as a Share of GDP Under Alternative Fiscal Policy
Simulations

* Data end when deficits reach 20 percent of GDP. Source: GAO's January 2001
analysis.

To move into the future with no changes in federal health and retirement
programs is to envision a very different role for the federal government.
Assuming, for example, that Congress and the President adhere to the often-
stated goal of saving the Social Security surpluses our long- term model
shows a world by 2030 in which Social Security, Medicare, and Medicaid
increasingly absorb available revenues within the federal budget. Under this
scenario, these programs would require more than threequarters of total
federal revenue. (See figure 4.)

-5 0

5 10

15 20

2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070
2075 Percent of GDP

Save Unified Surpluses* Save the Social Security

Surpluses*

Page 10 GAO- 01- 385T

Figure 4: Composition of Federal Spending as a Share of GDP Under the Save
the Social Security Surpluses Simulation

Notes: (1) Revenue as a share of GDP declines from its 2000 level of 20.6
percent due to unspecified permanent policy actions that reduce revenue and
increase spending to eliminate the non- Social Security surpluses. (2) The
“Save the Social Security Surpluses” simulation can only be run
through 2055 due to the elimination of the capital stock.

Source: GAO's January 2001 analysis.

Little room would be left for other federal spending priorities such as
national defense, education, and law enforcement. Absent changes in the
structure of Social Security and Medicare, some time during the 2040s
government would do nothing but mail checks to the elderly and their
healthcare providers. Accordingly, substantive reform of Social Security and
health programs remains critical to recapturing our future fiscal
flexibility.

Since these simulations assume current- law entitlement benefits, they both
overstate and understate the challenge. They overstate it because they
assume Congress and the President would take no action to change the cost
structure of these programs. However, they understate it because they also
assume no benefit enhancements such as the addition of coverage for
prescription drugs. In addition, these simulations- like the budget- do not
recognize the long- term cost implications of insurance programs,
environmental cleanup liabilities and other long- term commitments. In other
words, in some ways this could be seen as an optimistic scenario!

The government undertakes other activities and programs that directly
obligate it to spend in the future. While some steps have been taken to

0 10

20 30

40 50

2000 2030 2050 Percent of GDP

Social Security Medicare & Medicaid Net interest All other spending Revenue

Page 11 GAO- 01- 385T

improve financial statement reporting of a number of these commitments, more
needs to be done. In addition, many future costs are not reflected in either
budget projections or long- term simulations. Explicit liabilities not
reflected in the budget can be sizable. For example, estimates indicate that
environmental cleanup of government- caused waste is expected to cost the
federal government at least $300 billion. Other future financial commitments
and contingencies are also important considerations.

The future costs of other activities are often difficult to estimate, but
nonetheless can add to future fiscal stress. Some, such as credit subsidy
costs, are in the budget and thus in the baseline; others, like the risk
assumed by federal insurance programs, are not. All of these as well as
demands for increased federal support in areas ranging from health insurance
to national defense will compete for a share of the fiscal pie in the
future- a pie that will already be increasingly encumbered by higher costs
for the elderly. This highlights the government's stewardship responsibility
to provide future generations with sufficient budgetary flexibility to make
their own choices and an economic base sufficient to finance current
commitments as well as future needs.

Today Congress and the President face a very different set of budget choices
than did your recent predecessors. For over 15 years fiscal policy has been
seen in the context of the need to reduce the deficit. The policies and
procedures put in place to achieve a balanced budget do not provide guidance
for fiscal policy in a time of surplus. At the same time, as Chairman
Greenspan warned last month, we “need to resist those policies that
could readily resurrect the deficits of the past and the fiscal imbalances
that followed in their wake.”

As you know, we have looked at a number of other countries that have already
faced this challenge. 11 Like the United States, these nations achieved
budget surpluses largely as the result of improving economies and sustained
deficit reduction efforts. After years of restraint, there are pent- up
demands- for tax cuts and/ or for spending. In several notable cases, these
countries met current demands while retaining surpluses for longer- term
economic goals. How do countries meet these demands without abandoning
restraint? The countries we reviewed articulated a compelling case for
sustaining surpluses and developed a fiscal policy

11 Budget Surpluses: Experiences of Other Nations and Implications for the
United States (GAO/ AIMD- 00- 23, November 2, 1999). In the report we looked
at Australia, Canada, New Zealand, Norway, Sweden, and the United Kingdom.
Budget Policy in a

Time of Surplus

Page 12 GAO- 01- 385T

framework that addressed current needs within the context of broader
economic targets or goals. Some adopted fiscal targets such as debt- toGDP
ratios as a guide for decision- making while others such as Australia
attempted to focus on the impact of fiscal policy on national saving and
economic growth.

Achieving consensus on a long- term fiscal policy goal this year may seem
unlikely. Nevertheless, I believe it is important that Congress and the
President look at budget choices today in the context not only of today's
needs and demands but also of the long- term pressures we know loom on the
horizon. Today's surpluses create, in effect, a unique window of opportunity
to better position the government and the nation to address both current
needs as well as the longer- term budget and economy we will hand to
succeeding generations. Our long- term model illustrates how important it is
for us to use our newfound fiscal good fortune to promote a more sustainable
longer- term budget and economic outlook so that future generations can more
readily afford the commitments of an aging society.

Today's budget decisions have important consequences for the living
standards of future generations. The financial burdens facing the smaller
cohort of future workers in an aging society would most certainly be
ameliorated if the economic pie were enlarged. This is no easy challenge,
but in a very real sense, our fiscal decisions affect the longer- term
economy through their effects on national saving. Recent research estimated
that increasing saving as a share of GDP by one percentage point each year
would boost GDP enough to cover 95 percent of the increase in elderly costs
between now and 2050.

Simply put, we are not saving enough as a nation. Personal saving is at a
40- year low. As shown in figure 5, the reduction of federal deficits and
the emergence of budget surpluses in recent years have slowed the long- term
decline in national saving. While investment needed to promote growth has
been supported by foreign capital in recent years, the profits due to
foreign investment go abroad. What would happen if in the future foreign
investors found more attractive opportunities elsewhere? The most viable
strategy for expanded growth in the long run is to increase saving from our
own economy. Since expanding the nation's productive capacity through saving
and investment is a long- term process, increasing saving now is vital since
labor force growth is expected to slow significantly over the next 20 years.
Deficits, Debt, and

National Saving

Page 13 GAO- 01- 385T

Figure 5: Composition of Net National Saving (1960- 1999)

*“ Other net saving” consists of net saving by businesses and
state and local governments. Source: Department of Commerce, Bureau of
Economic Analysis.

Traditionally, the most direct way for the federal government to increase
saving has been to reduce the deficit or- more recently- to run a surplus.
Although the government may try to increase personal saving, results of
these efforts have been mixed. As a general rule the surest way for the
federal government to affect national saving has been through its fiscal
policy.

In general, saving involves trading off consumption today for greater
consumption tomorrow. When the government saves by reducing debt by the
public, it helps lift future fiscal burdens by freeing up budgetary
resources encumbered for interest payments- which currently represent more
than 12 cents of every federal dollar spent- and by enhancing the pool of
economic resources available for private investment and long- term economic
growth. This is especially important since- as I noted a year and a half
ago- we enter this period of surplus with a large overhang of debt held by
the public. Indeed, we should be a little more subdued in congratulating
ourselves on the decline in debt held by the public- we are still
significantly above the debt/ GDP ratio of the late 1970s. Given the

-5 0

5 10

15 1960-1969 1970-1979 1980-1989 1990-1999

Percent of gross domestic product Federal surplus/deficit Personal saving
Other net saving* Net national saving 1990 1991 1992 1993 1994 1995 1996
1997 1998 1999

Page 14 GAO- 01- 385T

demographic pressures looming, today's level of publicly held debt is not a
good benchmark.

However, current projections show that- depending on the budget policies
adopted- the United States could reach a point in this decade at which
annual budget surpluses could not be fully used to reduce debt. Although
estimates of exactly when this might occur vary, most put it between 2004
and 2011. If the entire unified surplus is saved, this point is likely to be
reached in sometime in the next 5 years; if only the Social Security surplus
is saved, this point will be delayed until the second half of the decade.

This would raise a number of issues: whether and if so how the government
should hold nonfederal assets; whether and if so how a market for debt held
by the public should be maintained; how do we as a nation raise the level of
national saving if reducing federal debt held by the public is not an
option.

The issues Chairman Greenspan raised concerning government ownership of
nonfederal assets deserve careful consideration. I note that while Chairman
Greenspan opposed such a step, he also said that if the government were to
acquire nonfederal assets, he would prefer that they be allocated to the
Social Security Trust Funds. At GAO we have looked both at the experiences
of other countries during times of declining debt and at the question of
trust fund investments in equities. We believe this work can assist you in
your deliberations.

For example, in our ongoing work looking at other nations' experiences with
declining debt, we found that some have decided to hold some nonfederal
assets as part of their efforts to deal with long- term pressures. With the
advent of surpluses, Norway established a goal of sustained surpluses in
order to build up savings to address long- term fiscal and economic concerns
resulting primarily from an aging population and declining petroleum
reserves. As a vehicle for accumulating assets, the government created the
Government Petroleum Fund in 1991 to help manage Norway's petroleum wealth
over the long term. The Fund serves several important fiscal and economic
functions. By investing surpluses, the Fund is an instrument for saving part
of Norway's petroleum revenues for the next generation. During the 1990s,
Canada modified its pension system to invest in nonfederal assets as one way
to improve the system's sustainability. Sweden also invests a portion of its
pension funds in nonfederal assets. Management of Norway's Petroleum Fund is
the responsibility of the Ministry of Finance, which has delegated the task
of operational management of the Fund to Norway's central bank. Both

Page 15 GAO- 01- 385T

Canada and Sweden have established separate boards to oversee the investment
of their fund assets. In the near future, we plan to conduct a study of
other nations that invest in nonfederal assets in order to learn more about
how they deal with governance issues.

In 1998, we reported on the implications of allowing the Social Security
Trust Funds to invest in nonfederal assets, specifically equities. 12 One of
the implementation issues we looked at was that of governance- at the
concern that there would be tremendous political pressures to steer the
trust funds' investments to achieve economic, social, or political purposes.
We concluded that passively investing in a broad- based index would reduce,
but not eliminate, the possibility of political influence over the
government's stock selections. The question of how to handle stock voting
rights, however, seemed likely to be more difficult to resolve. To blunt
concerns about potential federal meddling, the government's stock voting
rights could be restricted by statute or delegated to investment managers.

The issue of how to select stock investments also emerged when the federal
employees' Thrift Savings Plan (TSP) was created. To eliminate political
influence in TSP's stock investment decisions, the Congress restricted TSP
investments to widely recognized broad- based market indexes; thus the
portfolio composition is automatically determined by the market index chosen
and consideration of nonfinancial objectives is precluded. TSP board members
and employees are subject to strict fiduciary rules, and breaching their
fiduciary duty would expose them to civil and criminal liabilities. The
fiduciary rules require board members and employees to invest the money and
manage the funds solely for the benefit of the owners of the individual
accounts- the participating federal employees and their beneficiaries. TSP
board members and employees are prohibited from exercising stock voting
rights, and voting instead is delegated to investment managers according to
their own guidelines. Obviously, the design and management of any federally
owned assets will be critical to mitigate the risks of political
interference. Since TSP assets are owned by federal employees, it cannot be
seen as directly analogous to government investment. Nevertheless, it can be
helpful in considering these issues.

Government ownership of nonfederal assets is obviously complicated and would
carry certain risks. Although the governance issues may not be
insurmountable, another possible concern is the magnitude of federal

12 Social Security Financing: Implications of Government Stock Investing for
the Trust Fund, the Federal Budget, and the Economy (GAO/ AIMD/ HEHS- 98-
74, April 22, 1998).

Page 16 GAO- 01- 385T

involvement in the financial markets. Although the federal government would
become the largest single investor, the amounts invested might not seem
disproportionately large in terms of the size of the U. S. financial
markets. Under our Save the Social Security Surpluses simulation, the
federal government would buy nonfederal assets for about a decade and
cumulative federal holdings would peak at about 2 percent of GDP assuming
that a federal debt market is not maintained. This would represent about 1
percent of the stock market or 4 percent of the corporate bond market today.
Any price effects associated with the federal government acquiring and then
selling these assets are uncertain. However, the government would not
necessarily be selling its nonfederal assets in this window.

If nonfederal assets are to be held by the government, the question arises
whether they could be used to prefund a portion of federal commitments and
liabilities. Since a successful stock investment strategy should be grounded
in a long- term outlook, the idea of investing in nonfederal assets could be
considered appropriate for federal programs with a long time horizon. For
example, federal civilian and military retirement programs could buy and
hold assets that match the expected timing of their liabilities.

As I have already noted, there is a growing body of experience in other
nations that might help us understand this new landscape better. It is worth
noting that investing in the financial markets is a standard practice for
state and local governments, and the experiences of public pension funds may
yield some insights into the implications of the federal government
investing on behalf of Social Security or other federal retirement programs.
Other nations have decided that the potential risks of political
interference with markets can be managed and are outweighed by what they
perceive as a risk of failing to save for the future or providing a cushion
for contingencies. These trade- offs are inherently political decisions- and
although we can look to others for insights, we will have to resolve these
issues in our own way.

If the governance, control and size issues loom so large that there is a
consensus the federal government should not hold nonfederal assets, we face
a new set of issues: should we avoid eliminating debt held by the public,
and if so, how? How then would we accumulate sufficient national saving to
promote the level of economic growth needed to finance the baby boom
retirement? The surest way for the federal government to raise national
saving has been by raising government saving. How to raise national saving
in an environment of zero federal debt is a complex question. The government
could aim for a balanced budget once the

Page 17 GAO- 01- 385T

federal debt held by the public is eliminated. In such a case, all national
saving would have to be achieved through increased private saving. Whether
existing federal incentives for people to save have been effective in
increasing private saving and ultimately national saving is open to
question. Even with preferential tax treatment granted since the 1970s to
encourage retirement saving, the personal saving rate has steadily declined,
as shown in figure 6.

Figure 6: Personal Saving Rate (1960- 1999)

Note: This rate as measured in the National Income and Product Accounts
(NIPA) is personal saving as a percentage of disposable personal income.

Source: Department of Commerce, Bureau of Economic Analysis, Survey of
Current Business, Tables 5. 1 and 2.1.

Some have suggested that one option would be using the surpluses to finance
individual saving accounts. Various proposals have been advanced that would
create a new system of individual accounts as part of comprehensive Social
Security reform, while other proposals would create new accounts outside of
Social Security. Individual account proposals also differ as to whether
individuals' participation would be mandatory or voluntary. If the goal of
individual account proposals is to increase national saving, careful
consideration must be given to the specifics of design. 13 Matching
provisions may affect how much such accounts

13 Social Security: Capital Markets and Educational Issues Associated With
Individual Accounts (GAO/ GGD- 99- 115, June 28, 1999).

0 2

4 6

8 10

12 1960 1965 1970 1975 1980 1985 1990 1995 Percent of disposable personal
income

NIPA personal saving rate

Page 18 GAO- 01- 385T

increase national saving. On another dimension, allowing early access to
these accounts increases people's willingness to put money in them- but
reduces their usefulness as retirement accounts. One possible approach might
be to use part of any realized surplus as a kind of surplus dividend that
could be returned in the form of an individual saving account. Again, design
features including targeting and limitations on access would be important.

As I discussed earlier, reducing the relative future burdens of Social
Security and health programs is critical to promoting a sustainable budget
policy for the longer term. Moreover, absent reform, the impact of federal
health and retirement programs on budget choices will be felt as the baby
boom generation begins to retire. While much of the public debate concerning
the Social Security and Medicare programs focuses on trust fund balances-
that is, on the programs' solvency- the larger issue concerns
sustainability. Absent reform, the impact of federal health and retirement
programs on budget choices will be felt long before projected trust fund
insolvency dates when the cash needs of these programs begin to seriously
constrain overall budgetary flexibility.

The 2000 Trustees Reports estimate that the Old- Age and Survivors Insurance
and Disability Insurance (OASDI) Trust Funds will remain solvent through
2037 and the Hospital Insurance (HI) Trust Fund through 2025. This date does
not incorporate either the technical panel's suggested higher cost growth
assumption or any benefit expansions such as prescription drug coverage.
Furthermore, because of the nature of federal trust funds, HI and OASDI
Trust Fund balances do not provide meaningful information about program
sustainability- that is, the government's fiscal capacity to pay benefits
when the program's cash inflows fall below benefit expenses. From this
perspective, the net cash impact of the trust funds on the government as a
whole- not trust fund solvency- is the important measure. Under the
Trustees' intermediate assumptions, the OASDI Trust Funds are projected to
have a cash deficit beginning in 2015 and the HI Trust Fund a deficit
beginning in 2009 (see figure 7). At that point, the programs become net
claimants on the Treasury. In addition, as we have noted in other testimony,
14 a focus on HI solvency presents an incomplete picture of the Medicare
program's expected future fiscal claims; the Supplementary Medical Insurance
(SMI) portion of Medicare,

14 Medicare Reform: Issues Associated with General Revenue Financing (GAO/
T- AIMD- 00- 126, March 27, 2000). Entitlement Reform

Page 19 GAO- 01- 385T

which is not reflected in the HI solvency measure, is projected to grow even
faster than HI in the future.

Figure 7: Social Security and Medicare's Hospital Insurance Trust Funds Face
Cash Deficits as Baby Boomers Begin to Retire

Note: Projections based on the Trustees' 2000 intermediate assumptions.
Source: GAO analysis of data from the Office of the Actuary, Social Security
Administration and the Office of the Actuary, Health Care Financing
Administration.

To finance these cash deficits, Social Security and the Hospital Insurance
portion of Medicare will need to draw on their special issue Treasury
securities acquired during the years when these programs generated cash
surpluses. In essence, for OASDI or HI to “redeem” their
securities, the government must raise taxes, cut spending for other
programs, or reduce projected surpluses.

Our long- term simulations illustrate the magnitude of the fiscal challenges
associated with our aging society and the significance of the related

-600 -500

-400 -300

-200 -100

0 100

200 2000 2005 2010 2015 2020 2025 2030 2035 2040 Billions of 2000 dollars

Medicare HI cash flow Social Security cash flow

Medicare HI cash deficit

2009 Social Security cash

deficit 2015

Page 20 GAO- 01- 385T

challenges that government will be called upon to address. As we have stated
elsewhere, 15 early action to change these programs would yield the highest
fiscal dividends for the federal budget and would provide a longer period
for prospective beneficiaries to make adjustments in their own planning.
This message is not changed by the new surplus numbers. It remains true that
the longer we wait to take action on the programs driving long- term
deficits, the more painful and difficult the choices will become.

While these new surplus projections offer an opportunity to address today's
needs and the many pent- up demands held in abeyance during years of
fighting deficits, they do not eliminate our obligation to prepare for the
future. Today's choices must be seen not only in terms of how they respond
to today's needs, but also how they affect the future capacity of the nation
and our ability to meet our looming demographic challenge.

When we looked at how other nations responded to budget surpluses, we
discovered that most found a way to respond to pressing national needs while
also promoting future fiscal flexibility and saving. Their actions could be
seen as constituting a range of actions across a continuum by the degree of
long- term fiscal risk they present. Figure 8 illustrates this array along
one dimension. At one end debt reduction and entitlement reform actually
increase future fiscal flexibility by freeing up resources. One- time
actions- either on the tax or spending side of the budget- may neither
increase nor decrease future flexibility- although here many would
distinguish between types of actions; devoting funds to previously
underfunded liabilities or to one- time capital investments may be seen as
different than actions that increase consumption. Permanent or openended tax
cuts and/ or spending increases may reduce future fiscal flexibility-
although that is likely to depend on their structure and implementation. For
example, many would argue that certain permanent changes in the tax
structure and/ or funding for well- chosen investments can enhance economic
growth and build for the future.

15 Major Management Challenges and Program Risk: A Governmentwide
Perspective (GAO- 01- 2421, January 2001), p. 45. Moving From

Balancing the Budget to Balancing Fiscal Risk

Page 21 GAO- 01- 385T

Figure 8: Array of Fiscal Choices

The decision on how to allocate surpluses is by its very nature inherently a
political one- and I am not here to advocate any particular tax or spending
proposal. Rather, my point is that since surplus projections are more
uncertain than demographic trends, prudence would argue for seeking to
balance risk. You might think about the budget choices you face today as a
portfolio of fiscal actions balancing today's unmet needs with tomorrow's
fiscal challenges. If the experience of other nations and the states is any
guide, we will most likely choose actions across an array of choices. In
thinking about balanced risk, it is not the merits of any individual
proposal that are key but the impact of these decisions in the aggregate or
from a portfolio perspective.

This suggests that whatever the fiscal choices made in allocating the
surplus among debt reduction, tax cuts, and spending increases, approaches
should be explored to mitigate risk to the long term. For example,
provisions with plausible expiration dates- on the spending and the tax
side- may prompt re- examination taking into account any changes in fiscal
circumstances. A mix of temporary and permanent actions may also reduce
risk. In our recent Performance and Accountability series, we also suggested
that, given the inherent uncertainty of surplus projections, consideration
be given to linking a portion of new fiscal commitments to the actual levels
of surpluses achieved. As I mentioned earlier, one possible approach could
be a kind of “surplus dividend” that had to be saved. Whatever
the form, linking new commitments to actual results can be seen as a kind of
contingency planning. Others have suggested considering a portion of the
surplus as a kind of contingency fund.

Some states have developed approaches to limiting fiscal risk by linking
temporary tax cuts or spending to actual fiscal results. In Ohio, an Income

Reduce debt

Capital investments

One-time tax refunds

Permanent tax cut

Reserve funds

Address underfunded

liabilities One-time

spending Permanent

spending increase

Invest surpluses

Page 22 GAO- 01- 385T

Tax Reduction Fund was established as a mechanism to return surplus revenues
to taxpayers based on the size of the actual surplus in excess of the amount
required to maintain the budget stabilization fund. Minnesota has refunded
surplus revenues beginning in 1997 and has since instituted a requirement
that a revenue surplus exceeding 0.5 percent be designated for a tax rebate.
Arizona developed triggers which designate the use of surplus revenues for
specific tax reductions, or new appropriations based on the amount of actual
surpluses achieved. Arizona also has increased the balances in the Budget
Stabilization Fund. The excess surplus funds triggered reductions in vehicle
license and corporate taxes as well as increased education funding.

Surpluses challenge our nation to move beyond a focus on reducing annual
deficits to a broader agenda. They offer us an opportunity to look more
closely at what government does and how it does business. With the advent of
surpluses in the near- term, the nation needs to develop a new fiscal
paradigm– one that will prompt greater attention to the long- term
implications of current programs and policy choices and help to better
balance today's wants against tomorrow's needs.

For more than a decade, budget processes have been designed with the goal of
reaching a zero deficit. Now that goal has been reached- indeed passed.
Clearly, the limits imposed to achieve a balanced budget are not working in
the world of surplus. At the same time eliminating all controls would be a
mistake. You face the need not only to make choices about tax and spending
policy, but also to design a process for the future.

Now that the goal of “Zero Deficit” is gone, what should replace
it? Whatever measure you select, we believe that the budget and the budget
process must pay more attention to the long- term cost implications of
today's budget and program decisions. We have recommended, for example,
budgeting for the fully accrued costs for insurance and pensions in current
budgets to reflect the future commitments made in current programs. 16
Ultimately, the federal government needs a decision- making framework that
permits it to evaluate fiscal good fortune and choices against both today's
needs and the longer- term fiscal future we wish to hand to future
generations.

16 Accrual Budgeting: Experiences of Other Nations and Implications for the
United States (GAO/ AIMD- 00- 57, February 18, 2000) and Budget Issues:
Budgeting for Federal Insurance Programs (GAO/ AIMD- 97- 16, September 30,
1997). Conclusion

Page 23 GAO- 01- 385T

I have suggested here today that budget choices can be seen as a fiscal
portfolio- and as such the ideal set would balance different types of fiscal
risks. Not only should policy choices be examined individually, but also
their aggregate impact on the nation's long- term economic health should be
considered. The budget surpluses before us offer policymakers the
opportunity to strike a balance between addressing today's needs and the
obligation to hand a strong economy and sustainable fiscal policies on to
our children, our grandchildren, and future generations.

(450041)

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