Federal Budget: The President's Midsession Review (Letter Report,
07/27/1999, GAO/OCG-99-29).

Pursuant to a congressional request, GAO discussed the President's
Midsession Review and the implications of the President's proposals on
fiscal policy and the federal budget.

GAO noted that: (1) the large on-budget surpluses are still projections;
(2) even in the near term these projections are optimistic and may not
be realized since they assume full compliance with existing tight caps
on discretionary spending; (3) absent any changes in social security,
Medicare, and Medicaid, the budget will increasingly be absorbed by
payments to the retired--making it more difficult to meet other
priorities; (4) bills will also come due for a variety of other
commitments and contingencies, such as cleanup costs from federal
operations known to result in hazardous waste, including defense
facilities and weapon systems, and federal insurance programs; (5)
overall, the President proposes to reduce debt held by the public by
more than he did in his February budget; (6) he also proposes to spend
more in several areas; (7) the big items in the budget, however, remain
social security and Medicare; (8) there is still a need for fundamental
reform of these programs to ensure their long-range solvency and
sustainability; (9) the President has changed the form of his social
security proposal; (10) instead of transferring to the Social Security
Trust Fund additional Treasury securities equal to a share of the
unified surplus, the President proposes to use the social security
surplus to reduce debt held by the public and then to transfer to the
Trust Fund securities equal to the fiscal dividend that results from
lower publicly held debt; (11) the Social Security Trust Fund already
earns interest on its surplus; (12) under the new proposal, it will
receive, in effect, a second interest payment equal to interest savings
that result from paying down publicly-held debt; (13) the policy in the
Midsession Review envisions more debt reduction than that in the
President's February budget; (14) under his most recent proposals, the
entire social security surplus goes to debt reduction; (15) the debt
reduction proposed by the President would confer significant short- and
long-term benefits to the budget and the economy; (16) if all
assumptions hold, interest would fall from $229 billion in 1999 to about
$10 billion by 2014; (17) while the President is to be commended for the
amount of debt reduction, GAO remains concerned about the consequences
for trust fund financing and reform; and (18) the President's proposal
to grant additional securities--to both Medicare and the interest
transfer to social security--creates the risk of reducing transparency
about the underlying financial condition of these trust funds.

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

 REPORTNUM:  OCG-99-29
     TITLE:  Federal Budget: The President's Midsession Review
      DATE:  07/27/1999
   SUBJECT:  Economic analysis
             Budget administration
             Budget surplus
             Presidential proposals
             Future budget projections
             Deficit reduction
             Fiscal policies
             Social security benefits
             Health insurance
             Budget outlays
IDENTIFIER:  Hospital Insurance Trust Fund
             Medicare Trust Fund
             Social Security Trust Fund
             Medicaid Program

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CG99029

GAO/OCG-99-29

A Observations Of David M. Walker Comptroller General
of the United States

FEDERAL BUDGET The President's Midsession Review

This statement was originally prepared in anticipation of a
hearing before the Senate Budget Committee, July 21, 1999.

This statement discusses the President's Midsession Review and the
implications of the President's proposals on fiscal policy and the
federal budget. The press has focused on the fact that both OMB
and CBO have revised upward their projections for the unified
budget surplus. The phrase $ 1 trillion more has been widely
reported in the media. Further, these new projections show an on-
budget surplus throughout the next 10- 15 years. An earlier- than-
expected and larger- than- expected surplus is only good news for
the future health of our economy if two conditions are met. First,
the surplus must be realized. Second, the surplus must be put to
prudent use. To the extent that the surplus is used for debt
reduction, it offers the benefit of lower interest costs. And the
miracle of compound interest means that savings in today's
interest payments will yield benefits tomorrow.

The surplus we celebrate today came about not only through
stronger- than- expected economic growth but also as the result of
some difficult policy choices you and the President made over the
past years. Now, after the recent years of tight discipline and
focus on fiscal responsibility, the surplus offers a chance to
debate the relative merits of different priorities. Should some of
the surplus be used to meet pent- up demand for spending in
certain domestic discretionary areas? For an increase in defense
spending? For tax cuts? To secure existing unfunded entitlement
promises? For debt reduction? For a combination of all of these?
Most would not argue for devoting 100 percent of the surplus to
debt reduction over the next 10 years. However, unless a good
portion of the surplus is saved, it will not be used to redeem
debt, and we will lose a portion of the interest savings. And it
is critical to save a good deal of the surplus because known
demographic trends require that we hand the next generation a
stronger economy and a lower debt burden.

A Federal Reserve Board chairman once described his job as to take
away the punch bowl when the party was just getting going. My job
as Comptroller General of the United States, I believe, is to
serve as an accountability cop at the surplus celebration party
and to offer a note of caution about how we deal with this welcome
shift from an environment of persistent deficits to one of
projected large surpluses.

There are several reasons to be prudent: 1. These large on- budget
surpluses are still projections, and the history of budget
projections especially over a long period should give us pause
about making large and long- lasting commitments that consume the
surplus. Even in the near term these projections are optimistic
and may not be realized since, among other things, they assume
full compliance with existing tight caps on discretionary
spending. Further, the fact that even given these assumptions a
little over half of the surplus occurs 11- 15 years from now
should make us even more cautious about committing these

surpluses for permanent changes on either the revenue or the
spending side. 2. We enter this surplus period with a large debt
built up from years of running deficits. Deficits are an
indication that the American people are

getting more government benefits and services than they are paying
for. Just as families that have built up debt during years in
which expenses exceeded income use newfound income to reduce that
debt, so the federal government might think about using surplus to
reduce its debt. This is especially important given known
demographic trends whereby fewer and fewer workers will be
supporting a growing retired population for longer periods of
time. 3. In addition and this makes the previous point even more
salient we face looming cost pressures over the next decades which
will lead to a significant decline in budgetary flexibility unless
current policies are changed. Absent any changes in Social
Security, Medicare, and Medicaid, the budget will increasingly be
absorbed by payments to the retired making it more difficult to
meet other priorities. In addition, Social Security and Medicare
are not the only cost pressures on the horizon. Bills will also
come due for a variety of other commitments and contingencies such
as cleanup costs from federal operations known to result in
hazardous waste, including defense facilities and weapon systems,
and federal insurance programs.

The following discusses each of these in turn and then moves on to
discuss briefly the President's proposals. Projections Are The
history of budget forecasts should remind us not to be complacent
Uncertain about the certainty of these large projected surpluses
and make us cautious about committing them to large permanent tax
cuts or spending increases.

In a recent outlook book, CBO compared the actual deficits or
surpluses for 1988 through 1998 with the first projection it had
produced 5 years before the start of each fiscal year. Excluding
the estimated impact of legislation, CBO says its errors averaged
about 13 percent of actual outlays. Such a shift in 2004, for
example, would mean a potential swing of about $250 billion in the
surplus. It is important to remember that it was not so long ago
that forecasts were for deficits as far as the eye can see. Today
we are pleasantly surprised by upward revisions in surplus
estimates. Yet only a decade ago we were

being unpleasantly surprised by upward revisions in deficit
estimates. I note this not to raise questions about either OMB or
CBO analysis but rather to remind us all about the inherent
uncertainty of projections. All projections are heavily dependent
on assumptions that, while reasonable, may still not hold. And in
a budget of nearly two trillion dollars a year, the smallest
change in one assumption can lead to very large

changes in the fiscal outlook especially when carried out over a
decade. Indeed, the dramatic increase in surplus projections
between this past winter and this summer are the result of very
small changes in economic assumptions. But it is not just
uncertainty about the economy that should give pause about these
projections. Both CBO and OMB use what is called the capped
baseline. That is, they assume that total discretionary spending
including defense and emergencies remains within the legislated
caps for fiscal years 2000, 2001, and 2002. 1 After fiscal year
2002, the projections assume that discretionary spending grows
only with inflation. Under this assumption, total discretionary
spending over the next 10 years would be reduced by $595 billion
below the fiscal year 1999 levels of nonemergency

discretionary spending adjusted for inflation over the same 10-
year period. 2 Although this is the only assumption that CBO and
OMB appropriately can make in projections, a look at recent
history makes it unlikely. It is much more likely that there will
be some spending increases, and if discretionary spending exceeds
these levels either because of emergencies or because of an
agreement to raise the caps the surplus, and hence the interest 1
OMB actually assumes that discretionary expenditures exceed the
caps, but OMB also assumes offsets

for those expenditures thus the analytic point holds. 2 This
calculation is based on CBO projections.

would also argue that projected periods Percent of G NP/ GDP

savings, will be smaller. Some of surplus would prompt a tax cut,
and that, too, would shrink the surplus. The further out the
projection the more uncertain it is. Given that, it is worth
noting that a little more than half the surplus projected by OMB
comes in years 11- 15 of the projection period. This has real
significance for the policy debate: Making large long- term
commitments on either the tax or spending side of the budget is
very risky.

Surpluses Follow Debt We need to view these surpluses not in a
vacuum but in the context of Buildup where we've been. Figure 1
below shows the deficit or surplus as a share

of the economy since 1797.

Figure 1: Deficit/ Surplus as a Share of GNP/ GDP

10 5 0 -5 -10 -15 -20 -25 -30 1797

18 07

1817 1827

1837 1847

1857 1867

1877 1887

1897 1907

1917 1927

1937 1947

1957 1967

1977 1987

1997 Fiscal Year

Note: Data until 1940 are shown as a percent of gross national
product (GNP); data from 1940 to present are shown as a percent of
gross domestic product (GDP). Traditionally, in the United States,
periods of high deficits and debt buildup have tracked recessions
or wars and have been followed by periods of shrinking debt
usually from a combination of fiscal restraint and economic
growth. According to CBO's baseline budget projections which
assume compliance with the discretionary caps even after 2 years
of

budgetary surplus, debt held by the public stands at about 40
percent of GDP, a level that the United States rarely reached
before 1940. This debt is the result both of previous economic
slowdowns and of the structural imbalance between spending and
revenues over the last 29 years. For 29 years, the U. S.
government took in less in taxes than it spent; the difference was
made up by borrowing from the public.

Now we face the happy reverse but because of the previous deficits
we enter this surplus period with this overhang of debt. If the
surplus were to be used entirely for spending increases or tax
cuts, the budget might be in balance on an annual basis, but we
would have done nothing to make up for the years of deficit
spending and we would have done nothing to remove the burden of
the debt from future generations. Importantly, our demographic
situation is far different now than during previous times when we
emerged from prolonged periods of deficits. Longer life
expectancy, the aging baby boom generation, and a relatively
smaller working population means demographic trends will be
working against rather than for the financial condition of the
Social Security and Medicare programs. This debt issue is
especially salient given the third reason for prudence: the
looming cost pressures that face the nation and their implication
for budget flexibility.

Looming Cost Nothing in either the OMB or the CBO midsession
update changes the fact Pressures and Reduced that our society is
aging and the obligations relating to my generation, the baby boom
generation, will begin coming due in the not- too- distant future.
Budgetary Flexibility

Further, increasingly people live a long time in retirement. In
addition, Medicare and other health care costs historically have
outpaced inflation. What I said in February remains true today, We
face a demographic tsunami in the future that poses significant
challenges for the Social Security system, Medicare, and our
economy as a whole. 3

Over the next several decades the United States will experience an
unprecedented shift in our demographic profile, and this shift
will have consequences not only for Social Security and Medicare
expenditures but also for the rest of the federal budget and
economic growth. Less than

3 Social Security and Surpluses: GAO's Perspective on the
President's Proposals (GAO/ T- AIMD/ HEHS- 99- 95, February 23,
1999).

10 years from now the first baby boomers will be eligible for
early retirement benefits, and with increasing life expectancy
they will expect to live a long time in retirement. The oldest of
this generation will reach early retirement age (62) in 2008, and
the youngest will reach it in 2026. As the baby boom generation
retires, labor force growth is expected to slow considerably and
eventually stop altogether. This demographic

shift is expected to cause a decline in economic growth rates as
growth in total hours worked disappears. As the labor force growth
stagnates, labor productivity will become even more important to
economic growth. Without a major increase in productivity, low
labor force growth will inevitably lead to slower growth in the
economy and slower growth of federal revenues. This slower revenue
growth will come at the same time

that a large retired population will place major expenditure
demands on federal programs for the elderly. GAO's updated model
results continue to show that even if the total surplus is saved
and the budget caps adhered to, these changing demographics
referred to above will if all assumptions hold inevitably lead to
renewed deficits and growing debt, absent a change in fiscal
policy. These deficits will result primarily from the combined
spending pressures of Social

Security, Medicare, and Medicaid. As more and more of the baby
boom generation retires, these pressures will fuel new deficits
even if we save the whole surplus and the nation will once more
find itself in the vicious circle of escalating deficits, debt,
and interest costs. This longer- term problem of re- emerging
deficits provides the critical

backdrop for any permanent changes in tax or spending. Absent
changes in current fiscal policy and even assuming the spending
caps are adhered to, and all surpluses are saved and devoted to
debt reduction spending for Social Security, health, and interest
alone would absorb a little over half of all federal revenues by
2018. By 2066, this spending would consume the entire federal
budget. Budgetary flexibility declines drastically, and there is
increasingly little to no room for programs for national defense,
the young, infrastructure, and law enforcement i. e., essentially
no discretionary programs at all. Figure 2, below, illustrates
these trends.

2: Composition of Spending as a Share of GDP Under Save the
Unified Simulation 6 0%

5 0% 4 0% 3 0%

Revenue

2 0% 1 0%

0% 1 998 203 0* 205 0 2 070

N e t In te re P ercent o f G DP

Figure Surplus So c ia l S ec urity Med ic are & M e dica id st
All o th e r s p en din g

*In 2030, all other spending includes offsetting interest
receipts.

Unimaginable as this picture is, as figure 3 below shows, it
becomes even more dramatic if we assume the entire surplus is used
and none of it is saved. In that scenario, lower GDP and higher
interest payments lead to a world in which revenues cover little
beyond Social Security, health and interest payments in 2030 and
by 2050 revenues don't even cover those!

3: Composition of Spending as a Share of GDP Under No Unified
Surplus 6 0% 5 0% 4 0% 3 0%

Revenue

2 0% 1 0%

0% 1 998 2030 20 5 0

d ic a id N et In te r e st All o th er P ercent o f GD P

Figure Simulation So cia l S e c u r ity Med ic a re & M e s pe n
din g

Although views about the role of government differ, it seems
unlikely that many would advocate a government devoted solely to
sending checks and health care reimbursements on behalf of the
elderly. Therefore, under any fiscal and economic scenario,
reforms reducing the future growth paths of Social Security,
Medicare, and Medicaid are vital to restoring fiscal flexibility
for taxpayers of the future. Early action yields great returns the
miracle of compounding again. Figure 4 below illustrates this for
Medicare.

Share of GDP Percent of GDP

Figure 4: Federal Deficits as a Under Alternate Medicare
Simulations

20 15 10

5 0 -5

1998 2010 2020 2030 2040 2050 2060 2070 No action Action taken in
2002 Action taken in 2012

Figure 4 also shows that although reducing debt helps, debt
reduction alone is not enough. Even if we were to save the entire
surplus, entitlement reform would still be necessary. This is even
clearer when we realize that Social Security and Medicare are not
the only long- term cost pressures facing us. Federal commitments
such as those for insurance, Medicaid, and environmental
liabilities for the Departments of Energy and Defense cleanup will
also likely result in large costs that encumber future fiscal
resources and constrain future financial flexibility to meet
emerging needs. Midsession Policies Overall the President proposes
to reduce debt held by the public by more

than he did in his February budget. He also proposes to spend more
in several areas. The big items in the budget, however, remain
Social Security and Medicare. There is still a need for
fundamental reform of these programs to assure their long- range
solvency and sustainability.

The President has changed the form of his Social Security
proposal. Instead of transferring to the Social Security Trust
Fund additional Treasury securities equal to a share of the
unified surplus, the President proposes to use the Social Security
surplus to reduce debt held by the public and then beginning in
2011 to transfer to the Trust Fund securities equal to the fiscal
dividend i. e., interest savings that results from lower publicly
held debt. The Social Security Trust Fund already

earns interest on its surplus. Under the new proposal it will
receive, in effect, a second interest payment equal to interest
savings that result from paying down publicly held debt. This is
simply a general fund transfer pegged to the interest saving.
Unlike the February proposal, the general fund transfer does not
start until 2011. However, this general fund transfer is open-
ended in duration. The policy in the Midsession Review envisions
more debt reduction than that in the President's February budget.
Under his most recent proposals, the entire Social Security
surplus goes to debt reduction. The President projects that his
proposals would reduce debt held by the public by

$3.6 trillion over the next 15 years, virtually eliminating
publicly held debt by 2015. Almost two- thirds of projected
unified budget surpluses would be used to reduce the debt through
lockbox provisions dedicating all of Social Security's surpluses
and about a quarter of the on- budget surplus transferred to
Medicare for debt reduction. The debt reduction proposed by the
President although less than the baseline, which assumes that all
surpluses would be saved would confer significant short- and long-
term benefits to the budget and the economy. GAO's work on long-
term budget outlooks illustrates the benefits of maintaining
surpluses for debt reduction. Interest on the debt today

represents the third largest program in the federal budget.
Reducing the publicly held debt reduces these costs, freeing up
budgetary resources for other programmatic priorities. Under the
President's plan, if all assumptions hold, interest would fall
from $229 billion in 1999 to about

$10 billion by 2014. For the economy, running surpluses and
reducing debt increases national saving and frees up resources for
private investment. This in turn leads to stronger economic growth
and higher incomes over the long term. Over the last several
years, our simulations have illustrated the long- term economic
consequences flowing from different fiscal policy paths. Our
models consistently show that any path saving all or a major share
of projected budget surpluses ultimately leads to demonstrable
gains in GDP

per capita over a 50- year period. GDP per capita would more than
double from present levels by saving most or all of projected
surpluses, while incomes in the simulation actually fall during
this period if we failed to sustain any of the surplus. Although
rising living standards are always important, they are especially
critical for the 21 st century, for they can increase the economic
capacity of the projected smaller workforce to

maintain a good standard of living as well as to finance future
government programs and the commitments for the baby boomers'
retirement. While the President is to be commended for the amount
of debt reduction, I remain concerned about the consequences for
trust fund financing and reform. It is fair to note that nothing
in his midsession proposal changes the fundamental structural
imbalance in Social Security. The system's cash flow still turns
negative in 2014 and Social Security becomes a draw on the general
fund. When federal deficits re- emerge, however, baby boomers will

still be retiring with long expected lifespans in retirement. If
the President's proposal to transfer interest savings to the
Social Security Trust Fund is adopted, the Trust Fund solvency on
paper is extended, but the structural imbalance will remain. The
new securities will be redeemed and constitute a new claim on the
general fund until they run out in 2053. 4 Absent substantive
program reform, our children will be saddled with a budget heavily
burdened by commitments to fund entitlement programs for the
elderly. At heart the President's Social Security reform proposal
is a combination of debt reduction and a general fund transfer. As
I have said before, I believe there are legitimate arguments on
both sides of the question of bringing some general fund financing
to Social Security but the issue should be debated openly and on
its merits.

Medicare is a more complicated story. Under the President's
proposal some of the on- budget surplus would be transferred to
Medicare, invested in federal Treasuries and so used to reduce
publicly held debt. As with Social Security, this formalizes a new
claim on general fund revenues for the Hospital Insurance Trust
Fund. The President also proposes to add a

new benefit, namely a prescription drug benefit that is only
partially funded by premiums. At the same time, the long- term
cost pressures facing this program remain. Fundamental program
reforms to reduce the future growth of the Medicare program are
critical both to budget flexibility in the future and to any
attempt to modernize and upgrade the benefit package. The
President's proposal to grant additional securities both to
Medicare and in the interest transfer to Social Security creates
the risk of reducing transparency about the underlying financial
condition of these trust funds. In fact, the transfers would
interfere with the vital signaling function that 4 According to a
White House press release dated June 28, 1999.

trust fund mechanisms can provide for policy makers about
underlying fiscal imbalances in covered programs. The greatest
risk is that these transfers could induce an unwarranted
complacency about the financial health of these programs. From a
macro perspective, the critical question is not how much a trust
fund has in assets or solvency but whether the government as a
whole has the economic capacity to finance the trust fund's claims
to pay benefits now and in the future namely, sustainability.

Concluding After some years of restraint and difficult policy
choices, the goal of budget Observations balance has been
achieved. Now the Congress and the President face a series of
decisions that will have a major impact on the economic future of
the nation.

I believe the first issue is how much of the current and projected
surpluses should be used for debt reduction. We come to these
surpluses with a high level of debt built up from years of
deficits. Devoting a significant portion of the surplus to
reducing that debt would yield benefits in terms of lower interest
costs and greater future economic capacity. Few would expect the
entire projected surplus to go to debt reduction. Therefore,
decisions must be made about how to use some portion of the
surplus to respond to those demands that have had to be held in
abeyance during the effort to reach budget balance: How should
these funds be allocated for spending or tax cuts? The critical
decision is how to strike a

balance between today's needs and addressing tomorrow's
challenges. Finally, the surplus presents both opportunity and
obligation. The new surplus projections offer an opportunity to
address today's needs, but we should not forget our obligation to
build for the future. Every generation is in part responsible for
the world it passes on to the next. That responsibility may be
especially great for us given the burden the aging of our society
and declining worker- to- retiree ratios will place on society and
the economy. We have a stewardship responsibility to reduce the
debt burden we leave, to provide a strong foundation for future
economic growth, and to ensure that our future commitments are
both adequate and affordable. Common sense tells us that it is
better to make the tough choices today while we have a healthy
economy, sufficient resources to meet some current needs while
still building for the future, and a relatively

large cohort of workers. National saving pays future dividends but
we need to begin soon to permit compounding to work for us. In
addition, we have an obligation to get on with meaningful reform
of the Social Security

and Medicare programs in order to make them both affordable and
sustainable for the future. Finally, we should avoid attempts to
create new unfunded promises before we have made significant
progress on addressing current funding gaps. Contact and For
information about this product, please contact Susan Irving at
(202) Acknowledgements

512- 9142 or by e- mail at irvings. aimd@ gao. gov or Paul L.
Posner at (202) 512- 9573 or by e- mail at posnerp. aimd@ gao.
gov. This statement was originally prepared in anticipation of a
hearing before the Senate Budget Committee, July 21, 1999.

GAO United States General Accounting Office

GAO/OCG-99-29

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