Budget Issues: Deficit Reduction and the Long Term (Testimony, 03/13/96,
GAO/T-AIMD-96-66).

GAO discussed its work on the budget deficit and long-term economic
growth. GAO noted that: (1) its long-term simulations show that unless
the budget deficit is reduced or eliminated, economic growth, personal
incomes, national investment, and the standard of living will be sharply
reduced; (2) the nation's present fiscal policy is unsustainable in the
long term; (3) reaching and sustaining a balanced budget would reduce
federal spending on interest, a fast-growing segment of federal
spending; (4) reductions in spending on fast-growing health, social
security, and interest costs would be most beneficial and would have the
most sustained effects; and (5) foreign governments' deficit reduction
efforts have been painful but have provided significant fiscal benefits.

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

 REPORTNUM:  T-AIMD-96-66
     TITLE:  Budget Issues: Deficit Reduction and the Long Term
      DATE:  03/13/96
   SUBJECT:  Balanced budgets
             Budget deficit
             Deficit reduction
             Fiscal policies
             Budget cuts
             Economic growth
             Macroeconomic analysis
             Econometric modeling
             Foreign governments
             Gross National Product

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


Before the Committee on the Budget, House of Representatives

For Release on Delivery
Expected at
10 a.m.
Wednesday,
March 13, 1996

BUDGET ISSUES - DEFICIT REDUCTION
AND THE LONG TERM

Statement of Paul L.  Posner
Director, Budget Issues
Accounting and Information Management Division

GAO/T-AIMD-96-66

GAO/AIMD-96-66t


(935200)


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


============================================================ Chapter 0

Mr.  Chairman and Members of the Committee: 

I appreciate the opportunity to appear before you today to discuss
GAO's work on the deficit and the long-term economic health of our
nation. 

In 1992, we examined the role of fiscal policy in promoting or
inhibiting long-term economic growth and concluded that deficit
reduction was key to our nation's future economic health.\1 We noted
then that long-term economic growth and the requisite investment are
central to almost all our major concerns as a society.  The surest
way to increase the resources available for investment is to increase
national savings, and the surest way to increase national savings is
to reduce the federal deficit.  We also noted that how the deficit is
reduced matters.  Last year, we updated this work for you and
Chairman Domenici.\2

By now, the relationship of the deficit to the nation's long-term
interest has been more broadly recognized.  Both the Congress and the
President have proposed plans to reverse previous fiscal trends and
balance the budget.  It seems reasonable to conclude that the debate
is no longer over whether to balance the budget, but rather over when
and how. 

In my testimony today, I will first describe GAO simulations of the
economic impact of different fiscal policies over the long term and
then address several issues related to the impact of deficit
reduction specifically: 

  the important and compelling benefits to be gained from
     successfully shifting to a new fiscal policy;

  the importance of how we reduce the deficit--by which I mean both
     the composition of federal spending and the need to deal with
     the drivers of the deficit; and

  the experience of other industrial nations. 


--------------------
\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). 


   LONG-TERM SIMULATIONS
---------------------------------------------------------- Chapter 0:1

Long-term simulations can be useful for comparing potential outcomes
of alternative policies within a common economic framework.  Given
the broad range of uncertainty about future economic changes,
however, any simulations should not be interpreted as forecasts of
the level of economic activity 30 years in the future.  Instead,
simulation results provide illustrations of the budget or economic
outcomes associated with alternative policy paths. 

In our most recent work, we used a long-term economic growth model to
simulate three of the many possible fiscal paths through the year
2025: 

  a "no action" path that assumed the continuation of fiscal policies
     in effect at the end of fiscal year 1994;

  a "muddling through" path that assumed annual deficits of
     approximately 3 percent of gross domestic product (GDP); and

  a path that reaches balance in 2002 and sustains it.\3

To suggest some of the trade-offs facing policymakers in choosing
among fiscal policies, we examined some long-term economic and fiscal
outcomes of these paths.  We also simulated how some types of early
action on the deficit, including early action on health care
spending, might affect the long-term deficit outlook.  Finally, we
examined the prospects for sustaining balance over the long term. 
While we discuss the consequences of alternative fiscal paths, we do
not suggest any particular course of action, since only the Congress
can resolve the fundamental policy question of choosing the fiscal
policy path and the composition of federal activity. 

In our simulations we employed a model originally developed by
economists at the Federal Reserve Bank of New York (FRBNY) that
relates long-term GDP growth to economic and budget factors.  Details
of that model and its assumptions can be found in our reports. 


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


   THE COMPELLING CASE FOR DEFICIT
   REDUCTION
---------------------------------------------------------- Chapter 0:2

As we noted in 1992 and 1995, important and compelling benefits can
be gained from shifting to a new fiscal policy path.  As illustrated
in figure 1, chronic deficits have consumed an increasing share of a
declining national savings pool, leaving that much less for private
investment. 

Lower investment will ultimately show up in lower economic growth. 
Future generations of taxpayers will pay a steep price for this lower
economic growth in terms of lower personal incomes and a generally
lower standard of living at a time when they will face the burden of
supporting an unprecedented number of retirees as the baby boom
generation reaches retirement. 

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

   (See figure in printed
   edition.)

The problem has been that the damage done by deficits is long-term,
gradual, and cumulative in nature and may not be as visible as the
short-term costs involved in reducing deficits.  This has presented,
and continues to present, a difficult challenge for public leaders
who must mount a compelling case for deficit reduction--and for the
steps required to achieve it--that can capture public support.  The
updated simulations we presented to you and Chairman Domenici last
spring confirmed that the nation's current fiscal policy path is
unsustainable over the longer term.  Specifically, a fiscal policy of
"no action" on the deficit through 2025 implies federal spending of
nearly 44 percent of GDP, and as figure 2 shows, a deficit over 23
percent of GDP. 

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

   (See figure in printed
   edition.)

Let me explain these ominous trends.  The increased spending is
principally a function of escalating federal spending on health care
and Social Security, which is driven by projected rising health care
costs and the aging of our population.\4 Spending on interest on our
national debt also rises as annual deficits and accumulated public
debt expand.  Essentially, current commitments in these areas become
progressively unaffordable for the nation over time.  Without any
significant changes in spending or revenues, such an expanding
deficit would result in collapsing investment, declining capital
stock, and, inevitably, a declining economy by 2025. 

As emphasized in both our 1992 and 1995 reports, we do not believe
that such a scenario would take place.  Rather, we believe that the
prospect of economic decline would prompt action before the end of
our simulation period.  Nevertheless, this "no action" scenario, by
illustrating the future logic of existing commitments, powerfully
makes the case that we have no choice but to take action on the
deficit.  The questions that remain are when and how. 

Our 1995 simulations also confirm the long-term economic and fiscal
benefits of deficit reduction.  We assessed the long-term impacts of
balancing the budget by 2002, as was contemplated in the fiscal year
1996 budget resolution and in the recent executive-congressional
discussions over budget policy, and of sustaining such a posture
through 2025.  We also estimated the effects of following a path that
we called "muddling through"--that is, running deficit of about 3
percent of GDP over the next 30 years.  Although current policy is
better than this in the near term, it is still a useful illustration. 

A fiscal policy of balance would yield a stronger economy in the long
term than either a policy of no action or of muddling through.  Table
1 shows that a budget balance reached in 2002 and sustained until
2025 would, over time, lead to increased investment, increased
capital stock, a larger economy, and a much lower national debt than
either of the other scenarios.  This means that Americans could enjoy
a higher standard of living than they might otherwise experience. 



                                         Table 1
                         
                         The Economic and Fiscal Position in 1994
                                       and in 2025

                          (All dollar values in per capita 1995
                                         dollars)

                                                                                  Percent
                                                                  Percent      difference
                                                               difference         between
                                  2025      2025                  between     balance and
                                    No  Muddling      2025    balance and        muddling
                        1994    action   through   Balance      no action         through
------------------  --------  --------  --------  --------  -------------  --------------
Real GDP             $26,300   $27,900   $35,100   $37,400             34               7
Debt                 $13,500   $60,200   $21,400    $4,800            -92             -78
Debt as a percent         52       213        60        13            -94             -78
 of GDP
Nonfarm business      $3,100        $0    $4,200    $5,100             NA              21
 investment
Nonfarm capital      $23,700   $11,600   $30,100   $36,600            216              22
 stock
-----------------------------------------------------------------------------------------
Reaching and sustaining balance would also shrink the share of
federal spending required to pay interest costs, thereby reducing the
long-term programmatic sacrifice necessary to attain deficit
reduction targets.  Even "muddling through" with deficits of 3
percent of GDP would exact a price through higher interest costs and
thus require progressively harder fiscal choices as time progresses. 
Under the balance path, debt per capita would decline from $13,500 in
1994 to $4,800 in 1995 dollars by 2025; debt as a percentage of the
economy would drop from about 52 percent to 13 percent.  Because of
this shrinkage in the debt, by 2025 a balance path could bring
interest costs down from about 12 percent in 1994 to less than 5
percent of our budget, compared to about 18 percent under "muddling
through" and almost a third of our budget with no action.  These
differences are illustrated in figure 3. 

Alarming as these model results may appear, they are probably
understated.  Our model incorporates conservative assumptions about
the relationship between savings, investment and GDP growth that tend
to understate the differences between the economic outcomes
associated with alternative fiscal politicize.  Furthermore, budget
projections for the near term and those assumed in our long-term
model results may not tell the whole story.  By convention, baseline
budget projections do not include all the legitimate claims that may
be made on the budget in the future.  Rather, budget projections
ignore many future claims and the costs of unmet needs unless they
are the subject of policy proposals in the budget.  Examples of such
claims and needs would include the cost of cleaning up and
restructuring the Department of Energy's (DOE) nuclear weapons
production complex, the cost of hazardous waste pollution clean-up at
military facilities, and cost overruns in weapons systems.  In short,
most of the risks to future budgets seem to be on the side of
worse-than-expected, rather than better-than-expected outcomes.  I
make this observation not to create despair but to underline the need
to continue efforts at deficit reduction. 

   Figure 3:  Net Interest as a
   Share of Total Expenditures in
   2025 Under GAO's Three Fiscal
   Policy Simulations

   (See figure in printed
   edition.)


--------------------
\4 Budget assumptions rely upon the CBO January 1995 estimates
through 2004 to the extent practicable.  Beyond that, Social Security
estimates were based on the April 1995 intermediate projections from
the Social Security Trustees.  Medicare projections were based on the
Health Care Financing Administration (HCFA) long-term intermediate
forecast from the Medicare Trustees' April 1995 report.  For
Medicaid, in the absence of HCFA projections, we used projections
developed in 1994 by the Bipartisan Commission on Entitlement and Tax
Reform. 


   THE TYPE OF SPENDING REDUCTION
   MATTERS
---------------------------------------------------------- Chapter 0:3

Not all spending cuts have the same impact over the long run. 
Decisions about how to reduce the deficit will reflect--among other
considerations--judgments about the role of the federal government
and the effectiveness of individual programs.  I would like to call
attention today to two significant considerations in deficit
reduction:  (1) the importance of federal investment in
infrastructure, human capital, and research and development (R&D),
and (2) the importance of addressing the fast-growing programs in the
budget. 


      COMPOSITION OF FEDERAL
      SPENDING:  INVESTMENT
-------------------------------------------------------- Chapter 0:3.1

In our 1992 work, we drew particular attention to the importance of
well-chosen federal investment in infrastructure, human capital, and
R&D.  A higher level of national savings is essential to the
achievement of a higher rate of economic growth but, by itself, is
not sufficient to assure that result.  Certain other ingredients are
necessary--including the basic stability with which this nation has
been blessed in its social, political, and economic environment.  In
addition, however, economic growth depends on an efficient public
infrastructure, an educated work force, an expanding base of
knowledge, and a continuing infusion of innovations. 

In the past, the federal government, through its investments in these
areas, has played an important role in providing an environment
conducive to growth.  Thus the composition of federal spending, as
well as overall fiscal policy, can affect long-term economic growth
in significant ways.\5


--------------------
\5 See also Federal Budget:  Choosing Public Investment Programs
(GAO/AIMD-93-25, July 23, 1993) and Budget Issues:  Incorporating an
Investment Component in the Federal Budget (GAO/AIMD-94-40, November
9, 1993). 


      DEALING WITH THE DEFICIT
      DRIVERS
-------------------------------------------------------- Chapter 0:3.2

The extent to which deficit reduction affects spending on
fast-growing programs also matters.  Although a dollar is a dollar in
the first year it is cut--regardless of what programmatic changes it
represents--cutbacks in the base of fast-growing programs generate
greater savings in the future than those in slower-growing programs,
assuming the specific cuts are not offset by increases in the growth
rates of the programs.\6

Figure 4 illustrates this point by comparing the long-run effects of
a $50 billion cut in health spending with those of the same dollar
amount cut from unspecified other programs.  For both paths the cut
occurs in 1996 and is assumed to be permanent but, after 1996,
spending is assumed to continue at the same rates of growth as those
shown in the "no action" simulation.  We used the simple assumption
that a reduction in either health or other programs would not alter
the expected growth rates simply to illustrate the point that a cut
in high-growth areas of spending will have a greater fiscal effect in
the future than the same size cut in low-growth areas.  A $50 billion
cut in health spending in 1996 leads to a deficit in 2025 that is
about 4 percent of GDP lower than would be the case from a $50
billion cut in a low-growth program. 

   Figure 4:  Comparison of
   Deficit Path With an Early Cut
   in Health to Deficit Path With
   an Equal Cut in Other Spending

   (See figure in printed
   edition.)

Further, our simulations show that even if a balanced budget is
achieved early in the next century, deficits would reappear if we
fail to contain future growth in health, interest, and social
security costs. 


--------------------
\6 We did not simulate the effect of reducing growth rates.  If
cutting the base also had the effect of slowing the rate of growth,
the action would have an even greater impact on the long-term
deficit.  Of course, if cutting the base raised the growth rate, the
actions could raise the deficit in the long term. 


   THE EXPERIENCE OF OTHER
   INDUSTRIAL DEMOCRACIES
---------------------------------------------------------- Chapter 0:4

We conclude from these simulations that how and when deficit
reduction occurs can have important long-term implications for the
future economy and future budgets.  As noted earlier, the benefits of
deficit reduction in the long run may not seem as compelling as the
short-term costs necessary to reduce the deficit.  Nevertheless our
work on the deficit reduction experiences in other nations\7 shows
that significant fiscal improvement is indeed possible in modern
democracies, at least for a time. 

To reach fiscal balance or surplus, the governments we studied
instituted often painful measures while generating and maintaining
political support.  Spending control proved the dominant policy tool
used to achieve fiscal goals, although few programs were actually
eliminated.  Notably, however, several countries restrained social
benefit commitments in their quest for savings.  Government leaders
sought to gain support or at least defuse potential opposition by
bringing key interest groups that would be affected into the
decision-making process. 

In addition, the design of the specific deficit-reducing strategies
helped.  Approaches such as reducing benefits instead of eliminating
programs, targeting benefit cuts to higher-income beneficiaries, and
deferring or shifting painful adjustments all helped maintain
political support for spending reductions. 

The deficit reduction brought about in these governments provided
significant fiscal benefits by slowing or reversing the growth of
public debt, thereby slowing or reversing the growth of government
interest costs.  As we simulated in our long-term growth model, what
was once a "vicious" circle of rising deficits, debt, and interest,
which can in turn increase deficits, became a "virtuous" circle of
falling deficits or rising surpluses, accrued even though most
governments we studied did not sustain fiscal balance or surplus,
possibly in part because public support for austerity was frequently
linked to relatively short-run concerns.  Despite this return to
deficit, the increases in savings and investment resulting from
deficit reduction may have boosted economic prospects for the
long-term future, as well as provided fiscal benefits in the short
run. 


--------------------
\7 Countries studied were Australia, Canada, Germany, Japan, Mexico,
and the United Kingdom.  See Deficit Reduction:  Experiences of Other
Nations (GAO/AIMD-95-30, December 13, 1994). 


   CONCLUSION
---------------------------------------------------------- Chapter 0:5

Although the experiences of the nations in GAO's study suggest that
resolving deficits is possible in advanced democracies, they also
indicate that sustaining fiscal discipline over the longer term is
difficult.  Thus, deficit reduction strategies designed to promote
long-term fiscal progress may help ensure that future budgets are
better positioned to withstand future economic and political
pressures. 

For the United States, reaching budgetary balance in 2002 would
indeed represent an achievement that by itself would bring about
fiscal and economic benefits.  Yet this achievement will not
eliminate the need for future fiscal discipline.  In fact, the needs
of an aging society will be more easily met if fiscal balance--or
even surplus--is both achieved and sustained for several years. 

In conclusion, Mr.  Chairman, I would repeat our view that current
policy is unsustainable.  The question, therefore, is not whether to
reduce the deficit but when and how.  We believe those choices
matter. 


-------------------------------------------------------- Chapter 0:5.1

Mr.  Chairman, this concludes my written statement.  I would be happy
to answer any questions you or your colleagues might have. 


*** End of document. ***