Budget Issues: Long-Term Fiscal Outlook (Testimony, 02/25/98,
GAO/T-AIMD/OCE-98-83).

GAO discussed its work on long-term budget issues, focusing on the: (1)
results of GAO's simulations updated to incorporate the Congressional
Budget Office's (CBO) new budget projections; and (2) programmatic
composition and design of federal spending--for which policymakers need
to consider the long-term fiscal and spending implications of the
government's commitments.

GAO noted that: (1) long-term simulations are useful for comparing
outcomes of alternative fiscal policies within a common economic
framework; (2) while long-term simulations provide a useful perspective
that is often lacking in budget debates, they should be interpreted
carefully; (3) since GAO's October 1997 report was issued, CBO's 10-year
budget projections have shown continued improvement in the short term;
(4) CBO now projects that the budget is already virtually in balance and
that, in a few years, there could be a period of budget surpluses on a
unified budget basis; (5) the dramatic drop in the deficit and the
expected budget surpluses for the near future have changed the fiscal
policy climate; (6) while GAO's no action path remains an unsustainable
policy over the long term, it does include a period of budget surpluses
over the next 15 years, consistent with CBO's current baseline; (7) GAO
presents two alternatives to the no action simulation; (8) under the no
surplus scenario, the deficit would reach 10 percent of the gross
domestic product (GDP) 8 years earlier than the no action plan; (9) the
maintain balance simulation is an example of a sustainable fiscal path
under which government activities can be maintained without a continual
rise in the debt as a share of GDP; (10) to some degree, the long-term
fiscal policy of the nation is determined by the spending or revenue
paths inherent in the design of federal programs; (11) without adequate
information about the long-term cost implications of specific program
designs, fiscal policy may not follow the expected path; (12) just as
the current long-term projections are driven by a combination of
demographics and the design of Social Security and federal health care
programs, so future projections may also be affected by the long-term
costs of other programs; (13) the broad range of long-term federal
commitments complicates the challenge of integrating more complete
information on their expected future cost into the budget process; and
(14) the diverse nature of these commitments, combined with the varying
quality and amount of information available outside the budget process,
suggests that across-the-board changes in budget reporting or process
may not be the most effective way to proceed.

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

 REPORTNUM:  T-AIMD/OCE-98-83
     TITLE:  Budget Issues: Long-Term Fiscal Outlook
      DATE:  02/25/98
   SUBJECT:  Gross National Product
             Budget deficit
             Future budget projections
             Budget surplus
             Fiscal policies
             Deficit reduction
             Economic analysis
             Balanced budgets
             Economic growth
             Econometric modeling
IDENTIFIER:  Medicare Program
             Social Security Program
             Medicaid Program
             
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Cover
================================================================ COVER


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

For Release on Delivery
Expected at
10 a.m.
Wednesday,
February 25, 1998

BUDGET ISSUES - LONG-TERM FISCAL
OUTLOOK

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

GAO/T-AIMD/OCE-98-83

GAO/AIMD/OCE-98-83t


(935257)


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

  CBO - Congressional Budget Office
  DOD - Department of Defense
  DOE - Department of Energy
  FRBNY - Federal Reserve Bank of New York
  GDP - gross domestic product
  HCFA - Health Care Financing Administration
  NIPA - National Income and Product Accounts
  OASDI - Old Age Survivors and Disability Insurance

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

Mr.  Chairman and Members of the Committee: 

I appreciate the opportunity to appear before you to discuss GAO's
work on long-term budget issues. 

A long-term perspective is important for broader fiscal policy as
well as for budget decisions on individual programs.  Today's
decisions affect tomorrow's reality.  In our previous work, we have
noted that the nation's economic future depends in large part upon
today's budget and decisions--both public and private--about
investments.\1 At the macro level, the budget needs to provide a
long-term framework grounded on a linkage of fiscal policy with the
long-term economic outlook.  This requires a focus on both overall
fiscal policy and the composition of federal activity.  Beginning in
1992, congressional leaders have requested that we provide this
perspective by modeling the long-term implications of differing
fiscal policy paths for the nation's economy.  We have periodically
updated our model to account for changes in the fiscal and economic
environment, and this testimony reflects the fourth iteration of our
simulation efforts. 

Since each generation is in part custodian for the economy it hands
the next, the President, the Congress, and the public need to think
about the longer term when making fiscal policy choices.  A
longer-term horizon is also important because (1) some changes are
best phased in over long periods of time, and (2) to make informed
decisions, policymakers need information on the long-term cost
consequences of today's commitments.  This is especially true of
those programs and activities where a longer time horizon is
necessary to understand the fiscal and spending implications of the
government's commitment.  Examples include Social Security, Medicare,
retirement programs, pension guarantees, and environmental cleanup. 

In my testimony today, I will first discuss the results of GAO's
simulations updated to incorporate the Congressional Budget Office's
(CBO) new budget projections.  Then I will turn to another important
aspect of budget policy--the programmatic composition and design of
federal spending--for which policymakers need to consider the
long-term fiscal and spending implications of the government's
commitments. 


--------------------
\1 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:  Analysis of Long-Term Fiscal Outlook
(GAO/AIMD/OCE-98-19, October 22, 1997), and Budget Issues:  Deficit
Reduction and the Long Term (GAO/T-AIMD-96-66, March 13, 1996). 


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

Long-term simulations are useful for comparing the potential outcomes
of alternative fiscal policies within a common economic framework. 
Such simulations can help the Congress assess the long-term costs and
benefits of fiscal policy decisions that are made today.  Adopting a
long-term perspective is particularly important because the long-term
consequences of today's actions are not as visible as their
short-term effects, a point made vividly by the economist Charles
Schultze when he compared budget deficits to "termites in the
basement." Long-term modeling can help illuminate these consequences
for policymakers faced with difficult budget choices. 

While long-term simulations provide a useful perspective that is
often lacking in budget debates, they should be interpreted
carefully.  Given the range of uncertainty about future economic
changes and the responses to those changes,\2 these simulations
should not be viewed as forecasts of budgetary or economic outcomes
50 years in the future.  Rather, they should be seen only as
illustrations of the budget or economic outcomes associated with
alternative policy paths based on current information about
demographic and budgetary trends and the functioning of the economy. 
While any long-term analysis is inherently uncertain, one thing is
certain:  the population is growing older.  And this factor is a
principal driver of our simulation results, as will be discussed
below. 

In our simulations, we employ a model originally developed by
economists at the Federal Reserve Bank of New York that relates
long-term gross domestic product (GDP) growth to economic and budget
factors.  The key interaction between the budget and the economy is
the effect of the federal deficit/surplus on the amount of national
saving available for investment.  In general, government budget
deficits represent dissaving--they subtract from national saving by
absorbing funds that otherwise could be used for investment. 
Conversely, government surpluses add to saving. 

For our budget assumptions, we incorporate CBO's most recent 10-year
budget projections.\3 After 10 years, we rely on the long-term
actuarial assumptions for the Social Security and Medicare
programs.\4 For Medicaid, we use the growth rates assumed by CBO in
its March 1997 report on long-term simulations.\5 Interest spending
is determined by interest rates--which are held constant over the
long term--and the level of federal debt held by the public, which
depends on the path of deficits/surpluses within each simulation. 
All other spending, along with federal revenue, is assumed to grow at
essentially the same rate as the economy.\6

Attachment I provides more details on the model and our assumptions,
but one point bears further discussion.  Recognizing the inherent
uncertainties of long-term simulations, we have deliberately chosen
conservative assumptions to estimate the economic consequences of
federal fiscal policy.  For example, we have held the interest rate
and productivity growth constant over the long term, even for budget
scenarios for which escalating deficits and declining national
savings would imply a substantial worsening of these indicators. 
Similarly, the economic benefits derived from long-term budget
balance scenarios would also tend to be understated due to our
constant interest rate and productivity growth assumptions. 


--------------------
\2 The impact of federal spending reduction on aggregate national
saving and investment depends on how consumers respond to such
reductions.  For example, a reduction in federal Medicaid spending
may result in greater private spending on nursing home care thereby
diminishing the effect on total national saving. 

\3 Congressional Budget Office, The Economic and Budget Outlook: 
Fiscal Years 1999-2008, January 1998. 

\4 The 1997 Annual Report of the Board of Trustees of the Federal
Old-Age and Survivors Insurance and Disability Trust Funds, The 1997
Annual Report of the Board of Trustees of the Federal Hospital
Insurance Trust Fund, and The 1997 Annual Report of the Board of
Trustees of the Federal Supplementary Medical Insurance Trust Fund. 

\5 Congressional Budget Office, Long-Term Budgetary Pressures and
Policy Options, March 1997. 

\6 This means that both revenues and other spending remain constant
as a share of GDP. 


   OUTLOOK CONTINUES TO IMPROVE,
   BUT CURRENT POLICIES REMAIN
   UNSUSTAINABLE OVER THE LONG
   TERM
---------------------------------------------------------- Chapter 0:2

In our October 1997 report to you and Chairman Kasich, we said that
the long-term outlook has improved greatly from when we did our first
report in 1992 and our update in 1995.  Since our October report was
issued, CBO's 10-year budget projections have shown continued
improvement in the short term.  CBO now projects that the budget is
already virtually in balance and that, in a few years, we could
experience a period of budget surpluses on a unified budget basis. 
At your request for this testimony, we updated our simulations to
reflect CBO's new baseline.\7

Our no action simulation assumes no changes in current policies. 
Since current policies include caps on discretionary spending, our no
action path assumes compliance with these caps--a real cut in
discretionary spending of 10 percent by 2002 assuming CBO's inflation
projections.  The budget surpluses that occur in the early years of
the no action path are assumed to reduce debt held by the public as
in CBO's baseline. 

The major improvement in the fiscal outlook discussed in our October
1997 report was due to both policy actions and the performance of the
economy.  Since then, the fiscal outlook has continued to improve due
to the strong economy and the slower growth in health care costs that
underlie the changes in CBO's baseline projections.  Despite this
improvement, our model shows that a fiscal policy of no action is
still unsustainable over the long term due to the spending pressures
caused by the retirement of the baby boom generation and growth in
health care costs. 

Our February 1998 no action simulation is a "good news but" picture. 
Figure II.1 in attachment II illustrates both the good and bad news
in our current no action simulation.  It shows how our no action
deficit path has changed since our initial report in 1992.  Both our
1992 and 1995 no action simulations indicated that deficits would
have reached 10 percent of GDP by 2016 at the latest.  In contrast,
our current no action simulation indicates that the federal budget
would be in surplus in the early years of the 21st century and
deficits would not reach the 10 percent level until about 2040. 
Despite this good news, under the current no action simulation,
deficits would reemerge in 2015, less than a decade after the baby
boom generation begins to retire.  These deficits would then escalate
quickly, reaching unsustainable levels as shown in figure II.1.  The
ratio of debt held by the public to GDP tells a similar
story--near-term improvement followed by rapid deterioration to
nearly 100 percent of GDP by 2040.  Such deficits and debt imply a
substantial reduction in national saving, private investment, and the
capital stock.  Assuming no policy change, GDP would inevitably begin
to decline under this scenario. 

The no action simulation is neither plausible nor sustainable.  The
negative effects of rapidly increasing deficits and debt on the
economy would force action at some point before the end of the
simulation period.  Policymakers would likely act before facing the
probable consequences, such as rising inflation, higher interest
rates, and the unwillingness of foreign investors to invest in a
weakening American economy.  Therefore, as we have noted in our past
work, the no action simulation is not a prediction of what will
happen in the future.  Rather, it underscores the need for additional
action to address the nation's long-term fiscal challenges. 

The primary causes of the large deficits in the no action simulation
are (1) the aging of the U.S.  population, which corresponds to
slower growth in the labor force and federal revenues and faster
growth in entitlement spending, and (2) the rising costs of providing
federal health care benefits.  Ten years from now, the first baby
boomers will be eligible for early retirement benefits.  As this
relatively large generation retires, labor force growth is expected
to slow considerably and, eventually, stop altogether. 

These demographic changes mean fewer workers to support each retiree. 
Between 1997 and 2030, the number of workers per Social Security
beneficiary is projected to drop from 3.3 to 2.0, a decline of nearly
40 percent.  Without a major increase in productivity, low labor
force growth will inevitably lead to slower growth in the economy and
in federal revenue.  This slower revenue growth will come at the same
time that a large retired population will place major expenditure
demands on Social Security, Medicare, and Medicaid.  In view of this
combination of slower revenue growth and increased expenditure
demands, the Social Security Trustees project that in less than 15
years the program's annual tax revenue would be insufficient to cover
annual benefits and, in 2029, the program's balance would be
exhausted. 

As Social Security and health spending rise, their share of GDP and
of federal spending grows dramatically in our no action simulation. 
(See figure II.2 in attachment II.) These spending pressures cause
large deficits to reemerge, adding substantially to the debt held by
the public.  Rising debt, in turn, increases spending on interest,
which compounds the deficit problem, resulting in a vicious circle. 
By about 2040, spending for Social Security, health programs, and
interest alone would consume more than 100 percent of federal
revenues. 

We are not the only agency to call attention to these unsustainable
long-term trends.  CBO also conducts long-term simulations that
produce similar results.\8


--------------------
\7 CBO's September budget projections, and thus our October 1997
simulations using CBO data, reflected the net effect of the Balanced
Budget Act of 1997 as well as the Taxpayer Relief Act of 1997.  CBO's
new projections, incorporated into our update, reflect subsequent
legislation, but CBO estimated that legislative actions taken since
September did not materially change the long-term outlook. 

\8 Statement of June E.  O'Neill on "The Economic and Budget Outlook: 
Fiscal Years 1999-2008" before the U.S.  Senate Committee on the
Budget, January 28, 1998.  Also see Congressional Budget Office,
Long-Term Budgetary Pressures and Policy Options, March 1997. 


   EFFECTS OF ALTERNATIVE FISCAL
   PATHS ON THE FISCAL AND
   ECONOMIC OUTLOOK
---------------------------------------------------------- Chapter 0:3

As in our prior reports, we have simulated alternatives to the no
action fiscal policy scenario, using the same underlying economic
assumptions.  However, unlike our prior reports, one of the
simulations discussed here would actually worsen the long-term fiscal
outlook.  In our past work, the no action simulation always
represented the least desirable fiscal path.  We chose this approach
because, in an era of large budget deficits, the fiscal policy debate
usually centered on how to reduce these deficits.  Policy
alternatives that would have increased deficits received less
attention, particularly after enactment of the Budget Enforcement Act
of 1990, which set up procedural hurdles to deter such policies. 

Currently, however, the dramatic drop in the deficit and the expected
budget surpluses for the near future have changed the fiscal policy
climate.  While our no action path remains an unsustainable policy
over the long term, it does include a period of budget surpluses over
the next 15 years, consistent with CBO's current baseline.  Some
recent policy proposals have suggested using at least part of these
prospective surpluses to increase spending or cut taxes rather than
to reduce the debt held by the public. 

Thus, as agreed with your office, we present two alternatives to the
no action simulation in this testimony.  The first alternative--no
surplus--assumes that short-term surpluses are not achieved due to
policy actions that permanently increase spending and/or reduce
revenues.\9 In this simulation, the budget would be in balance rather
than surplus over the next decade.  Thereafter, revenue and spending
would grow according to the assumptions of the no action simulation,
but from different baseline levels--that is, revenues would be lower
and spending would be higher than in no action.  As shown in figure
II.3 in attachment II, the deficit would reach 10 percent of GDP
under the no surplus scenario by 2033, or 8 years earlier than the no
action scenario where the surpluses are used to reduce debt held by
the public. 

The second alternative--maintain balance--assumes short-term budget
surpluses are used to reduce debt held by the public as in the no
action scenario, but then assumes policy actions are taken to prevent
deficits from recurring.  Beginning in 2015--when deficits reemerge
in the no action path--the maintain balance simulation assumes that
the budget is kept in balance through the end of the simulation
period, as shown in figure II.3 in attachment II.  Unlike no action
and no surplus, the maintain balance simulation is one example of a
sustainable fiscal path under which government activities can be
maintained without a continual rise in the debt as a share of GDP.\10

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

For both the federal government and the economy, the no surplus path
leads to the worst outcomes over the long term.  As shown in figures
II.4 and II.5 in attachment II, eliminating surpluses in the short
term increases interest costs over time and ultimately leads to lower
living standards when compared to either the no action or maintain
balance paths.  Over the longer term, maintaining budget balance
yields a vast improvement over either the no action or no surplus
paths.  However, running a surplus in the short term under the no
action scenario helps reduce the fiscal actions needed to maintain
budget balance over the longer term, compared to the no surplus
path.\11

Sharply reduced interest costs provide the most striking budgetary
benefit from following a sustainable policy.  Currently, interest
spending represents about 15 percent of federal spending, a
relatively large share that is a consequence of the deficits of the
1980s and early 1990s.  After shrinking in the early years of the no
action simulation, interest costs increase sharply over the long
term, reaching nearly 25 percent of spending in 2050.  Interest costs
become even more burdensome in our no surplus scenario, topping
one-third of all spending in 2050.  In contrast, maintaining a
balanced budget after the projected surpluses would reduce interest
costs well below where they are now--to a level less than 1 percent
of all federal spending.  Any path that reduces debt held by the
public and associated interest costs would help promote increased
flexibility for future budget policymakers. 

The economic benefits of a sustainable budget policy include
increased saving and investment levels and faster economic growth,
which results in higher living standards.  For example, under the
maintain balance simulation, per capita GDP would nearly double
between 1997 and 2050.  In contrast, under either the no surplus or
no action simulations, growth in living standards slows considerably
and living standards themselves would begin to decline in the 2040s,
as shown by figure II.5 in attachment II.  The differences
graphically show the emerging gaps in long-term living standards that
result from different fiscal policy paths.  Although the maintain
balance path would lead to higher living standards, the rate of
growth would be significantly lower than that experienced over the
past 50 years.  Achieving and sustaining the historic growth rate
would be extremely difficult given the slowdown in productivity
growth that has occurred in recent decades. 

As shown in table 1, by 2050, living standards would be over 50
percent lower under no surplus and 25 percent lower under no action
than under the maintain balance simulation.  This difference results
from a wide gap in private investment.  Under either of the
unsustainable simulations, large deficits eventually drive per capita
private investment spending down sharply while a balanced budget
policy could produce a near doubling of investment per capita.  As we
have said in our earlier work, the surest way to increase the
resources available for investment is to increase national saving,
and the most direct way for the federal government to increase
national saving is to achieve and sustain a balanced budget.  Running
budget surpluses would further increase saving and allow the
government to reduce the level of federal debt held by the public. 



                                     Table 1
                     
                     The Economic and Fiscal Position in 1997
                        (Preliminary) and 2050 (Simulated)

                           (In per capita 1997 dollars)

                                                          Percent difference in
                                                          2050 between Maintain
                                                               Balance and
                                                          ----------------------
                                                    2050
                                                  Mainta
                                 2050                 in
                                   No       2050  Balanc
                      1997    Surplus  No Action       e  No Surplus   No Action
------------------  ------  ---------  ---------  ------  ----------  ----------
Real GDP            $29,60    $36,600    $45,200  $56,50         54%         25%
                         0                             0
Debt                $13,90   $129,700    $86,800  $2,000      -98%\a      -98%\a
                         0
Nonfarm business    $3,500          0     $1,500  $6,700         N/A        347%
 investment
Nonfarm capital     $29,90    $10,100    $26,600  $60,00        494%        126%
 stock                   0                             0
--------------------------------------------------------------------------------
\a These two numbers are not identical, but they round to the same
full percent. 

Legend

N/A=Not applicable


--------------------
\9 Assuming that spending increases or revenue reductions were
temporary, rather than permanent, would produce different results. 
Such a path would diverge less from the no action baseline than the
one used in our analysis. 

\10 Our past reports and CBO's work have both illustrated a number of
different policy paths that could be sustained over the long term. 
For a detailed analysis of sustainability, see Olivier Blanchard,
Jean-Claude Chouraqui, Robert P.  Hagemann, and Nicola Sartor, "The
Sustainability of Fiscal Policy:  New Answers to an Old Question,"
OECD Economic Studies, no.  15 (Autumn 1990).  See also The Canadian
Institute of Chartered Accountants, Indicators of Government
Financial Condition, April 1997. 

\11 In fact, our maintain balance path is premised on preserving
short-term surpluses, i.e., using them to reduce debt held by the
public, consistent with the CBO baseline. 


   LONG-TERM COMMITMENTS NOT
   ADEQUATELY REFLECTED IN BUDGET
   REPORTING
---------------------------------------------------------- Chapter 0:4

To some degree, the long-term fiscal policy of the nation is
determined by the spending or revenue paths inherent in the design of
federal programs.  Without adequate information about the long-term
cost implications of specific program (or revenue) designs, fiscal
policy may not follow the expected path.  Just as the current
long-term projections are driven by a combination of demographics and
the design of Social Security and federal health care programs, so
future projections may also be affected by the long-term costs of
other programs. 

As the central process through which the President and the Congress
select among and balance the competing demands for government
activity in achieving various goals, the budget needs to provide more
complete information on the costs of various alternatives--on a
comparable basis--and on the nature of the government's commitment. 
Although the multiyear focus of the Budget Enforcement Act of 1990
represents significant progress in considering the longer term in
budgeting, some programs require an even longer time horizon to
understand the implications of commitments being made. 

The future implications of current policy decisions reflected in our
simulations and in other financial reports are generally not captured
in the budget process.  This is because the budget is largely a
short-term, cash-based spending plan focusing on the short- to
medium-term cash implications of government obligations and fiscal
decisions.  Accordingly, it does not provide comprehensive
information on the longer term cost implications stemming from the
government's commitments.  Of course, commitments the Congress
created by statute may subsequently be changed by the Congress either
modifying, amending, or repealing the underlying laws establishing
the benefits.  Nevertheless, a longer term perspective is necessary
to understand the fiscal and spending implications of key government
programs and commitments extending over a longer time horizon.\12 As
demonstrated by our simulations, the nation's economic future depends
in part upon today's budget and fiscal policy decisions.  In
considering what fiscal adjustments to make, policymakers need to be
presented with more complete information on the costs of the
government's long-term commitments. 

The federal government's long-term commitments are wide-ranging and
varied in nature.  While the sustainability of the government's
fiscal policy is driven primarily by future spending for Social
Security and health care commitments, the federal government's
commitments and responsibilities extend far beyond these programs. 
These commitments may themselves result in large costs that can
encumber future fiscal resources and also constrain the government's
future financial flexibility to meet all its commitments as well as
any unanticipated or emerging needs.  Although a portion of some of
the government's commitments have already been recognized in the
budget through appropriations for future costs there are others that
are not recognized at all.  In table 2, we show a number of federal
liabilities and commitments whose total long-term costs have not been
fully recognized in either the budget or in our long-term
simulations.  It must be noted that for some of these commitments,
the budget has recognized a portion of the long-term costs.  For
example, for federal civilian employees hired since 1987, the full
cost of pension benefits is recognized in the budget as they are
earned over the working lives of the employees. 



                                Table 2
                
                    Examples of Long-term Government
                 Liabilities and Commitments Not Fully
                    Recognized in the Federal Budget

                         (Dollars in billions)

Examples of federal liabilities and commitments                   1996
--------------------------------------------------------  ------------
Deferred Compensation
Civilian and military pensions                                $1,321.9
Veterans' compensation and benefits                             $240.0
Civilian and military retirees' health benefits                 $344.2
Insurance
Deposit insurance                                               $0.4\a
Pension Benefit Guaranty Corporation                           $10.8\b
Other insurance                                                $16.0\c
Environmental liabilities (DOE/DOD)                             $246.5
Unadjudicated Claims                                             $71.7
Liabilities for pre-credit reform loan guarantees               $2.7\d
----------------------------------------------------------------------
\a Financial Audit:  Federal Deposit Insurance Corporation's 1996 and
1995 Financial Statements (GAO/AIMD-97-111, June 30, 1997) and
National Credit Union Administration 1996 Annual Report. 

\b Pension Benefit Guaranty Corporation 1996 Annual Report. 

\c Analytical Perspectives, Budget of the United States Government,
fiscal year 1999. 

\d Governmentwide figure not available.  Amount reported is
calculated from agency financial statements and includes only the
Departments of Education, Agriculture, and Veterans Affairs and the
Small Business Administration. 

Source:  GAO analysis of data from the fiscal year 1996 prototype
Consolidated Financial Statements of the United States Government
issued by Department of the Treasury, except as noted.  These
statements were not audited, which limits their usefulness and
reliability.  GAO is auditing these statements for fiscal year 1997. 

While this list is not comprehensive and may not be universally
agreed with, it provides some perspective on the range and magnitude
of these commitments.  Some of the federal government's liabilities
are similar to those found on the balance sheet of a typical
business, such as deferred compensation.  Other commitments--not
shown in this table--are of a different nature.  For example, the
table we constructed does not show the implied commitments for social
insurance programs such as Unemployment Insurance, Black Lung
benefits, Railroad Retirement, and Medicaid, nor does it show those
programs which, in the absence of a change in law, would go on
forever.  In some of these cases, earmarked revenue, such as in the
form of individual contributions, has helped build public perception
of an enduring commitment by the government.  Also, the federal
government has other ongoing responsibilities, such as providing for
the common defense of the nation, that are not shown in the table. 
Still another category of long-term commitments may arise from those
programs or activities that commit the government to future operating
and maintenance expenses or from the expectation that a partially
funded capital project--such as the space station--will receive
future funding to complete the project. 


--------------------
\12 Budget Process:  Evolution and Challenges (GAO/T-AIMD-96-129,
July 11, 1996). 


   POSSIBLE BUDGET PROCESS AND
   REPORTING IMPROVEMENTS
---------------------------------------------------------- Chapter 0:5

The broad range of long-term federal commitments complicates the
challenge of integrating more complete information on their expected
future cost into the budget process.  The diverse nature of the
commitments, combined with the varying quality and amount of
information available outside the budget process, suggests that
across-the-board changes in budget reporting or process may not be
the most effective way to proceed. 

We think that it may be more useful to look at different categories
of the government's long-term commitments to identify the most useful
approach for incorporating a longer term perspective into current
policy actions affecting those commitments.  Alternatives could range
from enhancing the information available in the budget to developing
new frameworks for budgetary incentives and control, as the Congress
did for credit programs under the Federal Credit Reform Act of 1990. 
Thus, for different categories of commitments, changes in the
information provided or in the existing incentives and controls could
be selectively tailored to address specific problems.  For some types
of commitments, the problem may be a lack of information to judge the
expected future costs of programs as they are created or modified. 
For other commitments, such as insurance, the problem may be that the
incentives or signals provided by information reported in the budget
are misleading. 

While there is a great deal of information available to
decisionmakers on the future cost implications of the government's
two largest commitments--Social Security and Medicare--long-term
simulations like GAO's put the information in context by helping
focus attention on the broader fiscal and economic implications of
these commitments.  These models can be updated periodically to help
the Congress and the public assess the future consequences of current
or proposed policies and programs.  Such long-term simulation models
could provide information to help judge the future implications of
current or alternative fiscal policy paths.  The effects of
congressional budget resolutions could be simulated over the long
term to gauge their potential impact on the long-term outlook.  Thus,
use of economic simulations could help establish a long-term
framework linking budget planning and long-term fiscal policy goals. 

With regard to program categories for which the budget currently
provides misleading or incorrect incentives and signals, we recently
reported that the cash-based budget provides neither complete cost
information for budget decision-making nor the incentives necessary
to control costs for federal insurance programs.\13 While smaller
than the government's social insurance commitments, federal insurance
is provided to individuals and businesses against a wide variety of
risks, ranging from natural disasters under the flood and crop
insurance programs to bank and employer bankruptcies under the
deposit and pension insurance programs.  These commitments could
result in potentially large future obligations; however, their costs
are not currently reflected in the budget at the time the government
extends the insurance.  Although it is often hard to predict the
timing and magnitude of insured losses, estimates of the expected
long-term costs of these future claims are available for many of the
federal insurance programs.  In our report, we recommended that the
Office of Management and Budget work with the insurance program
agencies to improve these estimates and report this supplemental
information in the budget.  Reporting of such accrual-based insurance
costs would improve recognition of the government's commitments. 

Another area in which the budget provides incomplete cost information
and misleading incentives is future civilian and military retiree
health costs.  None of the accruing costs of civilian or military
retiree health benefits are recognized in the budget.  The budgetary
information and incentives to control costs for these programs could
potentially be improved through the use of accrual concepts, which
would recognize the full cost of these benefits in the budget as they
are earned. 

The cost of environmental cleanup resulting from federal operations,
which under federal accounting standards is reported as a liability
on financial statements, represents another category of long-term
costs, most of which have not been recognized in the budget.  While
it will be up to the Congress to decide on the most appropriate way
to deal with this large accumulated liability, we believe that
decisions to purchase capital assets should take into account the
cost of any new environmental liabilities to be created with the
operation or decommissioning of the asset.  The cost of future
environmental liabilities could be provided as supplemental
information or recorded in budget authority before the asset is
purchased. 

Information about the cost of some of these commitments will be
increasingly available as agencies produce audited financial
statements.  Financial reports based on federal financial accounting
standards will provide an additional perspective on the government's
various long-term commitments and finances.  The new standards
require new reports on a broad range of liabilities and commitments. 
Liabilities such as deferred compensation and environmental costs
will be reported on the balance sheet.  Information on the
government's commitments for programs like Social Security and
Medicare, while not treated as balance sheet liabilities, will be
presented in stewardship reports.  These are new reports
supplementing the basic financial statements that are intended to
provide additional financial and nonfinancial information useful for
assessing the government's stewardship over the resources entrusted
to it and the responsibilities it has assumed. 


--------------------
\13 See Budget Issues:  Budgeting for Federal Insurance Programs
(GAO/AIMD-97-16, September 30, 1997). 


   CONCLUSION
---------------------------------------------------------- Chapter 0:6

The economy and policy actions have combined to create a major change
in the near-term deficit outlook.  Current projections--assuming
compliance with discretionary spending limits set in the Balanced
Budget Act of 1997--are for surpluses through 2013.  Although
near-term budgetary improvement is a welcome achievement,
unsustainable deficits nonetheless would reemerge over the longer
term as a smaller generation of workers will be challenged to finance
the costs of public programs for baby boom retirees. 

Our near-term fiscal policy will have a decided impact on the future
budgets and economy inherited by the next generations.  Our
simulations suggest that preserving the anticipated budget surpluses
now makes some tangible difference for the long term, most notably by
reducing the burden of debt and interest passed on in future budgets. 
However, a sustainable policy will, at some point in the future,
require further fiscal actions to avoid the vicious cycle of
exploding deficits and debt--actions that could be more or less
painful based on our decisions today.  A budget reporting and
accounting framework making the future implications of today's
decisions more transparent would help the nation better understand
the stakes underlying the choices it faces. 


-------------------------------------------------------- Chapter 0:6.1

Mr.  Chairman, this concludes my written statement.  I would be happy
to answer any questions you or your colleagues may have.  We look
forward to working with you as you address the important long-term
issues I have discussed today. 


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

This update of GAO's work\1 on the long-term economic and budget
outlook relies in large part on a model of economic growth developed
by economists at the Federal Reserve Bank of New York (FRBNY).  The
major determinants of economic growth in the model include changes in
the labor force, capital formation, and the growth in total factor
productivity.  To analyze the long-term effects of fiscal policy, we
modified the FRBNY's model to include a set of relationships that
describe the federal budget and its links to the economy, using the
framework of the National Income and Product Accounts (NIPA).  The
simulations generated using the model provide illustrations, not
forecasts, of the budget or economic outcomes associated with
alternative policy paths.  The model depicts the links between the
budget and the economy over the long-term, and does not reflect their
interrelationships during short-term business cycles. 

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

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

There are also important links between national saving and investment
and the international sector.  In an open economy such as the United
States, a decrease in saving due to, for example, an increase in the
federal budget deficit, does not require an equivalent decrease in
investment.  Instead, part of the saving shortfall may be filled by
foreign capital inflows.  A portion of the net income that results
from such investments flows abroad.  In this update, we retained the
assumption in our prior work that net foreign capital inflows rise by
one-third of any decrease in the national saving rate. 

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

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

The more recent data prompted several parameter changes.  For
example, the long-term inflation rate is now assumed to be 2.5
percent, down from 2.7 in our October 1997 report, 3.4 percent in our
1995 report and 4.0 percent in our 1992 report.  In this update, the
average federal borrowing rate steadily declines to 5.1 percent,
compared to our assumption of 7.2 percent in 1995 and 7.8 percent in
1992.  Our work also incorporates the marked improvement in the
economic and budget outlook reflected in the 10-year projections that
CBO published in January 1998. 

As we use a broad NIPA framework for our long-term simulations, the
presentation of the mandatory and discretionary spending trends
implied by our results are only approximations.  We adopted the
NIPA-based budget assumptions from CBO's most recent 10-year economic
and budget outlook, which reflect the assumption that discretionary
spending equals the statutory caps from fiscal years 1998 through
2002 and increases at the rate of inflation from fiscal years 2003
through 2008.  For the period following fiscal year 2008, we assumed
that those NIPA categories broadly corresponding to discretionary
spending would keep pace with GDP growth. 

Mandatory spending includes Health (Medicare and Medicaid), Old Age
Survivors and Disability Insurance (OASDI, or Social Security), and a
residual category covering other mandatory spending.  Following NIPA
definitions, we did not net out premiums and contributions from these
categories.  Medicare reflects CBO's assumptions through 2007, and
increases at the Health Care Financing Administration's (HCFA)
projected rate in subsequent years.  Medicaid is based on CBO's
January 1998 assumptions; thereafter it increases at the rates
embodied in CBO's March 1997 report on the long-term budget outlook. 
OASDI reflects the April 1997 Social Security Trustees' Alternative
II projections. 

Other mandatory spending is a residual category consisting of
non-health, non-Social Security mandatory spending.  It equals CBO's
NIPA projection for Transfers, Grants, and Subsidies less Health,
OASDI, and discretionary spending that is included in NIPA
projections for these items.  Through 2007, CBO assumptions are the
main determinant of other mandatory spending, after which its growth
is linked to that of GDP. 

The interest rates for 1997-2007 are consistent with the average
effective rate implied by CBO's interest payment projections.  We
assume that the average rate remains at the 2007 rate of 5.1 percent
for the rest of the simulation period. 

Receipts follow CBO's dollar projections through 2007.  Thereafter,
they continue at 20.5 percent of GAO's simulated GDP, which is the
rate projected for 2007. 

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



                               Table I.1
                
                            Key Assumptions

                                    Assumptions
----------------------------------  ----------------------------------
Saving rate: gross saving of the    17.5 percent of GDP
private and state and local
government sectors

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

Total factor productivity growth    1 percent

Inflation rate                      Follows CBO through 2008; 2.5
                                    percent thereafter

Interest rate (average on the       Average effective rate implied by
national debt)                      CBO's interest payment projections
                                    through 2007; 5.1 percent (CBO's
                                    2007 implied rate) thereafter

Surplus/Deficit                     Follows CBO's budget surplus/
                                    deficit as a percentage of GDP
                                    through 2007; GAO projections
                                    thereafter

NIPA categories covering            CBO through 2007; increases at the
discretionary spending and other    rate of economic growth thereafter
mandatory spending

Medicare                            CBO through 2007; increases at
                                    HCFA's projected rate thereafter

Medicaid                            CBO's projections and simulation

OASDI                               Follows the Trustees' Alternative
                                    II projections

Receipts                            CBO's assumed levels through 2007;
                                    in subsequent years receipts equal
                                    20.5 percent of GDP (2007 ratio)
----------------------------------------------------------------------
Note:  In our work, all CBO budget projections were converted from a
fiscal year to a calendar year basis.  The last year of CBO's
projection period is fiscal year 2008, permitting the calculation of
calendar year values through 2007. 


--------------------
\1 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), and Budget Issues:  Analysis of Long-Term Fiscal
Outlook (GAO/AIMD/OCE-98-19, October 22, 1997). 

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


FIGURES
========================================================== Appendix II

   Figure II.1:  Deficit Paths
   Under GAO's Past and Present No
   Action Simulations

   (See figure in printed
   edition.)

   Figure II.2:  Long-Term Change
   in Composition of Spending as a
   Percentage of GDP Under No
   Action Simulation

   (See figure in printed
   edition.)

   Figure II.3:  Alternative
   Deficit/Surplus Paths

   (See figure in printed
   edition.)

   Figure II.4:  Net Interest as a
   Share of Total Spending in 2050
   Under GAO's Three Fiscal Policy
   Simulations

   (See figure in printed
   edition.)

   Figure II.5:  GDP Per Capita
   Projected Under GAO's Three
   Fiscal Policy Simulations

   (See figure in printed
   edition.)

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


*** End of document. ***