Confronting Budget Reality

The budget deficit is a no-win issue. The presidential nominating process showed that any candidate who proposed a real solution would lose more votes than he would gain. On the Democratic side, former Arizona Governor Bruce Babbitt kept challenging his opponents to stand up for a tax hike. Journalists and commentators applauded, but opponents stayed

in their chairs as Babbitt was quickly eliminated from the race. Among the Republicans, Vice President Bush bounced back from his Iowa defeat by charging that he was more opposed to tax increases than Senator Dole. Bush claimed he would attack the deficit with vetoes and a "flexible freeze" (a nice self-canceling phrase). Democratic nominee Dukakis, meanwhile, emphasized his experience balancing budgets as a governor. Having increased revenues through stricter enforcement efforts in Massachusetts, he would try that before raising taxes. No pain, except for the bad guys. Because Congress had been throwing such provisions into its budget packages for years, while the IRS was having enough trouble devising forms for the new "simplified" tax code, Dukakis's claims for enforcement were dubious. But the approach beat being specific about program cuts and tax hikes.

Jesse Jackson was the exception who proved the rule: by substantially raising taxes on higher incomes and severely cutting defense, he would reduce the deficit by a sizeable amount. Aside from a little fudging on how far down the income ladder he would have to go—most of the people make most of the money—Jackson was on target.^[64] Nothing would satisfy a majority, however, so candidates who wished to win said nothing.

Perhaps the candidates were just hiding their budget plans until after the election. Perhaps, but after the election, members of Congress, having to pass a budget deficit fix, would represent the same public; why would it represent the public any differently than before?

Maybe a Democratic president and Congress would, in trying to show they could govern, put party over constituency by enacting a deficit-reducing tax increase and spending-cut package. Gypsy moths did something similar in 1981. Maybe a Republican president would sell out his own side to make a deal with a Democratic Congress. Maybe turmoil in the financial markets would finally force balance, though one would have to wonder what it would take if Black Monday were not enough. Maybe a fairy godmother would appear, empowering the politicians to solve their problems.

This fairy godmother even had a name—the National Economic Commission, established as part of the budget summit agreement, a bipartisan group modeled on the Greenspan Commission that fixed social security. The Commission, consisting of twelve members, six Democrats and six Republicans, was expected to work through the summer and fall. The president-elect would then appoint two final members. This group of (politically) wise men would, sometime between December and March, propose a budget solution.

Republican members were former Transportation Secretary Drew Lewis, Senator Domenici, Casper Weinberger, former Secretary of Defense

and White House Chief of Staff Donald Rumsfeld, Representative Bill Frenzel, and the president of the American Farm Bureau Federation, Dean Kleckner. Democrats were Robert Strauss, former party chairman and U.S. Trade Representative, Representative Gray, Senator Moynihan, investment banker Felix Rohatyn, Chrysler chairman Lee Iacocca, and AFL-CIO president Lane Kirkland. Members chose Strauss and Lewis, experienced negotiators with good ties across parties, as co-chairmen. They selected as staff director the top civil servant in OMB, one of Washington's most respected budget professionals, David Matthiasen, whose appointment, as much as the Commission's membership, showed that the NEC would be where the action was in 1988.

Could twelve wise men do for the federal budget what had been done for social security? Could they devise a plan and give politicians political cover to push it through? In Chapter 14 on social security, we argued that the shortfall, proportionately so much smaller, was far easier to correct than the federal deficit. As members of the NEC quietly met through the summer—in informal, small groups so they could exclude the press—and reviewed budget difficulties, they would face, as the rhetoric goes, a hard reality.

At the beginning of 1988, CBO's baseline budget projected a deficit of $157 billion in FY88, followed by $176 billion in FY89 and, successively, $167 billion, $158 billion, $151 billion until $134 billion in FY93. The Balanced Budget Reaffirmation Act, otherwise known as the new Gramm-Rudman, required a $136 billion deficit in FY89, dwindling to zero in FY93. Let us review the conditions and requirements of balance under CBO and GRH.

How bad are those numbers? That depends, first, on the year we choose for comparison: $157 billion in FY88 was expected to be 3.4 percent of GNP; $134 billion in FY93 would be 2.1 percent.^[65] Assuming the baseline was accurate, time would reduce the problem.

The baseline might not be accurate. CBO projected moderate economic growth, around 2.6 percent per year, throughout its forecast period. That projection fit historical trends over five-year periods, but it could easily be wrong. CBO estimated there was a two-thirds chance that growth would average between 1.6 percent and 3.6 percent; that is, the deficit in FY93 would be within $125 billion of the estimated $134 billion. The good news was that the error might be virtuous—higher growth and lower deficits. The bad news was a one-sixth chance that the deficit would be $259 billion or higher.

There were two obvious reasons for pessimism. First, if the deficit were such a bad thing, then something bad eventually had to happen to the economy. Otherwise, why reduce it at all? CBO had essentially adopted former Director Rudy Penner's recommendation that budgeters

admit they could not predict the economy's swings, escaping the pressures for optimistic or pessimistic forecast manipulation by predicting that the future would look like an average of the past. However, the deficit was uncharted territory where unpleasant surprises seemed more likely than not.

Meeting that baseline, alone, never mind cutting below it, moreover, would require substantial policy sacrifices. The baseline's definition as current policy was deceptive. In a number of policy areas—control of the AIDS epidemic and drug traffic, NASA's space station, modernized air traffic control system—contemplated expenses in future years would rise well above the baseline, the existing level, because projects were in their early stages. The space station was already under fire within House Appropriations because, if it went above the baseline, other projects might have to be reduced. But that meant a battle just to stick to the baseline.

The domestic spending baseline was tough enough; defense figures posed brutal problems. There was no way to maintain the existing military force structure over the next five years if there were no real growth in military spending. That force structure might, some argued, be reduced without diminishing military capability. A 600-ship navy might not be necessary; some hardware, like the Bradley armored vehicle, might work so poorly it should be abandoned; the country's nuclear deterrent might not require either a rail-mobile MX missile or the single-warhead Midgetman missile. Disagreements abounded. Tough choices were required just to keep spending down to the baseline.

Let us be optimistic, however, and say that the baseline is reasonable. How much deficit reduction would be necessary to attain the new Gramm-Rudman target balance in FY93?

We could assume that the extra couple of billion dollars required by the summit agreement, but not included in the baseline, would be saved in the FY89 appropriations. Beyond that, earlier savings are better because they yield greater long-term savings in interest costs. Using moderate assumptions about interest rates, an average of CBO's projected rates for three-month T-bills and ten-year bonds, reducing the deficit by $100 billion in FY90 would eliminate the deficit in FY93.

It's not that simple, of course. A $100 billion deficit reduction in one year would be a nasty, recessionary swing in fiscal policy. Few economists would approve. We also have the old budget authority versus outlays problem: a $100 billion reduction in BA will not provide so much immediately in outlays. That's actually convenient, phasing in any spending cuts and moderating the fiscal contraction. Any slower, more phased deficit reduction, however, would yield lower interest savings and require more policy change. The $100 billion figure for FY90, therefore, is a

minimum estimate of the amount of policy change needed to meet Gramm-Rudman targets.

Having made our task a little easier at every step, we are left with a figure roughly equal to the U.S. Navy. Or, for those more concerned with domestic spending, a figure larger than medicaid, Department of Education, National Institutes of Health (including cancer and AIDS research), Department of Justice, Department of State, and Federal Highway Administration combined. Would you rather have no deficit and no navy? Or both? A deficit, or do without those domestic programs? Or mix and match: eliminate the deficit but have no medicaid, no NIH, no State Department, and half a navy? The choices may seem extreme; they are extreme, but there they are. People sometimes assume that a series of marginal cuts across programs can do the job, thus various freeze formulas. Yet, if across-the-board cuts à la Gramm-Rudman are as dumb as claimed, their policy consequences would be greater than those we are suggesting.

We might get our $100 billion from taxes. Individual income taxes would only have to be raised by 22 percent, an ironic number, virtually reversing the 1981 tax cut. Or we could raise individual income taxes by 10 percent, corporate taxes by 20 percent, and excise taxes by 50 percent. Whether these options are worse or better than spending cuts depends entirely on one's ideology. Even the most dedicated fan of the public sector can imagine the political difficulty of such tax hikes.

There are, of course, many more narrow options for deficit reduction. Each year CBO produces a volume, "Reducing the Deficit: Spending and Revenue Options." The March 1988 edition included twenty-six suggestions for defense savings, twenty-six for entitlements, seven for agriculture, thirty-eight in nondefense discretionary, eight changes in federal personnel policies, and twenty-five revenue increases. They ranged from canceling procurement of the F-15 fighter plane to creating a national value-added tax. Many, as the examples suggest, are controversial. Others, more obscure, may sound less troublesome. The navy has thirty-seven SSN-688 nuclear attack submarines—twenty-two on order and seven more they would like to order. Why not cancel the last seven, waiting for the new, improved SSN-21, on which delivery should begin in 1995? The navy could still maintain its force objectives, assuming the SSN-21 was not significantly delayed. But if it were, as is common for new weapons, Congress and the navy would be stuck. Should we put all our submarine eggs in one basket?^[66] Take another CBO option: counting, as part of income, payments under the Low-Income Home Energy Assistance Program (LIHEAP) in determining eligibility or benefit levels for AFDC and food stamps would save $255 million in FY90; it would also eliminate duplication where some recipients of LIHEAP

are better off than nonrecipients who actually earn more. But the change "would particularly penalize families facing large energy bills." Higher bills mean a higher offset against other payments, but what are the recipients to do, shower in the dark? Move south? Even the more harmless sounding proposals turn out to have thorns.^[67]

A value-added tax (VAT), one of CBO's alternatives, is the nuclear option of deficit reduction. Even with exemptions for food, housing, and medical care, a 5 percent VAT yields nearly $80 billion in FY93. Economists love a VAT because it taxes only consumption without inhibiting investment as the income tax can. (Except that people might save less if prices are higher.) States, however, do not like a VAT; sales taxes are their territory. Liberals object to a VAT because sales taxes are regressive (encouraging savings and favoring savers who have more money). And conservatives with any knowledge of comparative politics fear the device that largely finances European welfare states. Conservatives fought a minimal VAT in the 1985–1986 dispute over superfund financing because they feared the principle. In short, compared to other deficit reduction options, a VAT looks quite attractive. As a policy in its own right, the VAT's implications for our federal system are more revolutionary than tax reform, potentially as revolutionary as the invention of the income tax.^[68] We do not say it cannot happen; we do say that fundamental change in domestic and defense policy is required to achieve balance.

Even Rudolph Penner and Joseph Minarik, self-described as "two economists not far from the center of the ideological spectrum," in the most informed and careful budget reduction proposal we have seen, in their own words, "can arrive at a balanced budget only with some fairly radical—and many people would say politically implausible—changes in tax and spending policy."^[69] They suggested taxing social security benefits, deemphasizing naval "forward deployment" in the European theater, cutting medicare providers by $10 billion and raising recipients' premiums by $5 billion, somehow (they're not sure how) chopping price supports, and a "draconian approach" to intergovernmental grants "and other dubious federal government activities." They would double the cigarette and hard liquor taxes, raise beer and wine taxes, raise the motor fuels tax by 12 cents a gallon but not give the revenues to the trust fund. They would adopt a large menu of "base-broadening" measures on the income tax, such as cutting business deductions for entertainment and meals in half, taxing accrued capital gains, and capping the mortgage interest deduction. We can only agree with their own assessment; their figures add up, but it probably can't be done.

Citizens should realize how hard it is to balance the budget; even if they disagree, they should also be aware that others have good reasons for believing balance is unwise. They should also realize how much the

politicians have achieved. In 1986 John Palmer of the Urban Institute estimated the effects on the deficit of all budget decisions since the beginning of 1982. Those actions ranged from TEFRA to the February 1986 sequester.

Starting from a baseline that had defense growing by 7 percent per year—the policy Reagan proposed and Congress seemingly endorsed in 1981—Palmer found the politicians had reduced the FY86 deficit by $162 billion, or 3.9 percent of GNP. Unfortunately, nobody could see that they had done so much because a deficit of $208 billion remained.

The politicians seemed to have done little because the problem each year was much, much bigger than it seemed. Yet, if they actually had done nothing, the FY86 deficit would have been $370 billion, 8.8 percent of GNP. Each year they had acted; in most years their efforts were canceled out by revisions in the economic and technical assumptions. Thus, five-year savings of $184 billion from the February 1982 estimates were overwhelmed by $235 billion in larger deficits from changes beyond their control. Only in 1985 did the surprises go the politicians' way.^[70]

After 1986, by Palmer's estimates, the decisions to that point would save even more money. Congress more than shut down the defense buildup, saved some in the 1985–1986 reconciliation, raised taxes, and introduced some domestic cuts (mostly medicare) as part of the budget summit. Without a doubt deficit savings have increased in 1987–1988.^[71]

Most deficit reductions after 1981 came from winding down the defense buildup and raising taxes. From 1982 to 1986, domestic spending was cut by roughly 5 percent.^[72] As background, domestic spending had taken a big hit in 1981, and the 1983 package took social security off the table. CBO estimated outlays for nondefense discretionary spending would be the same in FY88 as in FY85 about $175 billion. In those years it was squeezed by inflation.^[73] Between FY81 and FY88, we see substantial effort, for nondefense discretionary spending fell from 5.7 percent of GNP to 3.7 percent. All these numbers add up to one result: politicians have done a great deal about the deficit, but each step is harder than the previous.

The best arguments against deficit panic, in our opinion, are those of experience. Nothing terrible happened. Yet. But "yet" is a long time coming. All the bad things prophesied from the deficit, from depression to inflation to decline in productivity, historically have happened during periods of balance as well. Why, then, go through tremendous trouble to balance the budget?

By 1987 mainstream economists emphasized that deficits should be cut because they reduced national savings and, thus, investment:

If continued over the long run, large budget deficits would either drive down domestic investment or be financed by increasingly uncertain, and

potentially reversible, capital inflow from abroad. In either case, living standards of U.S. citizens would fall: a reduced level of domestic investment would retard the growth of the economy, and continued heavy foreign investment would send a larger share of U.S. output abroad in payment of debt service or other returns to foreign investors.^[74]

They worried about demand management mainly in terms of how fast to move toward balance, that is, "Will Rapid Deficit Reduction Cause Recession?"^[75]

By 1988 this concern with savings was causing many economists to argue that the budget should move into surplus. They wanted social security surpluses invested in the economy, not in financing other federal programs. Minarik and Penner argued that for the social security "accumulation to have any economic meaning, the rest of the federal government must not run a deficit." They emphasized that "the main reason for deficit reduction is to increase long-term growth."^[76]

The economists' focus on growth returns us to the "productivity crisis" of the 1970s. It is a legitimate concern. We just have a few questions:

Lower deficits, even surpluses, might, under some conditions, be a good idea. But the kind of drastic budget action required to use the social security surpluses for savings is impossible. We fear that, as in the

famous story of the man who looked for an item not where he lost it but where the light is brightest, the government's budget is being asked to solve a problem because the budget is the nearest instrument at hand, even though not entirely appropriate.

There is only one reason to treat the deficit as a crisis: the markets. They remain the great unknown, at the end as at the beginning of our story. With one big difference: then concern focused mainly on American bondholders. Now we worry about foreign investors and foreign central bankers. Might they refuse to invest? Demand higher interest rates? Keep going because there was no other place to take their money? Invest, even more, just as Americans were investing more in Europe, because of continued prosperity? There is every reason to treat foreign investment as a good thing (if foreigners did not want to invest, wouldn't that be a sign of American decay?) signifying that opportunity and stability are found in the United States. Yet any borrower loses some independence; depending on foreign capital is worse than being the lender; nervousness is understandable.

The wolf, sighted so many times during the 1980s, could finally beat on the door. There is no way to tell. Nor could anybody know what would satisfy its appetite: $20 billion a year? $40 billion? $60 billion? If the markets posed the question, politicians could only guess at the answer.

When continued prosperity intersects with talk of economic Armageddon, do you wait and see, as the American public would like, or do you take drastic measures to ward off the worst, as the political stratum demands? That depends on at least two considerations: whether you think there is a better alternative (we present ours in the final chapter) and whether you believe balancing the budget in the short term is more important than maintaining majority rule.

Strange as it may seem, democracy and deficits now go together. The only way to sever that connection is to vote into office majorities dedicated to budget balance. The public interest and the state, as we shall argue in the next chapter, only coincide when public opinion joins together what political life normally keeps apart.