July 23, 2014

Fiscal Policy in Campaign 2004

Subtitle: 
Electing the First President of the Senior Boom

I. Introduction

Four years ago the budget was on its way to a $236 billion surplus and the presidential candidates were debating how best to divvy up a projected 10-year surplus of $4.6 trillion.[1] This year’s debate is far different. Fiscal year 2004 closed with a $413 billion deficit and the 10-year shortfall is projected to be $2.3 trillion - even assuming that the economy remains healthy, that appropriations growth slows by two-thirds from its recent pace, that all tax cuts are allowed to expire on schedule and that nothing is done to restrain the growing middle class bite of the alternative minimum tax. Using more plausible assumptions, the projected 10-year deficit is closer to $5 trillion.[2]

While the 10-year outlook is daunting, the longer-term outlook is even worse. In 2008, before the next presidential term ends, the first members of the huge baby boom generation will qualify for Social Security retirement benefits at age 62. From then on, the cost of boomers’ retirement and health care benefits will place a rapidly growing strain on the nation’s resources. As United States Comptroller General David Walker has observed, we are on the verge of a “demographic tidal wave that is never expected to recede.”[3]

Over the next 30 years, the number of Americans aged 65 and older will grow from 12 percent of the population to nearly 20 percent. During that time, the cost of Social Security, Medicare and Medicaid is projected to double as a share of the economy (GDP) - going from about 8 percent to more than 16 percent. To put this in perspective, if these three programs equaled 16 percent of GDP today they would amount to 81 percent of the entire federal budget and consume virtually all federal revenues. Total federal spending could reach 30 percent of GDP by the time the boomers are fully retired and if revenues continue to average about 18 percent of GDP ? as they have over the past 25 years - the resulting deficits and debt will eventually overwhelm the economy. Large chronic deficits really do matter.

The Congressional Budget Office (CBO) has bluntly warned: “substantial reductions in the projected growth of spending or a sizeable increase in taxes ? or both ? will probably be necessary to provide a significant likelihood of fiscal stability in the coming decades.”[4]

Should there be any doubt about the need for action, CBO notes “economic growth alone is unlikely to bring the nation’s long-term fiscal position into balance.”[5]

The election of 2004 will determine the first president of the looming “senior boom” ? and whether that president is George W. Bush or John F. Kerry, tough choices will be required to close both the renewed short-term gap and the even larger long-term shortfall.

II. Alternative Routes to a Similar Destination

Given these circumstances, it is appropriate for fiscal policy to assume a prominent role in the 2004 presidential campaign. At this stage, however, it cannot be said that either President Bush or Senator Kerry has a credible plan for dealing with the fiscal challenges he will face if elected. Both candidates are touting expensive initiatives that would make deficit reduction more difficult in the short-term and fiscal sustainability unlikely in the long-term. The policy options in their plans are very different but the bottom lines are not. Regarding the deficit, they appear to be taking alternative routes to a similar destination.

The best way to assess the potential budgetary impact of the Bush and Kerry proposals over the next 10 years is to weigh them against the non-partisan CBO baseline, which is how presidential budgets are traditionally “scored.” As described by CBO, the baseline represents its “best judgment of how the economy and other factors would affect federal revenues and spending under current laws and policies. Lawmakers can then use the baseline as a neutral benchmark against which to measure the effects of proposed changes in tax and spending policies.”[6]

An expression used in golf is apt: you play the ball where it lies. In this case, the ball is in deep rough and the toughest holes are ahead. The 2004 deficit was $413 billion (3.6 percent of GDP). The 2003 deficit was $374 billion (3.5 percent of GDP). In dollar terms, these were the two largest deficits in our nation’s history. Measured as a share of GDP, they were the worst back-to-back deficits since 1992-93. The 10-year baseline deficit of $2.3 trillion is CBO’s highest projection since 1997.

Using published material from the Bush Administration and the Kerry campaign, it is possible to make a rough comparison of the candidates’ major policy proposals. Any such comparison will be imprecise because the candidates have not filled in the details of their proposals and cost estimates vary widely. However, the approximate magnitude and direction of their respective plans can be shown.

President Bush’s proposals are detailed in the Fiscal Year 2005 budget released in February and the Mid-Session Review released in July. Additional proposals were added in his speech accepting the Republican presidential nomination. These have been labeled the “Agenda for America” programs.

Senator Kerry issued a budget “framework” in April that was updated in August and September. It is not as detailed as the Bush budget, but enough detail has been presented by the campaign to assess the impact and credibility of Kerry’s major policy proposals and assumptions. Nevertheless, Senator Kerry’s claim to have a more fiscally responsible plan than the President’s would be strengthened by a set of year-by-year numbers that could be compared with the President’s budget.

Senator Kerry’s major proposals (Totals for FY2005-2014)
Tax provisions
Repeal upper income tax cuts $278 billion7 (adds revenue)
Reform estate tax $8 billion (adds revenue)
Extend “middle class tax cuts” -$508 billion
Health care tax credits -$177 billion
College opportunity tax credit -$71 billion8
Energy and environment -$16 billion9
Jobs tax credit -$12 billion10
Subtotal taxes -$498 billion
Spending
Health care plan $476 billion11
Education $155 billion
Veterans and military families $55 billion12
State and local aid $25 billion
Add 40,000 troops $60 billion13
Subtotal spending $771 billion
Total deficit increase $1,269 billion ($1.27 trillion)*

*This total does not include $131 billion of offsets claimed by the Kerry campaign. Specifically, no credit is given for proposals to cut the government’s electricity bill by 20 percent ($14 billion), “cut other Federal energy bills” ($2 billion), improve government efficiency” by cutting 100,000 contractors ($55 billion) and pay for 40,000 new troops with an array of efficiency savings in other national security programs ($60 billion). Such purported savings are too vague and uncertain to be relied upon as offsets for new initiatives.

President Bush’s major proposals (Totals for FY 2005-2014)
Tax provisions
Extend all 2001 and 2003 tax cuts -$1,052 billion14
New tax cuts in FY05 budget - $157 billion15
Agenda for America tax cuts - $35 billion_
Subtotal tax cuts -$1,244 billion
Spending
Refundable health tax credit $54 billion16
Other mandatory spending in FY05 budget -$10 billion
Agenda for America programs $38 billion
Subtotal spending $82 billion
Total deficit increase $1,326 billion ($1.33 trillion)*

*Does not include the potential deficit increase from Social Security reform. See below.

Note: The items shown above highlight the costs of enacting the candidates’ major policy proposals and their differences in priorities. Because not all budgetary effects are enumerated, these numbers should not be added in isolation to CBO’s deficit projections to derive a total deficit outlook under the candidates’ plans. The potential impact of other changes in baseline assumptions would also have to be included in any such calculation.[17]

Many cost estimates are a matter of dispute between the campaigns. The two proposals with the greatest potential consequences are the President’s Social Security reform agenda and Senator Kerry’s health care plan. The possible costs and benefits of each are briefly discussed below.

Social Security reform and the Bush budget

A major fiscal question mark in the President’s agenda is the cost of allowing workers to invest a portion of their Social Security payroll taxes (FICA) in personally owned accounts. In effect, these accounts would pre-fund some portion of future benefits. Technically speaking, this would be neither a spending increase nor a tax cut. It would, however, increase the deficit.

Personal accounts have potential advantages over the current system. They provide a more reliable way than government trust funds for pre-funding future benefits. They can also offer workers higher returns on their contributions. However, the money must come from somewhere. Personal accounts are not a free lunch. Using existing FICA taxes, as the President proposes, would increase the deficit. Those dollars are now flowing into the Treasury where any surplus not needed to pay current Social Security benefits goes to pay for other government operations. The deficit impact of re-directing payroll taxes from the Treasury into personal accounts would depend on the amount of taxes re-directed and the extent, if any, of corresponding benefit reductions or other spending cuts.

In the absence of a specific proposal from the Bush Administration it is not possible to “score” the President’s Social Security reform agenda as part of his budget proposals. Cost estimates range from $1 trillion to $2 trillion over 10 years. A generic plan in which two percent of payroll is directed to personal accounts would reduce receipts by $1.2 trillion over 10 years. A revenue loss of that size, or anywhere near it, would represent a substantial increase in the federal government’s already unsustainable budget outlook.

However, the key issue in evaluating the fiscal implications of a Social Security reform plan is not its immediate 10-year cost but whether it achieves long-term sustainability. Both the costs and benefits of reform should be assessed over a time frame that goes well beyond the next decade. Incurring a modest near-term budget cost as part of the transition to a genuinely funded and sustainable system may not be fiscally irresponsible. But policymakers, and the public, should beware of plans that borrow profligately in the near-term while promising fiscal integrity in the long-term. Unfortunately most plans, including the three options presented by the President’s Commission to Strengthen Social Security, do just that.[18]

None of this, of course, is an excuse for inaction. Cash shortfalls begin under the current system in just 14 years and grow wider throughout the traditional 75-year valuation period, totaling $27 trillion in today’s dollars. Doing nothing to remedy this perpetual shortfall is not a fiscally responsible approach either, even though it would not worsen the deficit over the next 10 years.

There is no way of knowing whether President Bush will propose a reform plan with responsible transition costs. So far, he has not. What can be said is that the President is advocating a major reform of Social Security that would have substantial consequences, none of which are included in his budget assumptions.

 

Kerry’s expansion of health care responsibilities

Health care is a big fiscal question mark in Kerry’s plans. His largest proposal would reduce the number of people who lack health insurance through a combination of expanded enrollment in the Medicaid and State Children’s Health Insurance programs (SCHIP), new health insurance pools for small employers and individuals, and reinsurance at an estimated net cost of $653 billion over 10 years. This includes new spending and tax credits totaling $950 billion minus assumed savings of nearly $300 billion.[19]

A very different assessment of the Kerry health care plan by the American Enterprise Institute found that the tax, spending and savings provisions together would cost $1.3 trillion over a comparable time period (FY2006-2014) ? twice as much as Kerry assumes.[20]

The federal government already faces serious challenges balancing the interests of Medicare beneficiaries with those of general taxpayers, which neither candidate seems willing to confront head-on. Medicare’s projected spending growth has sharply accelerated with the addition of a prescription drug benefit. According to the latest Trustees Report, the program is now projected to more than triple as a share of the economy by 2040. In last year’s report, Medicare did not triple as a share of the economy until after 2060.[21]

These projections may be low for a variety of reasons. Prescription drug costs may rise faster than anticipated. A larger-than-expected number of employers may drop their retiree drug coverage, leaving government to pick up the tab. In the long run, a large share of the new Medicare drug benefits may simply replace existing public and private insurance. The projections also make the politically dubious assumption that future Congresses will raise beneficiary premiums in line with per capita drug spending. It is worth recalling that Medicare’s Part B premiums were originally set by law to cover 50 percent of program costs. They now cover 25 percent. With a 17 percent increase in Part B premiums scheduled for next year, political pressure to lower premiums is likely to mount. But any reduction in premiums without a corresponding reduction in costs would shift more of the financing burden onto general revenues and squeeze even further other parts of the budget.

Then there is so-called “doughnut hole” in the new drug benefit. Coverage starts, then stops at a certain level, then starts again. This coverage gap has no policy rationale. Its sole purpose was to keep the official cost projection from exceeding the $400 billion limit established in last year’s budget resolution. Because it is arbitrary, beneficiaries may regard the coverage gap as unfair and demand that it be filled in ? at an additional undetermined cost.

As all this suggests, controlling health care costs without limiting individual choice and adversely affecting the quality of care is extremely difficult and politically unpopular. Although the Kerry plan could help 27 million (out of an estimated 45 million) uninsured individuals obtain coverage, it would assume significant budgetary risk. The President’s proposed refundable tax credits for insurance coverage would be far more modest in cost (between $90 billion and $129 billion over 10 years) but also help fewer people (2.1 million to 6.7 million) obtain insurance. [22]

Discretionary spending

A complete comparison of the Bush and Kerry fiscal policy plans should also include the candidates’ assumptions regarding discretionary spending, which is controlled by annual appropriation bills and accounts for 39 percent of the budget.

This process is somewhat speculative because policymakers and candidates alike can simply make an assumption of future savings from the baseline without specifying how those savings will be achieved. The process is further complicated by the fact that neither campaign has produced a 10-year estimate of its discretionary spending assumptions. The President’s budget only goes out five years and Senator Kerry has not published any year-by-year numbers.

In its calculations, CBO is required to extend discretionary funding at enacted levels. As a result, its baseline deficit projections can be overly optimistic or pessimistic. For example, the baseline extends supplemental funds provided in 2004 for activities related to Iraq, Afghanistan, and the global war on terrorism, adding roughly $1.1 trillion in spending over 10 years. This assumption probably overstates likely expenditures (and thus the baseline deficit), but it is impossible to say by how much. Neither candidate is actually proposing to discontinue, or “zero out,” support for these operations. Indeed, both have pledged to provide whatever additional funding is required. On the other hand, neither candidate has set aside specific funding levels for war related activities in his published material.23 The next President will be required to provide additional funding for these activities: it may be less than or exceed amounts embedded in the baseline.

As for regular appropriations, available information suggests that Senator Kerry’s budget framework would result in a higher level of discretionary spending than the President’s proposals. The difference comes from the candidates’ assumptions on non-defense, non-homeland security spending. The President’s budget assumes a virtual freeze on such spending, while Senator Kerry assumes that it will be capped at the level of inflation (about 2.5 percent annual growth). Extended over 10 years, this assumption produces a difference of more than $300 billion.

Experience suggests that both candidates are underestimating likely expenses. Far from being frozen, or only growing at the rate of inflation, non-defense discretionary spending has grown at an average annual rate of 5.6 percent for the past 25 years. The uncertainty of “savings” to be achieved by assuming tight spending caps is demonstrated by recent events. Because emergency spending adjusts budget caps upward, the roughly $16 billion of hurricane and drought relief Congress recently approved will add to this year’s deficit even if the tight lid approved for non-emergencies is maintained. This is not to suggest that legitimate emergency relief is “fiscally irresponsible.” It does suggest that for budget plans to be credible they should assume a realistic level of future needs, including natural disaster relief.

Regarding defense spending other than activities related to Iraq, Afghanistan and the global war on terrorism, a note in the Kerry-Edwards “Initiatives and Offsets” table published by the campaign states that defense “is funded at the President’s level.” If one takes this at face value there is no reason to assume any divergence in numbers between the Bush and Kerry defense budgets other than the addition of 40,000 troops accounted for in the tabulation of Kerry’s major initiatives given above. The President’s defense spending level provides roughly $300 billion more over 10 years than the CBO baseline (after removing the effects of continued war spending).

III. Shared Weaknesses

While President Bush and Senator Kerry have very different assessments of the fiscal outlook and the best ways to address it, their plans share some basic weaknesses:

  • Neither candidate is proposing a balanced budget plan. Instead, they both propose to cut the deficit in half by 2009. This is a retreat from the bipartisan balanced budget consensus that developed in the 1990s. While it is a plus that the candidates are promising deficit reduction ? thereby acknowledging that the deficit is a problem ? the halfway goal they share minimizes the full magnitude of the fiscal challenges ahead. Even if the policies in their budget plans succeed in halving the deficit by 2009, deficits are on track to shoot up again after that due to rising entitlement costs. The campaign’s fiscal policy debate is thus in danger of becoming fixated on a goal that is too modest and a timeframe that is too limited.
  • Neither candidate sets aside resources for reform of the alternative minimum tax (AMT) beyond 2005. The AMT is intended to prevent high-income taxpayers from escaping income taxes through excessive use of tax preferences. However, it is capturing more and more taxpayers who were not meant to be targeted because it is not indexed to inflation. Moreover, the 2001 and 2003 tax cuts reduced regular tax rates, lowering thresholds for AMT liability. Absent change, the number of taxpayers subject to the AMT will explode, from an estimated 2 million returns in 2003 to over 40 million in 2014 if the tax cuts are extended. Even if the tax cuts “sunset,” as current law provides, the number of AMT taxpayers will grow to more than 20 million. The candidates agree that the problem must be addressed but fail to account for the cost of doing so in their respective budget proposals. According to CBO, extending the 2004 exemption amount and adjusting it for inflation would cost more than $145 billion through 2009 ? $45 billion in 2009 alone. The 10-year cost would be $500 billion if the other expiring tax cuts are extended and $340 billion if they were not.
  • Neither candidate has publicly stated his assumptions for the ongoing costs of operations in Iraq, Afghanistan and the global war on terrorism. As noted above, the CBO baseline assumes continued funding for these activities over 10 years at the 2004 level adjusted for inflation. Removing that assumption, as the candidates do in their budget plans, lowers the baseline deficit by $1.1 trillion but it also removes all further funding for these efforts ? clearly, not a policy option that either candidate favors. According to CBO, maintaining current operations will likely require $55 billion to $60 billion in 2005. The CBO 5-year cost estimate for a scenario in which force levels in Iraq gradually decline by about 50 percent is $193 billion. The 10-year estimate is $315 billion. While the eventual costs cannot be precisely determined at this time, they cannot be assumed to be zero. Whatever the cost, neither candidate is proposing to end funding related to those activities.
  • Neither candidate assumes full extension of several routinely renewed tax breaks that are scheduled to expire. These are an assortment of small tax breaks sometimes referred to in Washington as “the extenders.” The candidates achieve budget savings by assuming that many of these provisions will expire on schedule. Extending all of them would cost $41 billion over five years and $175 billion over 10 years.[24]
    • Taken together, the omission of AMT relief, continued war expenses and extending these expiring tax breaks gives the candidates’ phantom “savings” of about $400 billion over five years and $1 trillion over 10 years. These savings make it far easier to cut the deficit in half on paper, but they are not likely to be realized.
  • Neither candidate has proposed a strategy for achieving long-term fiscal sustainability. The CBO has warned, “Unless taxation reaches levels that are unprecedented in the United States, current spending policies are likely to prove financially unsustainable over the long term because they will lead to an ever-growing burden of federal debt held by the public, which will have a corrosive and potentially contractionary effect on the economy.”[25] The best way to avoid this unpleasant future is to begin working on the problem now. Yet, neither candidate is proposing, or even acknowledging, the kind of cost saving reforms that will be needed to prevent a future of spiraling taxes, burdensome debt, a stagnant economy, or all three.
    • Social Security. As recently as 1960, there were 5.1 taxpaying workers for every Social Security beneficiary. The program’s Trustees project that this support ratio, now 3.3, will fall to 2.2 by 2030 as baby boomers become senior boomers. A falling support ratio translates into a rising cost rate for a pay-as-you-go program like Social Security. The Trustees project that the cost of Social Security as a share of workers’ taxable payroll will grow from 11.1 percent today to 16.8 percent by 2030. Social Security will start paying out more in benefits than it takes in from taxes by 2018. Between 2020 and 2040, Social Security’s annual cash deficit will get deeper by roughly an extra $45 billion each year. Stemming the cash hemorrhage would ultimately require cutting benefits by one-third or raising payroll taxes by one-half. Potentially higher returns from personal accounts would not do much to change this, nor would a higher assumed level of economic growth ? the candidates’ suggested solutions. What they are ignoring is that some combination of reduced promised benefits and higher contributions, (i.e., new savings) will be necessary to solve the problem.
    • Medicare. Medicare presents an even more daunting fiscal challenge than Social Security. The number of Medicare beneficiaries is growing by 1.4 percent a year. As the baby boomers begin to retire, the growth rate will reach 2.7 percent by 2014 and the growing number of Medicare beneficiaries will exert increasing pressure on the overall budget. It will be impossible to simultaneously: increase Medicare coverage for beneficiaries; reimburse health care providers at levels sufficient to make them willing to serve Medicare patients; maintain beneficiary contributions and out-of-pocket medical spending at current levels; and keep taxpayer revenues supporting Medicare at present levels. General revenues currently pay for 35 percent of Medicare’s costs, while payroll taxes and beneficiaries’ premiums pay the rest. By 2014, CBO projects that 46 percent of Medicare spending will come from general revenues, assuming no changes in the current law requirement that Part B premiums pay for 25 percent of Part B costs. Something has to give, but the candidates avoid all talk of hard choices.

IV. Different Approaches to Fiscal Policy

The fact that the candidates’ budget proposals share weaknesses and would have a similar effect on the 10-year deficit should not obscure the fact that there are fundamental differences ? in substance, procedure and perspective.

What to do about the expiring tax cuts of 2001 and 2003?

  • The dominant policy initiative of the Bush budget is to permanently extend most of the tax cuts enacted in 2001 and 2003.[26] These tax cuts are all scheduled to expire by the end of 2010. Extending them will cost about one trillion dollars over 10 years.
  • Senator Kerry proposes to roll back the 2001 and 2003 tax cuts for those with incomes above $200,000 and to reform rather than eliminate the estate tax. He estimates that this would produce $860 billion of revenue over 10 years.[27] Much of this revenue gain is assumed in the CBO baseline because all the 2001 and 2003 tax cuts expire in 2010. Relative to the CBO baseline, therefore, this is a savings of less than $300 billion. The claimed savings of $860 billion is relative to the Bush budget, which assumes that all of these tax cuts are permanent.
  • In his budget framework, Kerry dedicates the higher revenue to pay for his health care and education initiatives, which the campaign estimates would cost $860 billion over 10 years ($653 billion for the health care plan and $207 billion for education).
  • Kerry would maintain the “middle class” tax cuts of 2001 and 2003 at a cost of about $500 billion through 2014.[28]
  • Both candidates’ proposals have back-loaded costs. The President’s 5-year budget omits almost 90 percent of the 10-year revenue loss from his tax policy proposals. The cost of Senator Kerry’s health care plan grows by 50 percent between 2009 and 2014.
  • Neither candidate’s tax proposals would help get the deficit under control. The choice is between large tax cuts that are unaffordable and smaller tax cuts with higher spending that are also unaffordable.

Pay-as-you-go - or not?

The pay-as-you-go rule (PAYGO) for tax cuts and entitlement expansions was originally designed during the last period of chronically high deficits to prevent policy changes that would make the situation worse. It did not guarantee deficit reduction or freeze in place all tax and entitlement laws. It did, however, require anyone proposing new tax cuts or entitlement expansions to come up with either a way of paying for them without enlarging the deficit or 60 votes in the Senate to bypass the rule. Both candidates say they want to revive PAYGO, which expired in 2002, but President Bush would do so in a way that redefines and substantially weakens the concept. Senator Kerry would reinstate the original rule, with exceptions for some existing tax cuts.

  • President Bush would exempt all tax cuts from PAYGO and require that entitlement expansions would have to be offset with cuts in other entitlements. The rule would prevent using tax increases to pay for an entitlement expansion. Shifting the focus of budget enforcement to long-term spending control is an appropriate goal, however, prohibiting tax increases as a PAYGO option would encourage the dangerous notion that government benefits have no cost and that debt is a painless alternative to taxation. If policymakers want to add new entitlements, they should either cut other entitlements or face up to the cost and raise taxes ? unlike the example set last year when Congress, with the President’s strong support, enacted a major expansion of Medicare without any effort to offset the cost.
  • The President’s proposal also de-links tax cuts from the need for matching spending reductions, thus allowing any amount of tax cuts to pass without regard to the fiscal consequences. Yet, depending on the circumstances, a tax cut can be every bit as fiscally irresponsible as a spending increase. There is no good reason to grant tax cuts a free pass from all fiscal scrutiny, particularly in the face of resurgent deficits.
  • Moreover, by exempting tax cuts from PAYGO the President’s proposal would encourage an expansion of so-called “tax entitlements” or “tax expenditures” where benefits are funneled through the tax code rather than by direct spending ? an approach generally thought to be far less efficient. The Joint Committee on Taxation estimates that these tax breaks already amount to about $500 billion annually for individuals and another $100 billion for corporations.
  • It should be noted that the President has not applied his PAYGO rule to the new spending he has proposed on the campaign trail. The Agenda for America programs include $38 billion of new spending with no suggestion of offsets. This, along with the Medicare experience of last year, is reason to be skeptical about the President’s willingness to apply PAYGO to either tax cuts or new spending.
  • Senator Kerry says that he will pay for all new initiatives using the traditional PAYGO rule, which applied to both tax cuts and entitlement expansions. Given current fiscal circumstances, this is a responsible proposal and represents a clear advantage over the President’s version of PAYGO. However, a few caveats should be noted:
    • Senator Kerry does not apply PAYGO to extending “middle class” tax cuts ($500 billion). It is unclear whether he would apply PAYGO to the “extenders,” which would cost $175 billion over 10 years to fully extend. In other words, Kerry would potentially exempt nearly $700 billion of tax cuts from PAYGO. President Bush would exempt even more because he would not apply PAYGO to any tax cuts. However, the fact that Kerry does not apply PAYGO across-the-board dilutes his argument that restoring fiscal discipline requires a deficit neutral policy. Exemptions, especially for “priorities,” invite exemptions for everything else.
    • PAYGO is not a deficit reduction tool. Its purpose is to achieve deficit neutrality ? in other words to “stop digging the hole.” Rolling back some of the tax cuts to pay for new initiatives, as Kerry proposes, represents a major shift in priorities from the Bush policies, but it does not reduce the deficit.
    • While PAYGO is a responsible short-term strategy, it does not remedy the huge long-term fundamental mismatch between spending commitments and revenue projections that already exists. As Federal Reserve Board Chairman Alan Greenspan has noted, PAYGO “was designed to constrain legislative actions on new initiatives. It contained no provisions for dealing with unanticipated budgetary outcomes over time. It was also not designed to be the centerpiece for longer-run budget policy.” (Emphasis in original.)[29]
    • Moreover, increased spending for entitlements - even if initially paid for with higher taxes - represents a substantial new commitment of resources. The fiscal responsibility of this must be assessed in light of the fact that federal spending is already on an unsustainable long-term track. Senator Kerry’s proposals would do nothing to remedy that situation. The more spending that is pumped into the baseline, particularly for entitlements, the more that must ultimately be financed by higher taxes or higher debt. Paying for new entitlements is more responsible than not paying for them. But given the existing long-term outlook, it would be better to not add any new entitlements at all.
    • The large amount of new initiatives Kerry has proposed requires him to use over $600 billion of potential offsets that could be used instead for deficit reduction. This does not include the $300 billion of assumed savings in his health care plan.

Discretionary spending caps

The President’s plan assumes a virtual five-year freeze on non-defense, non-homeland security discretionary programs. At best, this is an optimistic assumption. As noted, non-defense discretionary outlays have risen by an average of 5.6 annually over the past 25 years.

  • The President would enforce this 5-year cap with across the board cuts in most programs.

Senator Kerry proposes to hold discretionary spending increases to the rate of inflation, excluding defense, homeland security and education. This is a more realistic assumption than the President’s assumed freeze, but it is still a very optimistic target.

  • Kerry would enforce the cap with across-the-board cuts (again, exempting defense, homeland security and education) and promises to pay for new discretionary proposals by cutting or freezing “non-priority” programs although he has not identified programs he deems non-priority except “subsidies to high-income corporate farmers.” No cost saving is given for cutting back such subsidies.
  • Kerry specifically pledges to “sacrifice some of his priorities, if necessary, to control spending.” This is an important pledge that Kerry should be held to if elected. President Bush has made no similar pledge and he has certainly not sacrificed any of his tax cut proposals in the face of ballooning deficits. However, Kerry’s supposedly tight spending “cap” has an important loophole:
    • He would exempt two of his top domestic priorities, education and veterans’ health, from the cap by turning them into “mandatory” programs. This would make the cap less effective as a deficit reduction tool since it would apply to a diminished pool of spending.
    • It would also boost federal spending since freeing education and veterans’ health programs from annual appropriation decisions would allow them to grow on autopilot. The problem is not that these programs are unworthy but that turning them into entitlements shields them from annual fiscal scrutiny.
    • Entitlements already consume more than half of the budget. This percentage will balloon in the coming decades as the cost of Social Security, Medicare and Medicaid ratchet upward. Putting so much of the budget on autopilot reduces the flexibility of future policymakers to decide for themselves how much to spend and how much to tax. If anything, we should be looking for ways to reduce the number of programs that get entitlement status rather than increasing them.
  • With regard to either candidate’s plan, it is important to note that the potential savings from “getting tough” with domestic discretionary spending is limited by its relatively modest share of the budget. These programs comprise less than 20 percent of the budget. With the exemptions Kerry would make for education and veterans, health the available pool of savings shrinks to less than 15 percent.
  • As noted by the CBO, “If taxation is restricted to the levels that prevailed in the past, the growth of entitlement spending will have to be substantially reduced. Restricting the growth of outlays for defense, education, transportation, and other discretionary programs would not be enough to ensure fiscal sustainability.” (Emphasis added.)”[30]

The fiscal danger is - now or then?

It is a noteworthy aspect of this campaign that both candidates see a manageable fiscal problem and a threatening crisis - in very different time frames. For President Bush, the 10-year deficit is modest and manageable. The real fiscal danger, he says, comes over the long-term as the boomers begin to retire in large numbers. Senator Kerry has expressed much more alarm about the 10-year fiscal outlook, arguing that deficit reduction is linked to fiscal stability. He expresses far less concern, however, about the unsustainable long-term situation.

They are both ducking issues they don’t want to face. For President Bush, it’s potential tax increases. For Senator Kerry, it’s potential entitlement cuts. The credibility of their respective fiscal policy plans is stretched thin because neither will put all policy options on the table.

The Bush Perspective

“While the outlook for the budget improves considerably over the next five years, looking at the budget over a much longer term yields a less encouraging picture… fundamental forces are at work that will create serious fiscal problems if left unaddressed.”[31]

President Bush has expressed a relatively sanguine view of the short-term fiscal outlook. The Administration’s Mid-Session Review of the budget describes the 2004 deficit as “unwelcome” but notes that when measured against the size of the economy (GDP) “it would be smaller than the deficits in nine of the last 25 years and far below the peak deficit in that period of 6.0 percent of GDP in 1983.”[32]

The problem with this argument is that it ignores historical context. Far from being a common occurrence, the nine deficits cited by the Administration that were higher as a share of GDP than this year’s deficit all occurred between 1982 and 1993. These years were the first in our nation’s history that saw such high deficits in the absence of major war or economic dislocation. Climbing out of this fiscal hole ultimately took several major pieces of deficit reduction legislation, the “peace dividend” from the end of the Cold War, an unexpected slowdown in health care costs, an economic recovery of record length and a booming stock market. Such a simultaneous combination of positive budgetary developments cannot be counted on to recur.

More fundamentally, large deficits today pose a bigger threat than they did 10 or 20 years ago because the fiscal crunch of the baby boomers’ retirement years is that much closer. Ideally, current fiscal policy should be aimed at increasing national savings, lowering the debt to GDP ratio, and reducing debt service costs in preparation for the budgetary strains that are in store. Running large deficits would do just the opposite, making this a particularly bad time to run unusually large deficits.

The Administration has also attempted to calm deficit fears by arguing that the deficit is “coming down,” and that “good progress” has been made on cutting the deficit in half. At best this represents an overly complacent spin on the facts. It is true that the 2004 deficit ($413 billion) is not as bad as the February projection ($477 billion). What matters, however, is the bottom line and there can be no denying that a deficit of $413 billion (3.6 percent of GDP) is larger than the 2003 deficit of $374 billion (3.5 percent of GDP).

It is likely that the deficit will come down somewhat in 2005. However, as noted earlier, the President’s claim that he has a “plan” to cut the deficit in half by 2009 must be assessed in light of the omitted items and unrealistic assumptions ? such as no additional funding for operations in Iraq and Afghanistan beyond the $25 billion supplemental request for 2005, a five-year freeze on non-defense, non-homeland security discretionary programs and a major revenue windfall by not including a permanent alternative minimum tax (AMT) adjustment.

Economic growth can help close a budget gap and in his campaign documents the President says he will “continue with pro-growth policies that will increase revenues into the Treasury while holding the line on Federal spending.”[33]

Few would argue with the proposition that spending restraint and economic growth are a good combination for the budget. Yet under the President’s policies to date, revenues as a share of the economy have gone down in every year of his Administration while spending has seen a dramatic increase. See Appendix. Neither the proposed spending restraint nor the estimated economic growth in the President’s budget is enough to avoid permanent deficits when matched with the sizable tax cuts he has proposed.

Deficits persist in CBO’s forecast despite the projection of strong economic growth - beginning with 4.5 percent real GDP growth in 2004 and averaging 3.26 percent annual growth through 2009. By contrast, real GDP growth has averaged 3 percent since 1970. The deficit can no longer be dismissed as a mere “cyclical” event, and there is no basis for concluding that it will simply go away as the economy picks up.

In contrast to its sanguine view of the short-term outlook, the Bush Administration has identified the long-term outlook as “the real fiscal danger.” As described in the President’s FY 2005 budget:

Social Security and Medicare are critical programs for ensuring the financial security and health of elderly Americans, and President Bush is committed to ensuring that these programs continue to deliver benefits both for today’s beneficiaries and for future generations of retirees. Unless these programs are reformed however, over the long run they will overwhelm the rest of the budget and place an unsustainable burden on future generations.

Yet, having correctly identified the problem, the President offers no solution either in his official budget or on the campaign trail.

As noted earlier, he favors private accounts for Social Security but does not explain how to pay for them without chronic large scale borrowing, which would defeat the main purpose of reform.
He does not set aside any funds in his budget proposals to pay for such a huge new initiative, nor does he explain that even with personal accounts something must be done to close the gap between promised benefits under the current system and dedicated revenues.

The Kerry Perspective

“In the last three years, the federal budget has gone from record surpluses to record deficits - which, if left unchecked, can become a fiscal cancer that will erode any recovery and threaten the prospect of a lasting prosperity. Ultimately, as deficits drive up long term interest rates, they will dry up investment and undermine the belief, at home and overseas, that America is worth investing in.”[34]

Senator Kerry’s approach to short-term fiscal policy is much like President Bush’s approach to
long-term policy - he correctly perceives a serious problem but fails to offer a convincing solution. Moreover, he appears to be as sanguine on long-term policy, as President Bush is on the near-term.

In the Kerry fiscal framework there is no plan for dealing with the unsustainable long-term outlook. The subject is barely mentioned, and certainly not in a way to suggest that there is a serious problem. However, the Social Security and Medicare Trustees, Federal Reserve Board Chairman Alan Greenspan, the Government Accountability Office (GAO) and the Congressional Budget Office (CBO) - all nonpartisan entities - have consistently warned that Social Security and Medicare promise far more in future benefits than they can afford to deliver.

Senator Kerry criticizes the amount of tax cuts and increased debt under President Bush, but the Bush tax cuts, even if unwise fiscal policy, did not create the long-term problem and rolling them back would not provide a solution, especially if the revenues gained are redirected into costly new programs.

Even with the cost of Social Security and Medicare expected to double over the next 30 years, Senator Kerry has said he would not reduce benefits. The only alternatives are to raise taxes to match this spending growth, or allow rapidly growing deficits to pile up a debt burden that is unsustainable over the long-term.

On Social Security, his official position is that the program faces manageable challenges. He notes that under current law, “Social Security is projected to be solvent through 2042,” and that “revenues would be sufficient to pay 73 percent of scheduled benefits after trust fund exhaustion in 2042.” [35]

This view of the problem places too much emphasis on the concept of trust fund solvency, which has no economic significance. The trust funds are simply bookkeeping devices and the special issue U.S. Treasury bonds they contain represent nothing more than a promise from one arm of government (Treasury) to pay off IOUs held by another arm of government (Social Security). Thus, when the Trustees say that Social Security is “solvent” until 2042 they are only saying that the program will have explicit claims on the Treasury (i.e., taxpayers) to pay full benefits until that date.

The more important issue is how much paying off the IOUs is going to cost and whether it is affordable. Fiscally and economically, what matters is not the trust fund balance but the operating balance ? that is, the annual difference between outlays and dedicated tax revenues. According to the 2004 Trustees report, by 2018 Social Security’s cash in will no longer exceed the cash out. At that point, the trust fund bonds will need to be converted into cash to pay promised benefits. To do so, Congress will need to cut spending for other programs, borrow from the public, or raise taxes (or some combination of all three). The key point is that the trust fund assets are also taxpayer liabilities. Their existence does not ease the fiscal challenge of paying future benefits.

Medicare provides an even starker example of how trust fund accounting obscures the real issues. Officially, Medicare is said to be “solvent” until 2019. This figure, however, only refers to the Medicare Part A trust fund, which is already spending more than it takes in. Medicare’s other half, the Part B trust fund, is always “solvent” because general revenues automatically plug any gap between beneficiary premiums and outlays. Solvency, however, is not the same as sustainability.

V. Conclusion

Hope springs eternal, and never more so than when it is applied by political candidates to a tough fiscal situation. After all, getting control of a ballooning budget deficit requires two things that candidates are loath to discuss - spending cuts (when they would prefer to talk about increases) and tax increases (when they would prefer to talk about cuts). Yet the American people deserve something more from their candidates than an invitation to a free lunch ? even if that is what they want to hear.

Throughout his presidency, George W. Bush has refused to calibrate his drive for lower taxes with his support for expensive initiatives such as the global war on terrorism and a major expansion of Medicare. There is no reason to expect anything different in a second term.

Senator Kerry promises a different approach, in particular by promising to pay for new initiatives and to scale back his proposals if they cannot be accommodated within the goal of cutting the deficit in half. This seemingly responsible approach is undercut, however, by the sheer magnitude of the new initiatives he has promised and by the vagueness of the offsets he has proposed.

The bottom line is that neither candidate has produced a credible set of numbers to back up his deficit reduction rhetoric. President Bush is too complacent on the 10-year outlook and too vague on how to address the “real” fiscal problem. Senator Kerry expresses much more alarm about the growing deficit, but is vague on how to reduce it, and is much too complacent on the long-term outlook. The only clear advantage is in Kerry’s proposal to return to a more comprehensive concept of PAYGO than the President. However, PAYGO is not a strategy for achieving long-term fiscal sustainability.

The more realistic strategies require meaningful trade-offs. Policymakers can reduce the level of national commitment to financing entitlements for seniors, or plan responsibly to dedicate a much larger share of our economic pie to paying for these benefits and distribute the heavier burden equitably across generational lines. If by default they fail to make these tough choices, the result will be mounting public debt, serious harm to future economic performance, and a much higher tax burden for coming generations of Americans.
Absent a willingness to tackle cost saving reform of existing entitlement commitments, which PAYGO exempts and tax cuts ignore, fiscal policy will remain as unsustainable as it is now ? no matter who wins in November.

APPENDIX

Table 1. Outlays and Revenues (FY2000-2004)
2000 2001 2002 2003 2004
Revenues 2,025 1,991 1,853 1,782 1,880
(billions of dollars)
Revenues 20.9 19.8 17.9 16.5 16.2
(Percent of GDP)
Outlays 1,789 1,864 2,011 2,158 2,292
(billions of dollars)
Outlays 18.4 18.6 19.4 19.9 19.8
(percent of GDP)
Source: Congressional Budget Office, U.S. Department of the Treasury
Table 2. Surplus and deficits (FY 2000-2004)
2000 2001 2002 2003 2004
Surplus/deficit 236 127 -158 -374 -413
(billions of dollars)
Surplus/deficit 2.4 1.3 -1.5 -3.5 -3.6
(percent of GDP)
Source: Congressional Budget Office, U.S. Department of the Treasury

Sources:

[1] August 2000 Congressional Budget Office (CBO) baseline for fiscal years 2001-2010.
[2] See, http://www.concordcoalition.org/federal_budget/0408PlausBaselinechart.pdf. for The Concord Coalition’s plausible baseline scenario.
[3] David M. Walker, “Truth and Transparency: The Federal Government’s Financial Condition and Fiscal Outlook,” September 17, 2003, available at www.gao.gov.
[4] CBO, The Long-Term Outlook, December 2003, p. 9.
[5] CBO, The Long-Term Outlook, December 2003, Executive Summary.
[6] CBO, The Budget and Economic Outlook Fiscal Years 2005-2014, January 2004 p.5.
[7] Estimates of the first three provisions are based on Table 2B, “Senator Kerry’s Tax Proposals,” The Tax Policy Center, July 23, 2004. See http://www.taxpolicycenter.org/UploadedPDF/1000634_KerryPlan.pdf. An adjustment has been made for tax cut extensions advocated by Kerry that have now been enacted.
[8] Tax Policy Center estimate assuming that Senator Kerry’s entire tax plan is enacted. See above.
[9] Kerry’s framework includes $35 billion in energy and environmental initiatives. Some of the offsets proposed are too vague to be relied upon, such as cutting federal electricity costs by 20 percent.
[10] Includes an offset of $10 billion for a one-time tax “repatriation holiday” for corporate foreign earnings.
[11] Credit is given here for the campaign’s presumed savings of about $300 billion. The campaign relies on a published estimate by former Deputy Assistant Secretary of Health and Human Services Kenneth Thorpe. http://www.sph.emory.edu/hpm/thorpe/kerry8-23-04.pdf.
[12]According to the campaign, this total represents the additional cost of these proposals assuming that Senator Kerry’s other health care proposals are enacted. The campaign notes that a stand-alone version of these proposals would cost more. Kerry proposes to offset this with efficiency savings by cutting 100,000 contractors. This may be a good idea but it is not sufficiently detailed to be relied upon as an offset, particularly for entitlement spending.
[13] The Kerry campaign estimates that this option will cost $60 billion to $80 billion over 10 years, offset by “streamlining various large weapons programs, emphasizing electronics, advanced sensors and munitions in a ‘systems of systems’ approach to transformation, reducing total expenditures on missile defense, and further reforming the acquisition process.” No credit is given here for this offset because it is not sufficiently detailed.
[14] Based on CBO’s March 2004 estimate of the President’s tax proposals. This number includes revenue and outlay effects of tax cut extensions already passed by Congress.
[15] Adjusted for temporary extension of certain tax provisions already passed by Congress.
[16] The President’s budget contains an unspecified “contingent offset” for this expense. No credit is given here for this offset because no details are provided in the budget.
[17] See, for example, the discussion of discretionary spending on page 7. A total deficit projection would also include assumptions about items not in the CBO baseline ? most notably likely changes in the alternative minimum tax for individuals ? and the impact of debt service costs on all changes.
[18] In the President’s Commission Model One, after bankruptcy, Social Security’s cash deficits widen into the indefinite future. Models Two and Three both technically remain solvent throughout the valuation period (i.e., the next 75 years) but only because they authorize the transfer from Treasury of whatever sum might be needed on an annual basis to prevent the trust fund ratio from falling beneath 100 percent. In addition, Model 3 includes a special schedule of general revenue transfers that are set in advance. All of this comes on top of the draw down of existing trust fund assets. In Model Two, the borrowing would commence in 2025 and last all the way to 2054 (29 years). In Model Three, it would commence in 2034 and last all the way to 2065 (31 years). Under either option, the deficit impact on the federal budget would begin immediately and last until the 2040s, that is, for nearly half a century. However, it should be noted that Models 2 and 3 would reduce Social Security’s long-term general revenue requirement relative to current law.
[19] See estimate by former Deputy Assistant Secretary of Health and Human Services Kenneth Thorpe. http://www.sph.emory.edu/hpm/thorpe/kerry8-23-04.pdf.
[20] See http://www.aei.org/docLib/20040913_KerryBushHealthPlans.pdf. See also, Dr, Thorpe’s rebuttal at http://www.sph.emory.edu/hpm/thorpe/Comparison%20of%20Thorpe%20and%20AEI%20Estimates%20for%20the%20Kerry%20Health%20Plan%20(2).pdf.
[21] This estimate would be even higher without the assumption made in the Trustees Report that per capita health care spending will slow from its historic pace.
[22] Estimates of coverage of the uninsured come from former Deputy Assistant Secretary of Health and Human Services Kenneth E. Thorpe, May 5, 2004 and from “Analyzing the Kerry and Bush Health Proposals: Estimates of Cost and Impact,” Joseph Antos, Roland King, Donald Muse, Tom Wildsmith and Judy Xanthopoulos, American Enterprise Institute, September 13, 2004.
[23] The Kerry campaign says that its budget plan assumes $100 billion for war expenses. This number does not appear in the campaign’s published cost estimates or baseline assumptions. No money is set aside in the President’s FY2005 budget for war-related activities beyond the funding already approved.
[24] President Bush’s budget does assume extension of some provisions. The largest of these is extension of the Research and Experimentation tax credit. The CBO estimates that this proposal would reduce revenues by $23 billion over five years and $58 billion over 10 years. Senator Kerry’s budget framework does not mention extension of the R&E tax credit, although he is in favor of extending it.
[25] CBO, The Outlook for Social Security, June 2004 p.1.
[26] President Bush does not propose extending the partial expensing provision for businesses that is scheduled to expire at the end of 2004.
[27] The Tax Policy Center estimates that the savings would be $792 billion relative to the Bush budget. See, Table 2B, “Senator Kerry’s Tax Proposals,” The Tax Policy Center, July 23, 2004. See http://www.taxpolicycenter.org/UploadedPDF/1000634_KerryPlan.pdf.
[28] This reflects the enactment of tax cut extensions passed by Congress on Sept.23, 2004.
[29] Alan Greenspan, prepared testimony before House Budget Committee, September 8, 2004.
[30] CBO, The Long-Term Outlook, December 2003, Executive Summary.
[31] Fiscal Year 2005 Budget pp. 38-39.
[32] Office of Management and Budget (OMB), Mid-Session Review, July 2004 p.2.
[33] The Bush Record, Jobs & The Economy, Frequently Asked Questions, at georgewbush.com.
[34] John F. Kerry, “A Return to Fiscal responsibility,” April 7, 2004, Georgetown University.
[35] johnkerry.com, A Plan to Strengthen Medicare and Social Security.