April 18, 2014

The Case For Budget Surpluses

The recent rapid decline in the federal deficit has prompted some to conclude that we're heading for a long era of large budget surpluses. In a previous alert, we explained why this hoopla is premature. At best, we can expect a brief period of minor surpluses lasting several years beyond 2002, and even these won't materialize if the economy falters or if Congress fails to follow through on the back-ended spending cuts called for in this year's budget deal. After that, the deficit will again explode -- unless senior entitlements are reformed.

Still, the subject of surpluses is worth serious attention. As it turns out, many who are predicting large surpluses think it would be a mistake to run them -- and this kind of thinking may make entitlement reform (and the surpluses themselves) less likely. According to an emerging anti-surplus school, made up mostly of supply-side conservatives eager to tax less and big-government liberals eager to spend more, paying down the national debt would be an unwise use of public resources.

They're wrong. Running a substantial budget surplus of perhaps 1 to 2 percent of GDP over the next decade or so would be enormously beneficial for the economy. Indeed, if one considers the basic principles of public finance, the huge generational imbalance in today's budget policy, and America's anemic savings rate, the case for surpluses is so compelling that one wonders how critics have managed to obscure it.


Public Finance 101

Let's start with Public Finance 101. Economic efficiency requires that taxes be held relatively stable at a level sufficient to pay for public spending in all future years, regardless of whether this leads to surpluses or deficits in any given year. It makes no sense to cut taxes today if that cut will only necessitate raising taxes tomorrow. Over the business cycle, this principle is consistent with counter-cyclical fiscal policy: It implies that the federal balance should rise during expansions and fall during recessions. Over the longer run, it implies that revenues should exceed spending when economic circumstances are favorable so that they can be lower than spending when circumstances are not.

So what are our circumstances today? They are clearly favorable -- indeed, more favorable than they have been for many decades or are likely to be for many decades to come. Since the end of the Cold War, defense spending, as a share of the economy, has sunk to its lowest level since Pearl Harbor. With the expansion still chugging along, tax revenues are up and welfare spending is down. Most important, a large (Boom) generation is swelling the ranks of working-age Americans while a small (Depression-era) generation is retiring.

But the world cannot indefinitely remain as peaceful or as recession-free as it is today. And we know that America's Demographic Indian Summer will not last much longer. As the age wave hits the budget starting around 2010, entitlement spending will begin a decades-long spiral that the CBO projects will raise total federal outlays by nearly 50 percent as a share of GDP.

Many supply-siders in the anti-surplus school seem to believe that debt is a painless alternative to taxes. The truth is that deficits merely shift the tax burden toward the future, while surpluses shift it toward the present. An efficient tax policy would require us to pay for some of the coming explosion in entitlement costs today -- that is, it would require us to run surpluses. If we want to reduce the size of the requisite surpluses, we must reduce long-term spending growth. But ironically, those who argue most vociferously against surpluses generally have the least to say about how to do this.


Fairness to Our Kids

Beyond economic efficiency, there's also the question of generational equity. A fair budget policy should ensure some correspondence between how much a generation pays to government and how much it gets back in return. But younger generations are destined to pay far more than older generations in exchange for no more and possibly less. Economist Larry Kotlikoff calculates that, even with this year's budget deal, the lifetime net tax rate faced by today's newborns will exceed 60 percent, double the rate faced by Americans now retiring.

While the Concord Coalition has long advocated entitlement reforms that would dramatically reduce the long-term growth in federal spending, no realistic array of reforms will allow an aging America to hold spending to today's level. Simple fairness to our kids therefore dictates that we run budget surpluses today so that government can afford to borrow a bit more tomorrow.

It's worth recalling that this was the original logic behind the 1983 act that gave rise to today's Social Security surpluses. As Senator Moynihan explains, the assumption was that government would translate these trust-fund surpluses into unified budget surpluses of equal size, and therefore into genuine economic savings. In this way, Boomers would prefund their own retirement and reduce the economic burden on younger generations. Unfortunately, it didn't work out that way.


The Wealth of Nations

Finally, there's our anemic savings rate. The U.S. net national savings rate is already low relative to other developed nations and to our own long-term history. In future decades, a do-nothing fiscal policy would push it still lower, ultimately driving it beneath zero.

This brings us to history's bottom line, as insisted on by one economic luminary after another, from Adam Smith to Karl Marx to Alfred Marshall to John Maynard Keynes. No country can enjoy sustained living standard growth without investing, and no country can sustain high investment for long without saving.

These thinkers all understood that a rising living standard is a function with many variables. But they all agreed that capital formation is a necessary condition. Moreover, it is the one condition a society can directly control. We cannot legislate technological breakthroughs -- or even a higher private savings rate. But we can legislate a budget surplus, and surpluses add to national savings just as surely as deficits subtract from it.

The case for surpluses becomes all the more compelling if we recall that other developed nations are aging too, some more rapidly than America. Without reform, the widening pension deficits of the G-7 countries would, by 2030, consume all of G-7 savings. As a nation that has gotten into the habit of borrowing from abroad (currently at the rate of about $160 billion per year), the overseas age wave will narrow our options. To maintain even a minimum level of domestic investment, America will have to save more on its own.


Old Chestnuts

Confronted with these arguments, the anti-surplus school flails about for a coherent response. Some critics attack the goal of a surplus (or even budget balance) on the grounds that conventional accounting is arbitrary and misleading, and that, properly measured on an accrual basis, the federal budget today is already running a surplus. Even if this were true, it is irrelevant. All of the above arguments would still support raising public-sector savings, regardless of whether our "true" federal budget balance is now a surplus or a deficit.

But in fact, the critics are mistaken on the accounting issue as well. Yes, they may be right that inflation lowers the real value of the national debt and that federal investment purchases can be regarded as taxpayer assets. But all of this is dwarfed by the mountain of unfunded retirement liabilities that accrual accounting would require us to acknowledge. Any plausible method of amortizing this lien on our future (now totaling at least $15 trillion) would reveal our accrual budget to be even deeper in the red than our cash budget.

When all else fails, there's always the oldest chestnut of all -- namely, that the national debt doesn't matter because we only owe it to ourselves. (Except, of course, for the 28 percent and rising we now owe to foreigners.) Ever since Adam Smith, economists have been exposing this free-lunch myth, but it somehow keeps popping up. So let's roast this chestnut one more time.

Yes, the debt that taxpayers owe is balanced by the bonds that taxpayers own. But while it is true in this accounting sense that public debt is a wash, the original savings the debt displaced was not. That original savings, had it been invested in the real economy, would have generated a stream of income that would not otherwise have existed -- whereas, invested in government bonds for the purpose of financing consumption, it merely transfers existing income from one person to another. It may not matter much to private savers whether their dollars end up purchasing a tractor or a T-bill. But it matters a great deal to the economy.


Perfectly Sound Policy

Concord hopes that common sense prevails, and that America's leaders get serious about the kind of reform that might lead to substantial budget surpluses. Simply using these surpluses to pay down the national debt would be perfectly sound policy. But the surpluses could be saved in other ways as well. A portion might be devoted to higher public investment spending -- or, alternatively, to defraying the up-front costs of transitioning to a funded system of personally owned Social Security accounts.

Either way, the benefits would be enormous. The case we now hear against surpluses is no more persuasive than the case we used to hear against balanced budgets. This isn't surprising, since they fall flat for the same reasons.


The Concord Coalition web pages were designed by Marla Parker and Krista Reymann. These pages are now maintained byCraig Cheslog. Last updated: 8 Sep 1997