A multiple-choice question (from Regis Philbin’s show):

• What is the best thing to do with the budget surplus?– (a) Reduce the debt – (b) Increase government spending– (c) Cut taxes – (d) All of the above

The correct answer is (d), “all of the above”

• If that was your answer, then the next question is: – In what proportions?– For debt reduction, for spending increase, for tax cut

• 2-1-1? • 2-2-0?• 4-0-0?• Before you answer, let’s look at a few facts about

the surplus.

Is there really a surplus?

• Look at the handout: in the columns at the right, you see many, many, negative numbers, which are deficits. – tax revenues were less than government

spending.

• But, starting in 1998, the minus sign disappears; there is a surplus. – tax revenues are now greater than spending.

Surplus and debt

• When the government runs a deficit, it increases its debt

• When the government runs a surplus, it reduces its debt

• surplus (‘98) = debt (end ‘97) - debt (end ‘98)• 69 = 3771 - 3720 (+ 18 in new loans)

• Government borrows by issuing bonds– and retires or buys back bonds when in has a surplus

What happened?

• How could forecasters have been so wrong?

• Tax increases? – No that was in 1993,– and was small compared to the tax cuts in the

early 1980s.

Income growth for upper income taxpayers was very high.

• From 1994 to 1998 the percentage of taxpayers

with more than $200,000 in income rose rapidly from 1.1 percent to 1.6 percent.

• The percentage of all income in the United States earned by this group also increased, from 15 percent to 22 percent.

• And the share of taxes paid by this group rose from 30 percent to 40 percent.

Federal budget summary (billions of dollars)

Fiscal year 1998 versus 1995Tax revenues 1720.4 1351.8 Expenditures 1651.4 1515.7 Defense 270.4 272.1 Interest 243.4 232.2 Soc. Sec. 379.2 335.8 Medicare 192.8 159.9 Surplus 69.0 - 163.9

Debt as a share of GDP

• Debt/GDP can stay constant or even fall when there is a budget deficit

• Example– 5% growth of GDP– then ratio stays constant if

• Debt/GDP = Debt(1.05)/GDP(1.05)• thus $3.7 trillion times (.05) = $185 billion deficit

• Debt/GDP ratio falls with balanced budget

29_04

1950

High after WWII

19951955 1960 1965 1970 1975 1980 1985 1990

PERCENT

OF GDP

60

50

40

30

20

10

0

Steady declinewith small deficits,

some surpluses

Big deficitsstart

Post-WWII bottom

Late 1980splateau

Deficitsareback

80

70

Ratio declining again

2000

What is the forecast for the future?

• Look at the bottom row of the handout.

• Forecast of the budget surplus in the future—as far as the eye can see.

• Note that there are two parts to this– on-budget– off-budget

• Many assumptions go into this forecast.

Assumptions for revenues

• The strength of the economy• The extent to which people will move into higher

brackets• The CBO assumptions for both are conservative. • Most likely the economy will be stronger—Blue

Chip is at 4.1 versus 3.3 for CBO in 2000.

Assumptions for spending

• Discretionary spending depends on what Congress does, on who the next president is, etc.

• CBO has three alternatives (see charts in handout):– Inflated baseline

– Capped baseline

– Freeze baseline

• None are obviously good goals

Time for an answer

Debt Reduction

• A bipartisan consensus has developed that we should run an overall surplus no smaller than the off-budget surplus—that is the social security surplus.

• Now that is a good idea.• The important thing to notice is that even if the

budget is no greater than this there is still a tremendous amount of debt reduction.– Is it enough?

Spending

• Proposal: Increase spending by more than the capped baseline scenario, though not as rapidly as the inflated baseline – see handout.

• Would expect government to achieve some gains in productivity.

Taxes

• Look at handout again: – as a share of GDP, federal taxes are as high as

they have been since WWII. – It certainly seems feasible to reduce them, say

by about 1 percent of GDP.

• Would also be helpful for the economy– would lower marginal tax rates.

Conclusion and summary

• We have projections of surpluses over the next 10 years of about $4 trillion. – That is based on pretty sound assumptions.

• A balanced approach to these surpluses:– drawing down debt by 1/2 of that.– a spending increase for another 1/4, – tax cut that is about 1/4

• The proportions are 2-1-1, – Not 4-0-0 or 2-2-0– So there is room for a good debate

The End