April 17, 1998

Budget Surpluses as Far as the Eye Can See:
Can It Be True?

by Robert J. Kleine, Vice President and Senior Economist

Last week the Congressional Budget Office (CBO) estimated that the federal budget surplus for FY 1997–98 would be about $15 billion, up from its earlier estimate of $8 billion. The new estimate, however, may still be much too low. The Federal Reserve Board estimates that the surplus could be as high as $75 billion, and some Wall Street estimates are as high as $100 billion. If the surplus for April and the remainder of the year is equal to the $89 billion surplus posted in the second half of FY 1996–97, the surplus would be $18 billion, but most budget analysts expect this year’s second-half surplus to be larger than last year’s. If revenue grows as fast in the second half of the fiscal year as it did in the first, the surplus could reach $75 billion.

These numbers are difficult to comprehend, particularly given that the federal budget has not been in surplus since 1969 and the deficit was $290 billion in FY 1992. In May 1996 the CBO projected the deficit for FY 1998 at $194 billion, rising steadily to $285 billion in 2002 and $403 billion in 2006. What has happened to change these forecasts? The main cause has been stronger-than-expected economic growth, which has increased federal revenues. The current CBO projection for revenues is $136 billion higher than the 1996 projection. Also, projected expenditures are $65 billion lower, principally in mandatory spending programs, such as Medicaid, Medicare, food stamps, and unemployment compensation.

Although the budget outlook has improved markedly, it is still not quite as good as it appears. The reason for the projected budget surplus is that Social Security revenues are now well in excess of expenditures—$100 billion according to the March 1998 CBO estimate. The on-budget deficit, which excludes Social Security and several small trust funds, was projected at $92 billion. In effect, the Social Security surplus is being used to finance other government operations. In about 30 years, however, the Social Security Trust Fund will begin to run large deficits that will require tax increases or benefit cuts if the system is to remain solvent.

The big question is, What do we do with the projected budget surpluses? The March CBO report projected that budget surpluses would total $679 billion over the next ten years (see exhibit). The latest estimates would push the total ten-year surpluses to over $1 trillion. Most economists favor paying down the federal debt held by the public, which totals $3.8 trillion. This would result in lower real interest rates and likely produce faster economic growth. Most supply-side economists, however, favor reducing tax rates. A $75 billion surplus would finance a ten percent reduction in the federal income tax. Tax cuts would increase consumption and also stimulate faster economic growth. Others, largely from the liberal end of the political spectrum, believe that the money should be invested in new schools or health care for needy children. There already is a huge spending bill to finance transportation infrastructure improvements moving through Congress that many lawmakers argue will make the economy more productive. President Clinton and others also have proposed using the surpluses to shore up the Social Security system. One interesting idea is to use the surpluses to set up privately-managed individual retirement accounts for every American, which would be used to supplement Social Security. Those who support full (or partial) privatization of the Social Security system would like to use the surpluses to cover the huge transition costs of moving from the current system to a privatized one.

The idea of paying down the debt is quite attractive. Long-term projections prepared by the Office of Management and Budget (OMB) indicate that it might be possible to retire the entire federal debt in about 30 years assuming steady, moderate economic growth. This may be somewhat optimistic as it is unlikely the economy could continue to dodge a recession (or several recessions). Also, the political pressure to reduce taxes or increase spending likely would be too great to resist.

One reason the OMB projections are so favorable is the large savings on interest payments that would result from reducing the debt. In FY 1998, interest payments are projected at $245 billion, almost 15 percent of total outlays. The March CBO budget outlook, which now appears pessimistic, projected interest payments at $194 billion in 2008, only 8 percent of total outlays.

We caution that if the surplus is used to increase spending or reduce taxes, it will overstimulate an already robust economy. This could lead to higher inflation, which would cause the Federal Reserve Board to raise interest rates, offsetting the economic benefits of the tax cut or spending increase.

Our view is that the projected surpluses should not be used until agreement is reached on a long-term plan to shore up Social Security. Once this is done, any remaining surpluses should be used to fund a new "rainy day" fund (similar to Michigan’s Budget Stabilization Fund) and pay down the federal debt. The rainy day fund could be used to finance tax cuts or spending increases when the economy begins to show signs of slowing down.

The projected federal budget surpluses provide us with a rare opportunity to put our financial house in order and to adopt policies that will increase the possibility of sustained economic growth for a period of years not previously imagined. To do this, Congress and the President must avoid the temptation to pander to the public and special interests with tax cuts and new programs. This President and this Congress have the opportunity to leave a positive legacy that will last well into the 21st Century.