July 16, 1999

Federal Budget Surpluses:
An Opportunity We Can’t Afford To Waste

by Robert Kleine, Vice President and Senior Economist

A debate is raging in the halls of Congress and elsewhere about what to do with the projected budget surpluses, which are expected to total $6 trillion over the next 15 years. In late June the Federal Office of Management and Budget issued new surplus estimates based on real gross domestic product (GDP) growth of 2.5 percent, up from 2.3 percent earlier in the year; the growth pushed the surplus estimate from $5 trillion to $6 trillion. These figures are only forecasts, and much can change over the next 15 years, but growth of 2.5 percent is a reasonable expectation. The exhibit below shows that real GDP growth has exceeded 2.5 percent in every decade since 1960.

The Proposed Plans

Everyone has a plan for using the surplus. For example,

• the president wants to use most of the surplus to guarantee the solvency of Social Security and Medicare and create a new voluntary drug benefit for seniors;
• other Democrats would like to spend more money on programs such as Head Start, school vouchers, job training, and college tuition guarantees; and
• the Republicans would like to return much of the money to taxpayers.

There are benefits and drawbacks to all of these plans. The president’s proposal would allow for the elimination of the national debt (the debt held by the public is about $3.7 trillion), freeing up most of the nearly $250 billion currently spent yearly on interest to fund Social Security and Medicare. The president’s plan of paying off the debt would reduce real interest rates and encourage investment. There are two potential problems, however, with this course of action: First, reducing the debt takes money out of the economy, inhibiting growth. While diverting money out of the economy probably would not present a problem in the current economic boom, this move could combine with other factors in the future to push the economy into a recession. The second potential problem is that the long-term government bond market would be eliminated (the government would still need to borrow for short term cash flow needs). As a result, the Federal Reserve Board (Fed) would lose an important monetary tool: buying and selling treasury securities to adjust liquidity.

The Republicans’ plan for large tax cuts makes good sense at first glance. If the government collects more money than it needs, why not return it to the taxpayers? Furthermore, tax cuts increase disposable income and stimulate economic growth. There are three problems, however, with this proposal: First, the economy is already growing too fast in the opinion of the Federal Reserve Board, which just raised interest rates in an attempt to slow economic growth. A tax cut would make the economy grow faster and force the Fed to raise interest rates. A second, related problem is the current excessive rate of consumption at the expense of savings (the savings rate is currently negative), which would be further stimulated by a tax cut. Third, if taxes are cut before the Social Security and Medicare funding problems are solved, future taxpayers will be faced with either large tax increases or a sharp cut in program benefits.

Public Sector’s Proposed Plan

There is no perfect plan that will satisfy everyone, but we believe that it is possible to put together a proposal that avoids over stimulating the economy, protects future taxpayers, improves the equity of the tax system, ensures the solvency of Social Security and Medicare, and invests in programs that will stimulate future economic growth and reduce social costs. Such a proposal would recommend the following actions:

• Allocate 30 percent of the surplus to a rainy day fund to be used to (1) fund future Social Security and Medicaid needs and (2) give the government flexibility to reduce taxes (by reducing marginal income tax rates) in periods of below-average economic growth.
• Allocate 45 percent of the surplus to reduce the federal debt to about $1 trillion. This would free up about $150 billion in interest savings each year and would retain a modest federal bond market, leaving the Federal Reserve Board with continued clout.
• Allocate 15 percent of the surplus for immediate tax reductions, such as increasing the earned income tax credit, raising the personal income tax exemption, expanding individual retirement accounts, and reducing capital gains taxes.
• Allocate 10 percent of the surplus for investing in early childhood education, college tuition support programs, geographic areas with a high concentration of poverty, and infrastructure improvements, such as building or repairing schools.

We have an opportunity that may not come again—certainly not in our lifetime—to raise the standard of living of every American, prolong the current economic expansion well into the next century, guarantee the solvency of our major health and income support programs, and arguably, to put federal finances on the strongest footing in our 223-year history. Every American should follow the debate closely and make his or her views known to the appropriate elected representatives. While politicians will decide the issue, the public should be deeply involved in that decision.