VIEWPOINTS : Huge Deficits Won’t Go Away Until Basic Changes Are Made in Budget

A large and persistent deficit in the federal budget is like a loud and unusual noise coming from the engine of your car. It is a clear sign that something is wrong and that you had better get it fixed or you will wind up sitting beside the road. It is futile to think that it will eventually fix itself if you just wait long enough.

Unfortunately, the budget proposed last week by the Reagan Administration is similar to pouring a large dose of heavyweight oil into the engine to quiet the noise rather than fixing the problem.

The crucial assumption that made it possible to suggest that the budget would be balanced in 1991 is based on a totally unrealistic decline of market interest rates. Some very hard, real choices still have to be made, and it’s about time that our elected representatives--both in the Administration and in the Congress--went about doing their jobs.

Deficits tell us that real tax burdens have not been reduced even if tax rates have been cut.

Future taxes must be higher as a consequence of present deficits, but there are two alternative ways to raise them in the future: explicit hikes of tax rates or the hidden-but-effective tax of inflation.

Our society must live with some combination of three unpleasant courses of action.

First, Congress and the President could agree on sharp reductions in federal spending--such as Gramm-Rudman requires.

Second, they could agree on substantial increases in future explicit taxes--but, that is not likely.

Third, our elected representatives could continue to stalemate on fiscal priorities, which would ultimately result in economic stagnation or re-accelerating inflation.

Before the 1980s, the United States had not experienced long-term structural deficits in the federal budget.

Deficits occurred during time of war but were eliminated during peacetime as military expenditures were reduced. On other occasions, deficits occurred during recessions but were eliminated during economic recovery.

The situation started to change in the early 1970s and became institutionalized in the 1980s.

Before 1972, decisions to increase spending on specific programs required legislation by Congress. Social Security benefits and other payments to individuals, as well as all other programs requiring larger outlays, necessitated votes by both Houses of Congress and a signature by the President before spending rose.

Rules Changed

Legislation to index various “entitlement” programs changed the rules so that payments increased automatically as a result of inflation. By the end of the 1970s, most of the outlays of the federal budget were indexed in one way or another. That meant that when inflation increased, government spending also increased.

Starting in 1985, personal taxes began to be indexed. However, indexing taxes is the opposite of indexing expenditures.

Before indexation of the personal income tax structure, higher inflation increased tax revenue as a share of gross national product because individuals were pushed into higher brackets--a phenomenon known as “bracket creep.”

Indexing the tax structure means that tax brackets are shifted to prevent bracket creep, so revenue no longer increases automatically--in contrast to indexing the expenditure side of the budget which causes outlays to increase automatically.

These institutional changes, together with the policy decisions in 1981 to increase federal defense spending and reduce personal taxes gave rise to the deficit problem.

Even if the economy were at full employment and capacity utilization, the federal budget deficit would be between 3% and 4% of the GNP.

Furthermore, the relatively high market interest rates mean that interest expense on the national debt rises persistently as a share of the total budget and national income, so the deficits will grow larger if something is not done to prevent it.

To understand the kinds of public policy choices that must be made in view of the deficits, it is useful to look at changes in the composition of the budget over the past two decades.

In the early 1960s, total government spending was close to 19% of the GNP, with the non-defense share of the budget slightly exceeding the defense share. Defense spending amounted to about 9.5% of the GNP and non-defense spending almost 10%.

During the remainder of that decade, military expenditures grew rapidly as a result of the Vietnam War. However, non-defense expense also grew rapidly as the “Great Society” programs got under way.

Nevertheless, since inflation accelerated throughout the period and average real growth was high, the total federal budget ended the decade at only a somewhat larger share of the GNP.

The final year of the decade, 1969, was the first year of a new presidential term and the beginning of the winding down of the Vietnam War expenditures.

It was also the last year that there was a surplus in the federal budget (due principally to the surtax on personal and corporate income taxes that had been initiated by the Johnson Administration in its final year). The defense spending share had fallen slightly to 8.9% of the GNP while the non-defense share had grown to 10.8%.

Tax revenues from both personal and corporate income taxes in 1969 were 10% higher as a result of the surtax; otherwise a substantial deficit would have occured.

Nevertheless, the year represents an important turning point of social priorities. Both Congress and the Administration were committed to winding down the Vietnam War and reducing defense spending in order to make room in the budget for greater spending on social programs.

The shares of the federal budget were destined to change. That agenda was fulfilled during the next 10 years.

Defense Share Fell

Between 1969 and 1979, the defense spending share of the GNP fell by 4.2 percentage points while non-defense spending rose by 5 percentage points.

Tax revenue fell as a percent of the GNP in the early 1970s after the surtax expired, and it was still slightly less than 19% in 1979.

Spending by government had risen slightly to 20.5% of the GNP, so there was a deficit of about 1.5% of the GNP.

A second turning point of social priorities started to occur in 1979. It was the year of the second “oil shock” after the Shah of Iran was overthrown.

U.S. citizens were taken hostage in the embassy in Tehran, and other political and/or military developments in such diverse places as Afghanistan, Angola and Nicaragua created public support for greater defense spending.

However, there was no clear consensus that non-defense spending could or should be cut sufficiently to make room for the greater defense spending, and there was no support for additional taxes.

The recent deficits reflect the failure of the political process to set priorities.

It would be incorrect to say that the deficit was caused solely by increased defense spending, or solely by tax cuts, or solely by increased transfer payments.

Comparing figures for 1969--the year of the last surplus in the budget--and 1985 reveals the sources of the deficits: Tax revenue fell from 20% of the GNP in 1969 to 18.6% last year, which accounts for about one-fourth of the deficit; defense spending last year was 6.4% of the GNP, down from 8.9% in 1969, so none of the difference is associated with defense spending even though defense spending is now a larger share of the GNP than it was at the end of the 1970s.

Interest expenses on the national debt amounted to 3.3% of the GNP in 1985, up from only 1.4% in 1969, so about a third of the deficit is associated with borrowing money to pay interest on previously borrowed money. To that extent, deficit spending causes more deficit spending.

Biggest Difference

The biggest difference between 1969 and 1985 was in transfer payments made by the federal government.

In 1985, such payments added up to more than 11% of the GNP, compared with 6.4% in 1969.

Payments for such things as Social Security, Medicare, Medicaid, veterans benefits, federal pensions and disability are required by current law, so they are called “entitlements.”

While the laws require that such payments be made, there is no requirement that taxes be raised when outlays increase. In the case of Social Security and Medicare, the employment tax does generate sufficient revenue to cover current payments.

Other transfer payments must be paid out of general revenue or deficit financing.

Last year, the total of defense, interest expense, and entitlements added up to nearly 21% of the GNP.

Since the remainder of government spending was only 3.2% of the GNP, about the same as in 1969, the deficit could not be balanced by cutting out everything else. That is why so many people say a tax increase is unavoidable.

However, President Reagan believes that higher taxes will not reduce the deficit, but would only result in increased spending.

He has indicated a willingness to consider a structural tax increase only if there is some type of cap on federal spending, such as a balanced-budget amendment to the Constitution.

The budget proposals submitted by the Administration to Congress last week are based on the assumption that real output growth will both be about 4% for the rest of this decade, and that inflation and interest rates will continue to fall.

Assuming that, the Administration has made numerous proposals for reducing the non-defense share of the budget so that balance is reached in 1991.

At that time, according to the budget, total federal spending and tax revenue would be 19% of the GNP.

Former President Jimmy Carter had set a goal of balancing the budget at 20% of the GNP, and in 1981 President Reagan proposed a balanced budget at 19% of the GNP.

The lastest Administration budget proposals reflect the same priorities as five years ago.

Shift in Spending

In 1991, proposed defense spending would be 6.2% of the GNP, down slightly from 1985. Transfer payments would fall by one percentage point to 10% of the GNP.

In other words, President Reagan is proposing to move toward a balanced budget partly by rolling back a part of the growing share of the national income that went into transfer payments during the 1970s.

The most questionable assumption in the Administration’s budget proposals is that interest rates will fall sharply so that interest expense on the national debt falls from 3.4% of the GNP last year to under 2% of the GNP in 1991.

Most private forecasters expect the interest expense share to continue rising. Even if interest expense were the same share, the difference is more than $80 billion.

The Congressional Budget Office is likely to conclude that the deficit in 1991 will still be well over $100 billion.

To the extent that Congress does not agree with the Administration about reducing the non-defense share of the budget, or does not accept the assumption of a sharp decline of interest rates, it can still achieve a balanced budget only if members vote to raise taxes and override any veto.

Given the existing deficits, defense spending cannot be cut enough to balance the budget.

Congress might persuade the President to go along with a temporary anti-inflation, deficit-reduction surtax (similar to President Lyndon B. Johnson’s) to reduce the current deficit. But the structural deficit problem would still have to be addressed sometime.

Temporary Relief

Increased inflation would provide short-term relief, since most categories of government spending would lag behind the faster growth of nominal GNP and tax revenue.

That makes it temporarily easier to live with deficits but doesn’t make them go away.

Higher inflation means higher interest expense on the national debt as well as larger cost-of-living adjustments for entitlements in the future.

The best bet now is that the Administration and Congress will not be able to agree on either spending cuts or tax increases this year, but that inflation will start to increase.

Real growth will be faster this year, more jobs will be created, and the unemployment rate will fall toward 6%, so a feeling of prosperity will grow.

But, issues concerning fundamental social priorities will not be resolved, the deficits will still be enormous and the debates during the 1988 presidential campaign will address these same topics.