Cutting Deficit Requires Redefining What We Want Government to Do

One big subject never comes up in the presidential debate--the federal budget deficit. In a year in which the public must decide the leadership and direction of the United States government, everyone seems to have stopped talking about the biggest single problem facing the next President and the next Congress.

The federal government has been running deficits in the triple digit billions for a decade now. The statistics are mind-numbing--the deficit rose to a high of $221 billion in fiscal 1986, came down to a “mere” $150 billion between 1987 and 1989 and then rose again. In the current recession, the deficit is expected to be about $350 billion for fiscal 1992.

Much of the recent escalation is a temporary reflection of the recession and the savings and loan debacle. However, even when the temporary factors disappear, and even assuming that the Congress and the President abide by the strict rules of the 1990 Budget Enforcement Act, large structural deficits remain in the federal budget. The deficit (excluding deposit insurance transactions) will likely fall to $210 billion by fiscal 1995. After that, however, it is likely to rise again, even if the budget agreement is extended, largely because medical price inflation will push up the cost of Medicare and Medicaid faster than federal revenue is likely to increase.

Americans have lived with underlying deficits of roughly 3% of the gross domestic product for a decade now and have learned that such deficits do not necessarily precipitate economic crisis. The U.S. government can borrow huge sums and run up publicly held debt of more than $2.5 trillion without visibly affecting daily life.

They have also learned that deficits do not necessarily cause inflation. Economists who predicted inflationary consequences of big deficits in the early 1980s expected deficits to stimulate demand for domestic products and push up their prices and/or to send interest rates through the roof, crowd out domestic investment and plunge the economy into recession.

In fact, real interest rates did rise substantially, but foreign capital flowed into the United States to finance a somewhat lower level of domestic investment. Americans bought a lot of foreign goods, and international competition kept U.S. prices in check. Instead of inflation, or economic crisis, the persistent budget deficits produced a slower-growth economy, trade deficits and growing foreign ownership of U.S. securities and physical capital.

If Americans are to live better in the future, they need to save more and channel those savings into productivity-enhancing investment. The clearest path to higher national saving is reducing the federal budget deficit, which is simply large government “dissaving.”

One reason there has been so little discussion of deficits in the campaign is that nothing can or should be done in the short run except to continue enforcing the 1990 budget agreement, painful as that might be. While it would be a mistake to try to accelerate recovery from the current recession by tax cuts and other measures that makes the long-run deficit worse, it would also be a mistake to reduce the deficit much further right now and risk delaying the recovery. Hence, sticking to the 1990 agreement is the best bet for the next year, at least.

What the candidates ought to be talking about is the post-recession, post-election challenge: How to turn the federal government from a drag on the long-run vitality of the economy--draining off private saving to finance general government spending--into a positive contributor to saving and productive investment. Achieving this goal means moving the federal budget gradually from deficit to modest surplus (counting Social Security).

Such a plan need not be disruptive to the economy. Cutting spending and/or raising taxes by 4% of GDP by 2000 would be sufficient to close the projected deficit of about 3.5% of GDP and create a small surplus. Achieving this goal would entail shifting only about half a percent of GDP per year for the remaining eight years of the decade. A faster pace would be quite feasible if a healthy recovery were well started and the Federal Reserve helped out by keeping monetary policy easy.

The usual explanation of why no one is talking seriously about eliminating the long-run deficit is that Americans cannot contemplate the pain of even small tax increases or spending cuts. They would rather live with the deficit, whose negative effects they do not fully understand, than take the steps necessary to correct it.

There may, however, be a more fundamental reason: The deficit cannot be reduced without confronting the issue of what we want the federal government to do. The deficit reduction strategies of the last decade have squeezed down spending wherever possible without changing the federal government’s portfolio of responsibilities.

The demise of the Soviet empire has made it possible to reduce defense spending without changing the government’s fundamental responsibility for national security. Reducing the deficit by another 4% of GDP--on top of declining defense and domestic discretionary spending--will make some hard decisions necessary.

Deficit reduction is not the only key to a healthier economy in the future. There is broad consensus that a higher rate of public investment is needed to upgrade education and skills, and modernize the nation’s infrastructure. The health system needs restructuring to ensure access for everyone and control the rate of growth of costs.

Achieving these objectives at the same time the federal deficit is reduced will take a substantial tax increase at some level of government. For the federal government to take on all of these jobs and reduce the deficit at the same time will require a massive tax increase at the federal level. Alternatively, the federal government could get out of some areas of spending all together (education, training, housing, infrastructure, community development, for example) and turn these over to the states. Then the tax increases would have to come at the state and local level.

Serious deficit reduction will require that Americans make up their minds about what they want done, and who is to do it.