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Statement of Robert D. Reischauer
Joint Economic Committee
June 22, 1995
Mr. Chairman and members of the Committee, I appreciate this opportunity to
discuss with you the effort that is now underway to balance the federal budget. The
President's speech on June 13 was a significant and constructive contribution to this
effort. The President and the leadership in the Congress now have reached agreement
on what the nation's basic fiscal policy objective should be---namely, to balance the
federal budget by a set date in the not-too-distant future. Notwithstanding this
consensus about the objective, significant differences remain between the President and
the leadership in the Congress concerning the magnitude of the underlying problem, the
amount of time that should be taken to resolve it, and the specific measures that should
be pursued to achieve budgetary balance. While the rest of my statement elaborates on
these differences, the primary message that I would like to convey to you is that these
disagreements should not be allowed to derail this historic opportunity to enact
legislation that substantially reduces the deficit.
How Big is the Problem?
The major difference between the President's and the Congress' budget balancing plans
is the size of the deficit that each is attempting to eliminate. The Congress' view of the
problem is based on the Congressional Budget Office's (CBO's) baseline budget
*
Senior Fellow, The Brookings Institution. The views expressed in this statement are those
of the author and should not be attributed to the staff, officers or trustees of the Brookings
Institution.
projections. These projections, which assume no changes in policy and adherence to the
discretionary spending caps through fiscal year 1998, show the deficit growing steadily
and rapidly over the next ten years. CBO projects that the deficit will rise from $175
billion in fiscal year 1995 to $349 billion in 2002 and to $472 billion in 2005 (See Chart
1). As a fraction of GDP, CBO sees the deficit rising from 2.5 percent in 1995 to 3.5
percent in 2002 and to 4.1 percent in 2005. The rapid rise in the baseline deficit means
that the task of balancing the budget does not become any easier if it is stretched out
over a longer period of time.
The President's budget balancing plan is based on the Office of Management and
Budget's (OMB's) projections of the baseline deficit. Like those of CBO, OMB's
projections assume no policy changes and adherence to the discretionary spending caps
through fiscal year 1998. While OMB projects the baseline deficit to rise after 1995, the
increases are quite modest, from $193 billion in fiscal year 1995 to $240 billion in 2002
and to $266 billion in 2005 (See Chart 1). Compared to OMB's estimates of GDP, the
baseline deficit is projected to shrink modestly over the next decade, from 2.7 percent
in 1995 to 2.3 percent in 2002 and to 2.2 percent in 2005. Because OMB's projected
baseline deficits do not grow in real terms and shrink relative to the size of the economy,
the task of balancing the budget becomes easier the longer the period of time taken to
eliminate the deficit.
The differences between CBO's and OMB's baseline deficit estimates, which
amount to some $206 billion by 2005 (See Chart 2), are the result of different economic
2
and program or technical assumptions. OMB expects nominal GDP to grow, on average,
at a slightly faster rate over the next decade than does CBO. As a result, its estimate
of nominal GDP in 2005 is about three and one-quarter percent larger than that of CBO.
The differences in nominal GDP reflect OMB's higher estimates of both real economic
growth and the increase in the GDP deflator. Considering the inherent uncertainty in
economic forecasting, these differences are quite small. For example, after 1996 OMB
expects real GDP to grow each year only 0.1 or 0.2 percentage points faster than does
CBO. As a result of its higher estimate of nominal economic growth and differences in
other technical assumptions, OMB's projection of baseline revenues for 2005 is about $67
billion higher than that of CBO (See Chart 2).
OMB also assumes that the CPI will increase at a rate that is between 0.2 to 0.3
percentage points slower each year than the rate assumed by CBO. Slower CPI growth
translates into lower baseline costs for indexed benefit programs. Consistent with its
view of economic growth, OMB also assumes a slightly lower unemployment rate than
does CBO. This difference translates into somewhat lower spending on unemployment
compensation and other entitlement programs that are sensitive to the level of
joblessness. Altogether, OMB projects spending on the non-medical mandatory
programs to be about $33 billion less than does CBO in 2005.
3
Because both CBO and OMB use the CPI to inflate discretionary spending after
the caps expire in fiscal year 1998, CBO's assumption that the CPI will grow at a faster
rate contributes to its $20 billion higher estimate of baseline discretionary spending in
2005.
Not all of the differences between OMB's and CBO's economic assumptions
lower the Administration's baseline deficit path relative to that of CBO. The
Administration's long and short-term interest rate assumptions are generally a few
tenths of a percentage point higher than those of CBO. Nevertheless, OMB's estimates
of baseline net interest costs fall below those of CBO by 2002 because its lower baseline
deficit path results in less debt. By 2005, the difference between CBO's and OMB's
baseline net interest estimates is some $34 billion.
The most notable program differences between OMB's and CBO's baseline
projections are in Medicare and Medicaid. While CBO anticipates that Medicare
spending, net of Part B premiums, will grow at an average rate of 10.3 percent over the
next decade, the Health Care Financing Administration's (HCFA) estimates, which OMB
incorporates into its baseline projections, anticipate an average growth rate of 9.8 percent
per year. The differences with respect to Medicaid are a bit larger; CBO anticipates an
average growth rate of 10.0 percent while HCFA expects Medicaid spending to rise by
9.2 percent a year. Over the course of a decade, these modest differences compound so
that by 2005 OMB's baseline estimate of Medicare spending is some $32 billion below
that of CBO and its estimate of Medicaid outlays is $20 billion below CBO's.
4
The large gap between CBO's estimate of the baseline deficit that must be
eliminated to balance the budget and OMB's estimate of the problem raises the question,
"Which estimate is likely to be more accurate?" The simple answer to that question is
that no one knows. The methodologies used to generate the long-run baseline budget
projections are necessarily crude. The uncertainty that surrounds the likely course of the
economy five to ten years from now is great. Furthermore, if the past is any guide,
unexpected surges and slowdowns in entitlement program spending are likely to occur
in the future.
Some critics have suggested that the Administration has relied on excessively
optimistic economic assumptions for its baseline budget projections---that Rosy
Scenario's younger sister is making her debut. This charge is unwarranted. OMB's
economic assumptions for the 1995 to 2000 period are not significantly different from
those of the Blue Chip Consensus and are less optimistic than those of a number of
private forecasters. Compared to the projections made by the few forecasters who have
the nerve to predict the course of the economy past 2000, the Administration's
assumptions shade toward the optimistic, but are well within the bounds of the possible.
When compared to the differences that existed through much of the 1980s, the
differences between OMB's and CBO's views of the economy are quite modest. For
example, between 1982 and 1991 the average percentage gap between OMB's and CBO's
5
forecasts for real GDP after five years was 5.6 percent, over four times larger than the
difference that exists between the two agencies' current real growth projections after a
decade.
A recent revision by CBO has reduced one of the differences between CBO's and
OMB's baseline economic assumptions. In estimates made for the budget committees,
CBO has incorporated a 0.2 reduction in its estimate of the increase in the CPI after 1998
to reflect the likely effect of re-benchmarking the CPI to the consumption patterns of
the 1993-1995 period. CBO has estimated that this change reduces the $206 billion gap
between the two agencies' deficit estimates for 2005 by $18 billion.
While OMB's economic assumptions should not be viewed as a flight of unbridled
optimism, neither should CBO's assumptions be viewed as excessively pessimistic.
CBO's stable interest rate assumptions may be too benign. With the baseline federal
deficit rising as a percent of GDP, it might be more reasonable to expect that the
increased pressure on credit markets would push rates up a bit. Furthermore, while the
CBO projections could accommodate a mild recession at some point during the next
decade, a more realistic assumption might be to anticipate two mild recessions or one
more severe downturn.
The program assumptions are inherently even more uncertain than the economic
assumptions. The future course of entitlement spending, which has been the wild card
in recent years, will depend not only on demographic developments and the strength
6
of the economy, but also on the political climates in the states, court rulings, and changes
in the private health care market. CBO's assumptions about the growth of Medicaid and
AFDC implicitly assume that states will be able to find substantial resources for their
matching shares. If states find themselves under severe budgetary pressure, state
matching funds may not be forthcoming and, as a consequence, federal costs may not
grow as rapidly as CBO expects. The same result would occur if the political climate
in the states demands further retrenchment of welfare programs. Alternatively, the
innovations some states are making under the Section 1115 waivers to broaden Medicaid
coverage and place beneficiaries in managed care systems may prove to be very popular
with the voters. If that is the case, states may decide to expand Medicaid coverage to
the limit and CBO's projections of federal costs could prove to be too low.
Baseline Medicare spending will be affected by developments in private health
care markets which are notoriously difficult to predict. The managed care revolution
that is sweeping through employer-sponsored insurance markets could lead to an excess
of providers which might put downward pressure on prices. This could result in lower
update factors for Medicare hospital and physician payments than is now anticipated in
the baseline projections. Alternatively, providers struggling to maintain their incomes
in a world that is increasingly dominated by capitated payment arrangements, may turn
to Medicare patients to supplement their incomes. While Medicare's volume
performance standards and utilization reviews will limit their ability to increase
utilization, some increased volume pressure would not be surprising. DRG code creep
could also become a more serious problem than either CBO or HCFA anticipates.
7
Whether OMB's 9.8 percent average Medicare growth rate or CBO's 10.3 percent rate
proves to be more accurate will also depend on the course of technology----on the
diagnostic tools, surgical procedures, treatments, and pharmaceuticals that will be
developed over the next ten years and on the costs of these innovations. We can only
speculate about such developments.
Considering the substantial uncertainty that surrounds the size of the deficits that
will occur five to ten years from now if policies are left unchanged, which definition of
the underlying problem should the Congress use as it formulates its budget plans?
Prudence suggests that the Congress should stick with the CBO estimates of the size of
the problem if it believes that it is important that the budget plan it adopts be viewed
as one with a reasonable, but by no means certain, chance of eliminating the deficit by
the target year. As has been true in the past, unexpected and unforeseeable
developments will buffet federal spending and revenues. If history is any guide, these
surprises will worsen, not improve, the deficit outlook more often than not. For this
reason, starting from the more cautious set of projections represents the most prudent
course. If CBO's estimate of the size of the problem proves to be too pessimistic, the
retrenchment called for in the final years of the plan could easily be scaled back, tax cuts
could be provided, or we could enjoy the first budget surplus since fiscal year 1969.
8
How Long Should the Budget Balancing Effort Take?
The second major difference between the President's plan to balance the budget and the
approach embodied in the Congressional Budget Resolution is the length of time it takes
to erase the deficit. The President would eliminate the deficit over a ten year period
while the Budget Resolution's plan would get the job done in seven years. As I pointed
out before, under the Administration's baseline deficit path, the task becomes easier if
the period is stretched out; under the CBO deficit path, that is not the case.
Three factors should be considered when deciding how long to take to balance
the budget. The first is the risk that the fiscal restraint associated with the effort poses
for continued growth of the economy. The second is the possibility that sharp spending
cutbacks could impose undesirable hardship on vulnerable groups and institutions. The
third is that the effort might lose credibility if it is dragged out over too long a period
of time.
Unavoidably, the spending cuts associated with both the President's plan to
balance the budget and the Budget Resolution's plan will impose some fiscal restraint
on the economy. But the magnitude of this restraint is quite modest. The change in the
primary deficit as a percent of potential GDP--an accepted measure of fiscal restraint--
does not reach 0.6 percent in any year under the various plans. In most years, this
measure is below 0.3 percent. Whatever contractionary effects this modest dose of
restraint might have, much if not all of it could be offset by easier monetary policy. The
retrenchment should cause interest rates to fall somewhat which will stimulate private
9
investment and purchases of consumer durables. Net exports should strengthen with
a weaker dollar. In addition, the Federal Reserve could take actions to lower rates
further. In short, whether the deficit is eliminated in seven or ten years, the risk of the
effort derailing the economy is likely to be relatively small.
If there is genuine concern about the cyclical consequences of the deficit reduction
effort, it would make more sense to spread the restraint more evenly throughout the
plan period than to lengthen the period of time used to achieve balance. Both the
Budget Resolution plans and the President's plan load the fiscal restraint into the first
year and the last few years. Given the present uncertain state of the economy and the
fact that it is already too late for easier monetary policy to do much to offset the effects
of any cutback in fiscal year 1996 spending, it may be prudent to shift some of the fiscal
year 1996 restraint called for in the Congressional and Presidential plans into the 1997
to 2000 period. Similarly, it would make sense to move a portion of the cuts that have
been loaded into the final years of the plans into the middle years.
Even though the planned spending cutbacks may pose only a slight risk to the
economy, they could impose significant hardship on those individuals who have little
ability adjust when the transfer payments or services they receive from federal programs
are reduced or the orders their businesses receive from the government are suddenly
curtailed. Undesirable program disruptions couid also result if state and local
governments and non-profit entities are suddenly faced with new responsibilities that
require administrative and institutional capabilities that they have not yet had an
10
opportunity to develop. The more program changes called for by a deficit reduction
plan, the more sense it makes to spread the adjustment out over a longer time period
in order to facilitate a more orderly and sensible transition.
Judged on this dimension alone, the President's plan probably requires the
shortest implementation period because its budget cuts and program adjustments are
significantly smaller than those of the Congressional plans. The spending cuts and
program adjustments called for by the House version of the Budget Resolution, in
contrast, are the most far reaching. They not only eliminate a larger estimate of the
deficit, but also provide for a substantial tax cut. In addition, they would place
significant new responsibilities on the states because Medicaid and several welfare
programs are transformed from open-ended federal matching grant programs into block
grants. On this score, it would make sense to phase in the House plan over a longer
period of time than the President's plan. Whether that period is seven, eight or ten years
long is open to debate.
The credibility of the plan is the third factor that should be considered when
deciding on the length of time over which to balance the budget. In recent years, deficit
reduction delayed often has been deficit reduction avoided. When a deficit reduction
plan stretches over many years, policy makers will be tempted to backload the sacrifice
into the plan's final years. Claimants will always hope that circumstances will change
and the retrenchment will be canceled before the day of reckoning. For this reason, a
credible deficit reduction plan can not be stretched out over too long a time period.
11
Whether seven or ten years constitutes the boundary of a reasonable time period for a
deficit reduction package is debatable. But it is worth noting that a decade is longer
than a single individual can remain in the White House. Furthermore, during recent ten
year periods we have seen world conditions change dramatically, the attitude of the
public toward government swing 180 degrees, and the economy shift course in
significant ways. All of this argues for the shorter time span.
How Should the Budget be Balanced?
While the major difference between the President's plan and the plan being developed
as part of the Fiscal Year 1996 Budget Resolution is the amount of deficit reduction each
would impose, they also differ with respect to how a balanced budget would be
achieved. Because the plans reach balance in different years and because the baselines
are different, any comparison of the approaches necessarily involves some distortion--
some comparisons of apples with oranges.
Looking at the target year for each plan-that is, 2002 for the Congressional plans
and 2005 for the President's plan---the policy-related spending cuts amount to about
$302 billion in the House-passed version of the Budget Resolution, $272 billion in the
Senate-passed version of the resolution, and $188 billion in the President's plan. Of the
total cuts in the target year, the President's plan looks to discretionary spending and
Medicare to bear relatively more of the burden than is the case with the Congressional
plans (See Chart 3).
12
In spite of these differences, the composition of future federal program spending
would not be affected in a major way if one of the approaches to balance the budget
were adopted over another. For example, the three plans anticipate non-defense
discretionary spending amounting to between 15.5 percent and 15.8 percent of all non-
interest spending (See Chart 4). While the President's approach expects a smaller
portion of program spending to be devoted to defense and more to Medicare and
Medicaid than do the Congressional plans, these differences are quite modest when
compared to the compositional shifts that have taken place over past five to ten year
periods.
Conclusion
As was the case in 1990 and 1993, policy makers have an opportunity this year to
address the major problem facing the nation. This opportunity should not be sacrificed
on the altar of short-run political advantage. Nor should it be squandered because the
President and the Congress disagree over the size of the problem or the length of time
needed to resolve it. A balanced budget may be symbolically important, but from an
economic standpoint reaching a $50 billion deficit would represent a tremendous
accomplishment. It is certainly better to enact measures that would cut the deficit in half
over the next seven years than to come up empty handed.
Even if the Congress approves measures that are projected, using current
assumptions, to lead to a balanced budget at some future date, we all know that
economic shocks, changing priorities, and unforeseen demographic and technical
13
developments will soon render these estimates invalid. Many mid course corrections
will be required. Keeping the nation on an appropriate fiscal policy path is a never-
ending task.
Thank you.
14
Chart 1
The Baseline Deficit Outlook Through 2005
(billions of dollars)
500
450
400
350
300
250
200
1996
1998
2000
2002
2004
2006
Year
CBO
Administration
Chart 2
Difference Between CBO and Administration
Breakdown of the Difference Between CBO and the
Baseline Deficits for 2005
Administration Baseline Deficits for 2005
(billions of dollars)
500
(billions of dollars)
450
400
Revenues (67 )
Baseline Deficit(billions of dollars)
350
300
Net Interest (34 )
250
Discretionary (20 )
200
Other Mandatory (33)
150
100
Medicaid (20)
50
Medicare (32 )
0
Total = $206
CBO
Administration
$472
$266
Chart 3
Compositon of Policy-Related Spending Cuts
In Budget Balancing Plans' Target Year
(billions of dollars)
House
Senate
(2002)
(2002)
Medicare (62)
Medicare (86)
Discretionary (113)
Discretionary (118)
Medicaid (53)
Medicaid (57 )
Other Mandatory (46)
Total=$302
Other Mandatory (39)
Total=$272
President
(2005)
Medicare (67)
Discretionary (92)
Medicaid (19)
Other Mandatory (10)
Total-$188
(a)
Chart 4
Composition of Non-Interest
Outlays in Budget Balancing
Plans' Target Year
Senate
House
(2002)
Non-Defense
Non-Defense Discretionary
Discretionary
(2002)
(15.47%)
Medicaid/Medicare
Medicaid/Medicare
(15.52%)
(23.64%)
(22.54%)
Defense
Defense
Discretionary
Discretionary
(16.84%)
(17.88%)
Other
Mandatory
Other
Social Security
Social Security
Mandatory
(30.20%)
(14.10%)
(29.94%)
(13.86%)
Total=$1603
Total=$1566
President
Non-Defense
(2005)
Discretionary (15.79%)
Medicaid/Medicare
(26.87%)
Defense
Discretionary
(14.51%)
Other
Mandatory
(14.36%)
Social Security
(28.46%)
Total=$1945