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Lyndon Johnson
An income tax surcharge imposed by Lyndon Johnson contributed to the last balanced budget.
(File photo)

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_ Discuss the budget with The Post's Clay Chandler live online.


After Decades of Deficits, Expectations of Surplus

First of two articles

By Clay Chandler
Washington Post Staff Writer
Sunday, February 1, 1998; Page A01

In the budget plan he will submit to Congress tomorrow, President Clinton will propose a package of tax and spending measures he estimates will generate a $9.5 billion surplus in fiscal 1999, and nearly $1 trillion in surpluses over the next decade.

The proposed surplus, if realized, would mark the first time that the federal government has taken in more annually than it has spent since 1969, when a hefty 10 percent income tax surcharge imposed by Lyndon Johnson to finance the Vietnam War yielded a modest bonus of $3.2 billion.

The surplus would reverse the trend of three decades in which the federal government added nearly $3.5 trillion in red ink to the national debt, which now stands at $5.4 trillion. Many budget analysts think that it could signal the end of a period in which ever-larger federal deficits were considered an unhealthy but largely uncontrollable aspect of U.S. economic policy.

1968: The cost of new social programs and the Vietnam War add to the deficit. President Johnson imposes a temporary 10 percent surcharge on income taxes.

1969: The new tax generates a tiny surplus, but economic advisers to newly elected President Nixon are disappointed to discover a much-anticipated "peace dividend" from ending the war to be illusory.

1971: Nixon, alarmed by creeping inflation, announces a program of wage and price controls and declares the dollar no longer convertible to gold.

1973: Arab states withhold oil exports. Energy prices climb, motorists wait in long lines for gasoline.

1974: Inflation jumps above 12 percent as wage and price controls are lifted. Ford fights rising prices by calling for voluntary restraint and passes out buttons urging "Whip Inflation Now." The Fed raises interest rates and the nation suffers its worst recession in 40 years.

1975: Unemployment rises to 9 percent.

1977: President Carter promises to reduce the deficit and launches an energy conservation plan. Prices climb, employment falls.

1979: Iranian revolution, following OPEC price increases, triggers a second oil shock. Gasoline shortages return. Fed Chairman Volcker pushes interest rates to almost 20 percent. The economy stumbles, the deficit grows.

1980: President Reagan elected on a blunt appeal to voters: "Are you better off now than you were four years ago?"

1981: Reagan and Congress launch the largest tax cut in U.S. history. But the plan includes only modest cuts in spending.

1982: The economic stimulus from tax cuts is initially offset by interest rate increases. Recession hits. The deficit rockets past the $200 billion mark.

1983: The economy recovers, deficits recede.

1986: Congress passes Gramm-Rudman-Hollings legislation aimed at capping federal spending.

1987: The stock market crashes, but rebounds quickly. The economy continues to expand.

1988: George Bush elected on a pledge of no new taxes.

1989: Bush pledges federal backing of deposits in savings and loan associations battered by high interest rates and deregulation. The economy slips into recession.

1990: Bush reneges on his no-new-tax pledge, reaches agreement with Democrats in Congress on $500 billion deficit reduction plan.

1991: Bush launches Operation Desert Storm.

1992: Bill Clinton, declaring "It's the economy, stupid," elected on a pledge to restore growth. Even before his inauguration, the recovery has begun.

1993: Clinton wins passage, by a single vote, of a $500 billion deficit reduction plan that includes big tax increases on the wealthy.

1994: Republicans regain control of Congress, resolve to balance the budget by 2002.

1997: Clinton and Congress reach agreement on a five-year balanced budget plan.

1998: Clinton proposes a balanced budget for fiscal 1999.

SOURCE: News reports, Congressional Budget Office

The priorities of the federal budget have changed greatly over the past 30 years, with entitlements now accounting for more than half of spending, and defense's share much diminished.

1968: $178 billion budget

Defense 46.1%

Entitlements** 27.6%

Discretionary* 20.1%

Interest 6.2%

1998: $1.7 trillion budget

Defense 15.8%

Discretionary* 16.9%

Entitlements** 51.1%

Interest 14.4%

* Nondefense

** Social Security, Medicaid, welfare, other mandatory spending

SOURCE: Office of Management and Budget

Clinton's budget plan projects steadily growing surpluses in each of the next 10 years, with a windfall of about $219 billion in its first five years. In their most recent forecast, analysts at the Congressional Budget Office project comparable surpluses over a five-year period and $660 billion in excess revenue over 10 years even if there are no changes in current tax and spending policies.

"It's just amazing -- a different world," marvels Gene Sperling, director of Clinton's National Economic Council. His summary of the new budget outlook: "Surpluses as far as the eye can see."

Members of Congress, too, express astonishment. "When I came here 20 years ago, we were looking at a totally, absolutely, incredibly different environment," recalled Rep. Robert Livingston (R-La.), chairman of the House Appropriations Committee. "We had the Cold War and the Soviet Union aiming missiles at us. Jimmy Carter said we were running out of oil in an energy crisis. . . . We had inflation, unemployment and high interest rates."

And today? "The Soviet Union doesn't exist," Livingston said. "Inflation is almost nonexistent, interest rates are at a generational low and the biggest worry for businesses is finding enough skilled labor. There is no energy crisis. We've tackled welfare, crime is on its way down and the stock market has risen to all-time highs. Last year we had the first tax cut in 16 years and, effectively, we've already balanced the budget. It's a whole new America."

On the Road to a Surplus

How, exactly, did we get here? The answer is complex.

Politicians in Washington are eager to claim credit for leading the economy to the promised land. But budget analysts tend to assign far more significance to the remarkable resurgence of the economy, which has boosted federal tax revenue as it lifted the incomes of nation's families and firms.

Experts say, too, that the sudden flood of revenue has come not just from economic growth, but the structure of that growth -- with a disproportionate share of gains flowing to businesses and high-income households taxed at higher rates.

Of course, the full saga of the shrinking budget deficit has a tangled plot line.

In the story told by Republicans, former president Ronald Reagan gets top billing. The giant tax cut he pushed through in 1981 unleashed the century's biggest economic boom, conservatives said.

Republicans who seized control of Congress in 1994 also play a starring role in this drama for setting a deadline for a balanced budget -- and forcing Clinton to embrace their goal.

Democrats tell it differently. In their version, the climactic scene is passage of Clinton's first budget, narrowly enacted in 1993 without a single Republican vote.

To hear Clinton supporters tell it, that plan, which called for $500 billion in deficit reduction over five years, promptly led to lower interest rates, brought the bulls charging back to Wall Street and set in motion what Clinton economist Lawrence H. Summers hails as a "virtuous circle" of expanding growth.

"The 1993 budget deal freed up hundreds of billions of dollars for private investment, which grew the economy, which increased revenues, which reduced the deficit and freed up still more for private investment," Summers said. "It reversed the vicious cycle of previous policies."

Investors, meanwhile, tend to credit another actor: Federal Reserve Chairman Alan Greenspan, whom they praise for his steely vigilence against inflation and seeming willingness to let the economy grow faster than other economists had thought possible. And no doubt George Bush, who reneged on his no-new-taxes pledge in accepting a deficit reduction deal in 1990, and Mikhail Gorbachev, who conceded defeat in the Cold War arms race, played key roles.

Still, whatever the contributions of individual policymakers in balancing the budget, their task was simplified enormously by the unexpectedly robust growth of the U.S. economy this decade.

Historically, the growth of mature industrialized economies like that of the United States has followed an unnerving boom-bust pattern known as the business cycle, in which expansion is punctuated every few years by periods of contraction, marked by painful increases in unemployment.

A Lengthy Expansion

Since March 1991, the end of the last recession, the U.S. economy has grown without interruption. If it lasts through the calendar year, this will become the longest peacetime expansion in American history. Growth during this remarkable period has averaged a real annual rate of 2.9 percent.

Last week, the federal government announced that in 1997, the economy grew by 3.8 percent -- its highest annual growth rate in almost a decade.

Unemployment, meanwhile, has fallen to 4.7 percent last year from 7.7 percent in 1991.

Historically, when unemployment has declined to such low levels, inflation has been quick to follow. The fight to tame that rise in prices has generally involved raising interest rates, as well as other policy moves that can precipitate a slump.

For now, however, economists see no signs of inflationary pressure and in the absence of a major external shock, few see reasons why the economic good times should come to an end any time soon.

Former Congressional Budget Office director Robert D. Reischauer points out that in early 1995, when Republicans first promised a balanced budget by 2002, CBO projected that the deficit in the target year would be $349 billion in the absence of additional revenue increases or spending reductions.

But by May 1997, the baseline deficit projection for 2002 had melted to less than $130 billion even though very few spending cuts had been enacted.

By last summer Clinton and the Congress "were not faced with projections of seemingly insurmountable deficits" like those confronting their predecessors, Reischauer said in a recent analysis of the 1997 balanced budget deal.

"The amount of heavy lifting required to reach balance was no longer Herculean; Draconian spending cuts were not required, even if policymakers wanted to provide some modest tax relief as they eliminated the deficit," Reischauer said.

Some of this improvement came from reduced growth in spending. Costs for mammoth government programs such as Medicare and Medicaid climbed at a much slower rate than analysts had forecast.

More important, defense spending has fallen an average of 2 percent in each of the past five years.

Revenue Inflow Outpaces Growth

But the really impressive gains occurred on the revenue side. Typically, the amount of revenue collected each year by the Treasury Department rises in tandem with the growth of the economy. But from 1992 to 1997, according to the CBO, revenue increased at a surprising annual average of 7.7 percent in nominal terms, or about 2.4 percentage points faster than growth in the gross domestic product, which is the sum of all goods and services produced in the United States.

CBO Deputy Director James L. Blum attributes about 1 percentage point of that extra tax revenue to the 1993 budget deal, which raised marginal tax rates for Americans in the top 2 percent of the income scale.

Much of the rest, Blum estimated, came from an increase in taxes paid on capital gains -- profit from the sale of stock, property or other assets -- as many Americans cashed in their shares to take advantage of the surging stock market. Total capital gain realizations nearly tripled to $260 billion from 1992 to 1997. "That's remarkable growth," Blum said.

Federal coffers also fattened because earnings grew more rapidly for upper-income families, who are taxed at higher rates, than for typical taxpayers.

Strong corporate profits, on which the market run-up was based, contributed to the revenue windfall, too. Corporate income taxes, which are levied at a much higher rate than average individual income taxes, grew to $182 billion in 1997 from $100 billion in 1992, -- a formidable average annual increase of 12 percent.

Experts have been puzzling over the continued strength of the economy for several years. An influential group of Wall Street economists, corporate executives and management gurus argue that the U.S. economy has entered a "new era" in which high growth can coincide with low inflation without significant danger of triggering a recession.

Proponents of this view, which has been dubbed the "New Economy" school, cite several factors that might explain this shift, including:

Increased globalization, which prevents U.S. companies from raising their prices for fear of losing out to foreign competitors, while also offering new sources of production if bottlenecks in operations occur at home.

New technology, which has allowed companies to produce more goods with fewer workers.

Deregulation, which has opened more U.S. industries to competition and forced them to operate more efficiently.

Guarded Optimism

Academic economists, along with many top government policymakers, tend to be skeptical of this view, arguing that there are more conventional explanations for the economy's surprising resilience -- prudent policy decisions by the Federal Reserve, radical corporate cost-cutting, or possibly just good luck.

Critics of the New Economy theory are more apt than supporters to regard the economy's impressive performance of late as tentative and fragile rather than the result of a permanent structural shift. Still, even zealous New Economists see reasons to worry that the current rosy scenario for federal finances could go sour.

The top concern is demographic. Budget analysts expect the deficits to begin climbing again just beyond the government's 10-year budget projection window as the first wave of baby boomers enters retirement.

The generational change will result in more seniors drawing on federal health and benefit programs and fewer workers paying payroll taxes and contributing to Social Security.

Another fear is that politicians in Washington will simply return to their spendthrift ways, frittering away a temporary budget windfall on new programs or pork barrel projects.

Herb Stein, an economist at the conservative American Enterprise Institute who served on Nixon's council of economic advisers during the last surplus, worries that the aroma of future surpluses now wafting through Washington will erode attitudes of restraint and fiscal discipline painfully cultivated over more than a decade.

"Finding ourselves on a tiny island of surpluses in a sea of past and future deficits, the advice we are getting is to build a swimming pool, not an ark," he said.

Other analysts warn of potential shocks. For example, Edward Yardeni, an economist at Deutsche Morgan Grenfell Inc. and a well-known champion of the New Economy view, cautions that he sees a "high probability" that the "Year 2000 problem," in which computers can't recognize the date of the new millennium, could trigger a "major" global recession.

"We're always prone to take current events and extrapolate them into the future," he warns. "Now that everything is going so well, who knows? Maybe we'll continue this way for a while. But I worry about that brick wall in 2000 that, no matter how I look at it, seems to just be in the way."

Looking Ahead – and at Asia

Greenspan, meanwhile, is keeping a wary eye on the financial crisis that has engulfed the once-booming economies of Asia.

In congressional testimony last week, he pronounced the U.S. economy "exceptionally healthy" and suggested that the Asian meltdown did not pose a serious threat to U.S. growth, at least so far. But he warned pointedly that the United States has "as yet experienced only the peripheral winds of the Asian crisis."

Morgan Stanley Dean Witter economist Stephen Roach, in a recent note to clients, warned of the "the hubris of the moment," a sense of infallibility he regards dangerously reminiscent of the mood in America in the 1960s.

Now, as then, he argues, Americans have foolishly convinced themselves that they are "at the dawn of a new era of geopolitical and economic supremacy," with inflation tamed and politicians in Washington itching to spend tax dollars.

Recalling the words of famed counter-culture guru Timothy Leary -- "If you can remember the '60s, you weren't there" -- Roach issued a sober warning: "Make no mistake, memories have faded in these days of hubris some 30 years later."

© Copyright 1998 The Washington Post Company

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