What to do With a Budget Surplus?
By Clay Chandler and John M. Berry
How best to use the windfall? A good financial planner might recommend you start by cutting debt.
"One of the very first things I tell my clients is to get rid of debt," says L. Edward O'Hara, a financial planner in Silver Spring. "A lot of people are reluctant until I show them what a huge difference it can make to their financial situation over a long period of time."
Economists are offering much the same advice to Uncle Sam.
With the federal government suddenly expecting surpluses estimated between $660 billion and $1.1 trillion over the next decade, a large contingent of fiscal experts is recommending that President Clinton and Congress resist calls for new tax cuts or increased government spending. Instead, many economists argue, the government is likely to get the highest economic return from future surpluses by using them to whittle down the $3.8 trillion in federal debt held by the public.
"Pretty much all macro-economists would be in the debt reduction camp," asserts N. Gregory Mankiw, a professor of economics at Harvard University and author of one of the most popular economic textbooks for undergraduates. "For most of us, the choice seems clear."
Others aren't so sure. Supply-side economists and GOP presidential hopefuls Jack Kemp and Malcolm "Steve" Forbes Jr. blast debt reduction as a "castor oil" remedy of no benefit to the economy. A recent Wall Street Journal editorial excoriated Republicans who would "stand for an abstraction of paying down the national debt . . . even if it means taxing Americans at higher rates than needed to balance the federal books."
At the opposite end of the political spectrum, liberals such as Sen. Paul Wellstone (D-Minn.) and Northwestern University economist Robert Eisner decry the folly of extinguishing Treasury IOUs with money that might otherwise be "invested" in new schools or health care for needy children.
Meanwhile lawmakers from both parties, rallying behind House Transportation Committee Chairman Bud Shuster (R-Pa.), can tick off reasons why using the surpluses to fund construction of new roads, bridges or other projects in their districts will make the economy more productive.
Still, a little-noticed set of long-term projections prepared by the White House Office of Management and Budget makes a tantalizing case for the benefits of using projected surpluses over the next 30 years to pay down the debt. If Congress and the president agreed to toe the line and direct all surpluses to pay down debt for the next 30 years, and if the economy remained on a steady, moderate growth path, the government could pay off its entire debt while covering Social Security and other costs to boot.
Such an optimistic scenario hasn't been previously envisioned, in part, because official economic projections rarely go out longer than 10 years. But also, pragmatic economists note that it is unlikely a government would direct all surpluses to paying down the debt rather than funding important programs.
"From a political standpoint, the problem is simple: Paying down the debt doesn't get your picture in the paper," says economic historian John Steele Gordon. "There are no ribbon-cutting ceremonies," no throngs of grateful constituents.
Brookings Institution economist Henry Aaron said the OMB projections -- while they are based on conservative economic assumptions -- may be overly optimistic because they do not incorporate the distinct possibility of a recession. "The right way to look at this is to say that there has been a distinct change in the budgetary climate," Aaron said, noting that he believes current tax and spending policies could produce surpluses for the next 20 years. "The sun is shining, but that does not mean we won't have deficits arising from recessions . . . It does mean we have more elbow room to plan for the restructuring of Medicare and Social Security than we had just a few years ago."
One reason the OMB projections turn out to be so favorable is the enormous saving on interest payments as the size of the debt is reduced. If paying down the debt also caused interest rates to fall somewhat, as some economists believe it would, the fiscal picture would be even brighter.
Debt-burdened U.S. families last year used an average of 17 percent of their after-tax income to make interest payments. Similarly, last year the government paid out $244 billion, more than 15 percent of its income, to cover interest on the debt owed to the public.
Paying down debt triggers a sort of virtuous cycle: As the amount owed drops, so does the interest due on the remaining unpaid balance, and the saving on interest leaves still more money available to reduce the debt.
Many economists in the debt reduction camp concede, however, that their position of pay-down-the-debt-first is colored by assumptions about the mechanics of American democracy. In theory, they acknowledge, it might be possible to craft tax cuts or new spending programs that would harness projected surpluses as efficiently as shrinking the debt. But as a practical matter, they say, such ideas aren't likely to emerge from the legislative sausage grinder in an economically rational form.
Thus, much like an individual investor who uses extra cash to pay down debt because he is unable to identify investment opportunities likely to yield a higher return than the prevailing interest rate, many economists regard debt reduction as a least harmful fallback -- unimaginative, perhaps, but reliable.
"From an economic standpoint, the goal should be to use the surpluses in ways that will broaden and deepen the nation's long-term capital base," said University of California at Berkeley economist Laura D'Andrea Tyson, former chairman of President Clinton's National Economic Council. "None of the tax proposals I've seen meet that test. On the public investment side, the evidence is a little better, but it's uncertain and open to debate. . . . So on balance, I'd have to say that debt reduction probably makes the most sense."
Many debt cutters' opposition to using surpluses for tax cuts is rooted in their assumptions about the economy: that the nation's companies are operating at or near full capacity, and that Americans are likely to spend all but a sliver of any tax bonus. Revving consumer demand when the economy already is running full throttle, the argument goes, would only bid up wages and force the Federal Reserve to raise interest rates to counter inflation. The end result: The surpluses would be squandered with no net gain in growth.
The outcome of a tax cut would be "the worst of all worlds," warns economist Chris Varvares of Macroeconomic Advisers, a St. Louis forecasting firm. "There would be no upfront gain and a long-term loss."
Two tax proposals touted by Republicans in Congress this year -- one measure that would reduce the tax burden of dual-career married couples and another that would lower to 15 percent from 28 percent the rate at which some households are now taxed -- seem particularly unlikely to help the economy. The proposals would have "almost no impact" on private savings or long-term growth rates, said Stanford University economist John Taylor, an adviser to Republican Bob Dole's 1996 presidential campaign.
An increase in government spending -- whether for new social programs, public infrastructure projects, or government-sponsored research and development -- also could overheat the economy. White House polling suggests such "investments" are a big hit with the public. But proponents can point to little hard evidence that such endeavors yield significant and predictable contributions to the economy.
For the moment, President Clinton and GOP leaders in Congress have declared themselves in favor of "reserving" projected surpluses until they can agree on a long-term plan to shore up Social Security. The popular federal retirement program is projected to run short of funds around 2030 -- after waves of the baby boom generation have reached retirement, skewing the ratio of workers contributing payroll taxes to seniors collecting benefits. In practice, the pledges imply that neither side can propose new expenditures or tax cuts unless they can "pay for" their initiatives by identifying equivalent spending cuts and revenue increases.
But the moratorium may not last. President Clinton has proposed between $130 billion and $150 billion in new programs in his new budget. House and Senate leaders, meanwhile, are clamoring for some kind of tax reduction this year. Both sides have staked their claim to revenue -- estimated by the White House at about $65 billion -- expected to result from a legal settlement between the federal government and the big tobacco producers. But if that deal falls through, many fiscal analysts warn, Democrats and Republicans will be sorely tempted to divvy up the surpluses to finance their agendas.
Using projected surpluses to reduce the national debt would revive an approach to U.S. fiscal policy that was once the norm. In its first 200 hundred years, the U.S. government ran up huge debts in times of war or crisis, then dutifully paid them down in times of peace and prosperity.
During the 1980s, however, something peculiar happened: For the first time in U.S. history, the debt-to-GDP ratio began to worsen in the absence of a major war or economic depression. The current debt-to-GDP ratio stands at almost 50 percent.
Calculations by White House economists suggest that if projected surpluses are used entirely for debt reduction and current tax and spending policies remained unchanged, the share of federal income needed to pay interest would drop below 5 percent within 12 years.
In other words, 10 percent of the government's income would be freed up for other purposes, whether to help cover the huge rise in Social Security benefits, pay for other spending programs or to make way for tax cuts.
That's not small change. In 1997, 10 percent of federal receipts amounted to $158 billion. That would be more than enough to fund the entire package of new initiatives proposed by President Clinton in his 1998 budget plan and almost four times the amount needed to eliminate the higher tax burden borne by two-income married households, a top priority for Republicans in Congress this year.
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