United States General Accounting Office

GAO Testimony

Before the Committee on the Budget, U.S. Senate

For Release on Delivery

Expected at

10 a.m.

Wednesday,

February 25, 1998

BUDGET ISSUES

Long-Term Fiscal Outlook

Statement of Paul L. Posner

Director, Budget Issues

Accounting and Information Management Division

GAO/T-AIMD/OCE-98-83

Mr. Chairman and Members of the Committee:

I appreciate the opportunity to appear before you to discuss GAO’s work on

long-term budget issues.

A long-term perspective is important for broader fiscal policy as well as for

budget decisions on individual programs. Today’s decisions affect

tomorrow’s reality. In our previous work, we have noted that the nation’s

economic future depends in large part upon today’s budget and

decisions—both public and private—about investments.1

 At the macro

level, the budget needs to provide a long-term framework grounded on a

linkage of fiscal policy with the long-term economic outlook. This requires

a focus on both overall fiscal policy and the composition of federal

activity. Beginning in 1992, congressional leaders have requested that we

provide this perspective by modeling the long-term implications of

differing fiscal policy paths for the nation’s economy. We have periodically

updated our model to account for changes in the fiscal and economic

environment, and this testimony reflects the fourth iteration of our

simulation efforts.

Since each generation is in part custodian for the economy it hands the

next, the President, the Congress, and the public need to think about the

longer term when making fiscal policy choices. A longer-term horizon is

also important because (1) some changes are best phased in over long

periods of time, and (2) to make informed decisions, policymakers need

information on the long-term cost consequences of today’s commitments.

This is especially true of those programs and activities where a longer time

horizon is necessary to understand the fiscal and spending implications of

the government’s commitment. Examples include Social Security,

Medicare, retirement programs, pension guarantees, and environmental

cleanup.

In my testimony today, I will first discuss the results of GAO’s simulations

updated to incorporate the Congressional Budget Office’s (CBO) new

budget projections. Then I will turn to another important aspect of budget

policy—the programmatic composition and design of federal

spending—for which policymakers need to consider the long-term fiscal

and spending implications of the government’s commitments.

1

Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the Economy

(GAO/OCG-92-2, June 5, 1992), The Deficit and The Economy: An Update of Long-Term Simulations

(GAO/AIMD/OCE-95-119, April 26, 1995), Budget Issues: Analysis of Long-Term Fiscal Outlook

(GAO/AIMD/OCE-98-19, October 22, 1997), and Budget Issues: Deficit Reduction and the Long Term

(GAO/T-AIMD-96-66, March 13, 1996).

Page 1 GAO/T-AIMD/OCE-98-83
Long-Term

Simulations

Long-term simulations are useful for comparing the potential outcomes of

alternative fiscal policies within a common economic framework. Such

simulations can help the Congress assess the long-term costs and benefits

of fiscal policy decisions that are made today. Adopting a long-term

perspective is particularly important because the long-term consequences

of today’s actions are not as visible as their short-term effects, a point

made vividly by the economist Charles Schultze when he compared budget

deficits to “termites in the basement.” Long-term modeling can help

illuminate these consequences for policymakers faced with difficult

budget choices.

While long-term simulations provide a useful perspective that is often

lacking in budget debates, they should be interpreted carefully. Given the

range of uncertainty about future economic changes and the responses to

those changes,2

 these simulations should not be viewed as forecasts of

budgetary or economic outcomes 50 years in the future. Rather, they

should be seen only as illustrations of the budget or economic outcomes

associated with alternative policy paths based on current information

about demographic and budgetary trends and the functioning of the

economy. While any long-term analysis is inherently uncertain, one thing is

certain: the population is growing older. And this factor is a principal

driver of our simulation results, as will be discussed below.

In our simulations, we employ a model originally developed by economists

at the Federal Reserve Bank of New York that relates long-term gross

domestic product (GDP) growth to economic and budget factors. The key

interaction between the budget and the economy is the effect of the

federal deficit/surplus on the amount of national saving available for

investment. In general, government budget deficits represent

dissaving—they subtract from national saving by absorbing funds that

otherwise could be used for investment. Conversely, government

surpluses add to saving.

For our budget assumptions, we incorporate CBO’s most recent 10-year

budget projections.3

 After 10 years, we rely on the long-term actuarial

2

The impact of federal spending reduction on aggregate national saving and investment depends on

how consumers respond to such reductions. For example, a reduction in federal Medicaid spending

may result in greater private spending on nursing home care thereby diminishing the effect on total

national saving.

3

Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1999-2008,

January 1998.

Page 2 GAO/T-AIMD/OCE-98-83
assumptions for the Social Security and Medicare programs.4

 For

Medicaid, we use the growth rates assumed by CBO in its March 1997

report on long-term simulations.5

 Interest spending is determined by

interest rates—which are held constant over the long term—and the level

of federal debt held by the public, which depends on the path of

deficits/surpluses within each simulation. All other spending, along with

federal revenue, is assumed to grow at essentially the same rate as the

economy.6

Attachment I provides more details on the model and our assumptions, but

one point bears further discussion. Recognizing the inherent uncertainties

of long-term simulations, we have deliberately chosen conservative

assumptions to estimate the economic consequences of federal fiscal

policy. For example, we have held the interest rate and productivity

growth constant over the long term, even for budget scenarios for which

escalating deficits and declining national savings would imply a substantial

worsening of these indicators. Similarly, the economic benefits derived

from long-term budget balance scenarios would also tend to be

understated due to our constant interest rate and productivity growth

assumptions.

Outlook Continues to

Improve, but Current

Policies Remain

Unsustainable Over

the Long Term

In our October 1997 report to you and Chairman Kasich, we said that the

long-term outlook has improved greatly from when we did our first report

in 1992 and our update in 1995. Since our October report was issued, CBO’s

10-year budget projections have shown continued improvement in the

short term. CBO now projects that the budget is already virtually in balance

and that, in a few years, we could experience a period of budget surpluses

on a unified budget basis. At your request for this testimony, we updated

our simulations to reflect CBO’s new baseline.7

Our no action simulation assumes no changes in current policies. Since

current policies include caps on discretionary spending, our no action

path assumes compliance with these caps—a real cut in discretionary

4

The 1997 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and

Disability Trust Funds, The 1997 Annual Report of the Board of Trustees of the Federal Hospital

Insurance Trust Fund, and The 1997 Annual Report of the Board of Trustees of the Federal

Supplementary Medical Insurance Trust Fund.

5

Congressional Budget Office, Long-Term Budgetary Pressures and Policy Options, March 1997.

6

This means that both revenues and other spending remain constant as a share of GDP.

7

CBO’s September budget projections, and thus our October 1997 simulations using CBO data,

reflected the net effect of the Balanced Budget Act of 1997 as well as the Taxpayer Relief Act of 1997.

CBO’s new projections, incorporated into our update, reflect subsequent legislation, but CBO

estimated that legislative actions taken since September did not materially change the long-term

outlook.

Page 3 GAO/T-AIMD/OCE-98-83
spending of 10 percent by 2002 assuming CBO’s inflation projections. The

budget surpluses that occur in the early years of the no action path are

assumed to reduce debt held by the public as in CBO’s baseline.

The major improvement in the fiscal outlook discussed in our

October 1997 report was due to both policy actions and the performance

of the economy. Since then, the fiscal outlook has continued to improve

due to the strong economy and the slower growth in health care costs that

underlie the changes in CBO’s baseline projections. Despite this

improvement, our model shows that a fiscal policy of no action is still

unsustainable over the long term due to the spending pressures caused by

the retirement of the baby boom generation and growth in health care

costs.

Our February 1998 no action simulation is a “good news but” picture.

Figure II.1 in attachment II illustrates both the good and bad news in our

current no action simulation. It shows how our no action deficit path has

changed since our initial report in 1992. Both our 1992 and 1995 no action

simulations indicated that deficits would have reached 10 percent of GDP

by 2016 at the latest. In contrast, our current no action simulation

indicates that the federal budget would be in surplus in the early years of

the 21st century and deficits would not reach the 10 percent level until

about 2040. Despite this good news, under the current no action

simulation, deficits would reemerge in 2015, less than a decade after the

baby boom generation begins to retire. These deficits would then escalate

quickly, reaching unsustainable levels as shown in figure II.1. The ratio of

debt held by the public to GDP tells a similar story—near-term

improvement followed by rapid deterioration to nearly 100 percent of GDP

by 2040. Such deficits and debt imply a substantial reduction in national

saving, private investment, and the capital stock. Assuming no policy

change, GDP would inevitably begin to decline under this scenario.

The no action simulation is neither plausible nor sustainable. The negative

effects of rapidly increasing deficits and debt on the economy would force

action at some point before the end of the simulation period. Policymakers

would likely act before facing the probable consequences, such as rising

inflation, higher interest rates, and the unwillingness of foreign investors

to invest in a weakening American economy. Therefore, as we have noted

in our past work, the no action simulation is not a prediction of what will

happen in the future. Rather, it underscores the need for additional action

to address the nation’s long-term fiscal challenges.

Page 4 GAO/T-AIMD/OCE-98-83
The primary causes of the large deficits in the no action simulation are

(1) the aging of the U.S. population, which corresponds to slower growth

in the labor force and federal revenues and faster growth in entitlement

spending, and (2) the rising costs of providing federal health care benefits.

Ten years from now, the first baby boomers will be eligible for early

retirement benefits. As this relatively large generation retires, labor force

growth is expected to slow considerably and, eventually, stop altogether.

These demographic changes mean fewer workers to support each retiree.

Between 1997 and 2030, the number of workers per Social Security

beneficiary is projected to drop from 3.3 to 2.0, a decline of nearly

40 percent. Without a major increase in productivity, low labor force

growth will inevitably lead to slower growth in the economy and in federal

revenue. This slower revenue growth will come at the same time that a

large retired population will place major expenditure demands on Social

Security, Medicare, and Medicaid. In view of this combination of slower

revenue growth and increased expenditure demands, the Social Security

Trustees project that in less than 15 years the program’s annual tax

revenue would be insufficient to cover annual benefits and, in 2029, the

program’s balance would be exhausted.

As Social Security and health spending rise, their share of GDP and of

federal spending grows dramatically in our no action simulation. (See

figure II.2 in attachment II.) These spending pressures cause large deficits

to reemerge, adding substantially to the debt held by the public. Rising

debt, in turn, increases spending on interest, which compounds the deficit

problem, resulting in a vicious circle. By about 2040, spending for Social

Security, health programs, and interest alone would consume more than

100 percent of federal revenues.

We are not the only agency to call attention to these unsustainable

long-term trends. CBO also conducts long-term simulations that produce

similar results.8

8

Statement of June E. O’Neill on “The Economic and Budget Outlook: Fiscal Years 1999-2008” before

the U.S. Senate Committee on the Budget, January 28, 1998. Also see Congressional Budget Office,

Long-Term Budgetary Pressures and Policy Options, March 1997.

Page 5 GAO/T-AIMD/OCE-98-83
Effects of Alternative

Fiscal Paths on the

Fiscal and Economic

Outlook

As in our prior reports, we have simulated alternatives to the no action

fiscal policy scenario, using the same underlying economic assumptions.

However, unlike our prior reports, one of the simulations discussed here

would actually worsen the long-term fiscal outlook. In our past work, the

no action simulation always represented the least desirable fiscal path. We

chose this approach because, in an era of large budget deficits, the fiscal

policy debate usually centered on how to reduce these deficits. Policy

alternatives that would have increased deficits received less attention,

particularly after enactment of the Budget Enforcement Act of 1990, which

set up procedural hurdles to deter such policies.

Currently, however, the dramatic drop in the deficit and the expected

budget surpluses for the near future have changed the fiscal policy

climate. While our no action path remains an unsustainable policy over

the long term, it does include a period of budget surpluses over the next 15

years, consistent with CBO’s current baseline. Some recent policy

proposals have suggested using at least part of these prospective surpluses

to increase spending or cut taxes rather than to reduce the debt held by

the public.

Thus, as agreed with your office, we present two alternatives to the no

action simulation in this testimony. The first alternative—no

surplus—assumes that short-term surpluses are not achieved due to

policy actions that permanently increase spending and/or reduce

revenues.9

 In this simulation, the budget would be in balance rather than

surplus over the next decade. Thereafter, revenue and spending would

grow according to the assumptions of the no action simulation, but from

different baseline levels—that is, revenues would be lower and spending

would be higher than in no action. As shown in figure II.3 in attachment II,

the deficit would reach 10 percent of GDP under the no surplus scenario by

2033, or 8 years earlier than the no action scenario where the surpluses

are used to reduce debt held by the public.

The second alternative—maintain balance—assumes short-term budget

surpluses are used to reduce debt held by the public as in the no action

scenario, but then assumes policy actions are taken to prevent deficits

from recurring. Beginning in 2015—when deficits reemerge in the no

action path—the maintain balance simulation assumes that the budget is

kept in balance through the end of the simulation period, as shown in

figure II.3 in attachment II. Unlike no action and no surplus, the maintain

9

Assuming that spending increases or revenue reductions were temporary, rather than permanent,

would produce different results. Such a path would diverge less from the no action baseline than the

one used in our analysis.

Page 6 GAO/T-AIMD/OCE-98-83
balance simulation is one example of a sustainable fiscal path under which

government activities can be maintained without a continual rise in the

debt as a share of GDP.

10

The maintain balance simulation would require some combination of

policy or program changes that reduce spending and/or increase revenues.

We make no assumptions about the mix of those changes in our analysis

and recognize that such actions would not be taken without difficulty.

They would require the nation to make choices resulting in a greater share

of national income devoted to saving. While consumption would be

reduced in the short term, it would be increased over the long term. Early

action would permit changes to be phased in and so give those affected by

changes in, for example, Social Security or health care benefits, time to

adjust.

For both the federal government and the economy, the no surplus path

leads to the worst outcomes over the long term. As shown in figures II.4

and II.5 in attachment II, eliminating surpluses in the short term increases

interest costs over time and ultimately leads to lower living standards

when compared to either the no action or maintain balance paths. Over

the longer term, maintaining budget balance yields a vast improvement

over either the no action or no surplus paths. However, running a surplus

in the short term under the no action scenario helps reduce the fiscal

actions needed to maintain budget balance over the longer term,

compared to the no surplus path.11

Sharply reduced interest costs provide the most striking budgetary benefit

from following a sustainable policy. Currently, interest spending

represents about 15 percent of federal spending, a relatively large share

that is a consequence of the deficits of the 1980s and early 1990s. After

shrinking in the early years of the no action simulation, interest costs

increase sharply over the long term, reaching nearly 25 percent of

spending in 2050. Interest costs become even more burdensome in our no

surplus scenario, topping one-third of all spending in 2050. In contrast,

maintaining a balanced budget after the projected surpluses would reduce

interest costs well below where they are now—to a level less than

10Our past reports and CBO’s work have both illustrated a number of different policy paths that could

be sustained over the long term. For a detailed analysis of sustainability, see Olivier Blanchard,

Jean-Claude Chouraqui, Robert P. Hagemann, and Nicola Sartor, “The Sustainability of Fiscal Policy:

New Answers to an Old Question,” OECD Economic Studies, no. 15 (Autumn 1990). See also The

Canadian Institute of Chartered Accountants, Indicators of Government Financial Condition,

April 1997.

11In fact, our maintain balance path is premised on preserving short-term surpluses, i.e., using them to

reduce debt held by the public, consistent with the CBO baseline.

Page 7 GAO/T-AIMD/OCE-98-83
1 percent of all federal spending. Any path that reduces debt held by the

public and associated interest costs would help promote increased

flexibility for future budget policymakers.

The economic benefits of a sustainable budget policy include increased

saving and investment levels and faster economic growth, which results in

higher living standards. For example, under the maintain balance

simulation, per capita GDP would nearly double between 1997 and 2050. In

contrast, under either the no surplus or no action simulations, growth in

living standards slows considerably and living standards themselves would

begin to decline in the 2040s, as shown by figure II.5 in attachment II. The

differences graphically show the emerging gaps in long-term living

standards that result from different fiscal policy paths. Although the

maintain balance path would lead to higher living standards, the rate of

growth would be significantly lower than that experienced over the past 50

years. Achieving and sustaining the historic growth rate would be

extremely difficult given the slowdown in productivity growth that has

occurred in recent decades.

As shown in table 1, by 2050, living standards would be over 50 percent

lower under no surplus and 25 percent lower under no action than under

the maintain balance simulation. This difference results from a wide gap

in private investment. Under either of the unsustainable simulations, large

deficits eventually drive per capita private investment spending down

sharply while a balanced budget policy could produce a near doubling of

investment per capita. As we have said in our earlier work, the surest way

to increase the resources available for investment is to increase national

saving, and the most direct way for the federal government to increase

national saving is to achieve and sustain a balanced budget. Running

budget surpluses would further increase saving and allow the government

to reduce the level of federal debt held by the public.

Page 8 GAO/T-AIMD/OCE-98-83
Table 1: the Economic and Fiscal Position in 1997 (Preliminary) and 2050 (Simulated)

Percent difference in 2050

between Maintain Balance and

In per capita 1997 dollars

1997

2050

No Surplus

2050

No Action

2050

Maintain

Balance No Surplus No Action

Real GDP $29,600 $36,600 $45,200 $56,500 54% 25%

Debt $13,900 $129,700 $86,800 $2,000 –98%a –98%a

Nonfarm business investment $3,500 0 $1,500 $6,700 N/A 347%

Nonfarm capital stock $29,900 $10,100 $26,600 $60,000 494% 126%

aThese two numbers are not identical, but they round to the same full percent.

Legend

N/A=Not applicable

Long-Term

Commitments Not

Adequately Reflected

in Budget Reporting

To some degree, the long-term fiscal policy of the nation is determined by

the spending or revenue paths inherent in the design of federal programs.

Without adequate information about the long-term cost implications of

specific program (or revenue) designs, fiscal policy may not follow the

expected path. Just as the current long-term projections are driven by a

combination of demographics and the design of Social Security and

federal health care programs, so future projections may also be affected by

the long-term costs of other programs.

As the central process through which the President and the Congress

select among and balance the competing demands for government activity

in achieving various goals, the budget needs to provide more complete

information on the costs of various alternatives—on a comparable

basis—and on the nature of the government’s commitment. Although the

multiyear focus of the Budget Enforcement Act of 1990 represents

significant progress in considering the longer term in budgeting, some

programs require an even longer time horizon to understand the

implications of commitments being made.

The future implications of current policy decisions reflected in our

simulations and in other financial reports are generally not captured in the

budget process. This is because the budget is largely a short-term,

cash-based spending plan focusing on the short- to medium-term cash

implications of government obligations and fiscal decisions. Accordingly,

it does not provide comprehensive information on the longer term cost

Page 9 GAO/T-AIMD/OCE-98-83
implications stemming from the government’s commitments. Of course,

commitments the Congress created by statute may subsequently be

changed by the Congress either modifying, amending, or repealing the

underlying laws establishing the benefits. Nevertheless, a longer term

perspective is necessary to understand the fiscal and spending

implications of key government programs and commitments extending

over a longer time horizon.12 As demonstrated by our simulations, the

nation’s economic future depends in part upon today’s budget and fiscal

policy decisions. In considering what fiscal adjustments to make,

policymakers need to be presented with more complete information on

the costs of the government’s long-term commitments.

The federal government’s long-term commitments are wide-ranging and

varied in nature. While the sustainability of the government’s fiscal policy

is driven primarily by future spending for Social Security and health care

commitments, the federal government’s commitments and responsibilities

extend far beyond these programs. These commitments may themselves

result in large costs that can encumber future fiscal resources and also

constrain the government’s future financial flexibility to meet all its

commitments as well as any unanticipated or emerging needs. Although a

portion of some of the government’s commitments have already been

recognized in the budget through appropriations for future costs there are

others that are not recognized at all. In table 2, we show a number of

federal liabilities and commitments whose total long-term costs have not

been fully recognized in either the budget or in our long-term simulations.

It must be noted that for some of these commitments, the budget has

recognized a portion of the long-term costs. For example, for federal

civilian employees hired since 1987, the full cost of pension benefits is

recognized in the budget as they are earned over the working lives of the

employees.

12Budget Process: Evolution and Challenges (GAO/T-AIMD-96-129, July 11, 1996).

Page 10 GAO/T-AIMD/OCE-98-83
Table 2: Examples of Long-Term

Government Liabilities and

Commitments Not Fully Recognized in

the Federal Budget

Dollars in billions

Examples of federal liabilities and commitments 1996

Deferred Compensation

Civilian and military pensions $1,321.9

Veterans’ compensation and benefits $240.0

Civilian and military retirees’ health benefits $344.2

Insurance

Deposit insurance $0.4a

Pension Benefit Guaranty Corporation $10.8b

Other insurance $16.0c

Environmental liabilities (DOE/DOD) $246.5

Unadjudicated Claims $71.7

Liabilities for pre-credit reform loan guarantees $2.7d

aFinancial Audit: Federal Deposit Insurance Corporation’s 1996 and 1995 Financial Statements

(GAO/AIMD-97-111, June 30, 1997) and National Credit Union Administration 1996 Annual

Report.

bPension Benefit Guaranty Corporation 1996 Annual Report.

cAnalytical Perspectives, Budget of the United States Government, fiscal year 1999.

dGovernmentwide figure not available. Amount reported is calculated from agency financial

statements and includes only the Departments of Education, Agriculture, and Veterans Affairs and

the Small Business Administration.

Source: GAO analysis of data from the fiscal year 1996 prototype Consolidated Financial

Statements of the United States Government issued by Department of the Treasury, except as

noted. These statements were not audited, which limits their usefulness and reliability. GAO is

auditing these statements for fiscal year 1997.

While this list is not comprehensive and may not be universally agreed

with, it provides some perspective on the range and magnitude of these

commitments. Some of the federal government’s liabilities are similar to

those found on the balance sheet of a typical business, such as deferred

compensation. Other commitments—not shown in this table—are of a

different nature. For example, the table we constructed does not show the

implied commitments for social insurance programs such as

Unemployment Insurance, Black Lung benefits, Railroad Retirement, and

Medicaid, nor does it show those programs which, in the absence of a

change in law, would go on forever. In some of these cases, earmarked

revenue, such as in the form of individual contributions, has helped build

public perception of an enduring commitment by the government. Also,

the federal government has other ongoing responsibilities, such as

providing for the common defense of the nation, that are not shown in the

Page 11 GAO/T-AIMD/OCE-98-83
table. Still another category of long-term commitments may arise from

those programs or activities that commit the government to future

operating and maintenance expenses or from the expectation that a

partially funded capital project—such as the space station—will receive

future funding to complete the project.

Possible Budget

Process and

Reporting

Improvements

The broad range of long-term federal commitments complicates the

challenge of integrating more complete information on their expected

future cost into the budget process. The diverse nature of the

commitments, combined with the varying quality and amount of

information available outside the budget process, suggests that

across-the-board changes in budget reporting or process may not be the

most effective way to proceed.

We think that it may be more useful to look at different categories of the

government’s long-term commitments to identify the most useful approach

for incorporating a longer term perspective into current policy actions

affecting those commitments. Alternatives could range from enhancing the

information available in the budget to developing new frameworks for

budgetary incentives and control, as the Congress did for credit programs

under the Federal Credit Reform Act of 1990. Thus, for different categories

of commitments, changes in the information provided or in the existing

incentives and controls could be selectively tailored to address specific

problems. For some types of commitments, the problem may be a lack of

information to judge the expected future costs of programs as they are

created or modified. For other commitments, such as insurance, the

problem may be that the incentives or signals provided by information

reported in the budget are misleading.

While there is a great deal of information available to decisionmakers on

the future cost implications of the government’s two largest

commitments—Social Security and Medicare—long-term simulations like

GAO’s put the information in context by helping focus attention on the

broader fiscal and economic implications of these commitments. These

models can be updated periodically to help the Congress and the public

assess the future consequences of current or proposed policies and

programs. Such long-term simulation models could provide information to

help judge the future implications of current or alternative fiscal policy

paths. The effects of congressional budget resolutions could be simulated

over the long term to gauge their potential impact on the long-term

outlook. Thus, use of economic simulations could help establish a

Page 12 GAO/T-AIMD/OCE-98-83
long-term framework linking budget planning and long-term fiscal policy

goals.

With regard to program categories for which the budget currently provides

misleading or incorrect incentives and signals, we recently reported that

the cash-based budget provides neither complete cost information for

budget decision-making nor the incentives necessary to control costs for

federal insurance programs.13 While smaller than the government’s social

insurance commitments, federal insurance is provided to individuals and

businesses against a wide variety of risks, ranging from natural disasters

under the flood and crop insurance programs to bank and employer

bankruptcies under the deposit and pension insurance programs. These

commitments could result in potentially large future obligations; however,

their costs are not currently reflected in the budget at the time the

government extends the insurance. Although it is often hard to predict the

timing and magnitude of insured losses, estimates of the expected

long-term costs of these future claims are available for many of the federal

insurance programs. In our report, we recommended that the Office of

Management and Budget work with the insurance program agencies to

improve these estimates and report this supplemental information in the

budget. Reporting of such accrual-based insurance costs would improve

recognition of the government’s commitments.

Another area in which the budget provides incomplete cost information

and misleading incentives is future civilian and military retiree health

costs. None of the accruing costs of civilian or military retiree health

benefits are recognized in the budget. The budgetary information and

incentives to control costs for these programs could potentially be

improved through the use of accrual concepts, which would recognize the

full cost of these benefits in the budget as they are earned.

The cost of environmental cleanup resulting from federal operations,

which under federal accounting standards is reported as a liability on

financial statements, represents another category of long-term costs, most

of which have not been recognized in the budget. While it will be up to the

Congress to decide on the most appropriate way to deal with this large

accumulated liability, we believe that decisions to purchase capital assets

should take into account the cost of any new environmental liabilities to

be created with the operation or decommissioning of the asset. The cost of

13See Budget Issues: Budgeting for Federal Insurance Programs (GAO/AIMD-97-16, September 30,

1997).

Page 13 GAO/T-AIMD/OCE-98-83
future environmental liabilities could be provided as supplemental

information or recorded in budget authority before the asset is purchased.

Information about the cost of some of these commitments will be

increasingly available as agencies produce audited financial statements.

Financial reports based on federal financial accounting standards will

provide an additional perspective on the government’s various long-term

commitments and finances. The new standards require new reports on a

broad range of liabilities and commitments. Liabilities such as deferred

compensation and environmental costs will be reported on the balance

sheet. Information on the government’s commitments for programs like

Social Security and Medicare, while not treated as balance sheet liabilities,

will be presented in stewardship reports. These are new reports

supplementing the basic financial statements that are intended to provide

additional financial and nonfinancial information useful for assessing the

government’s stewardship over the resources entrusted to it and the

responsibilities it has assumed.

Conclusion The economy and policy actions have combined to create a major change

in the near-term deficit outlook. Current projections—assuming

compliance with discretionary spending limits set in the Balanced Budget

Act of 1997—are for surpluses through 2013. Although near-term

budgetary improvement is a welcome achievement, unsustainable deficits

nonetheless would reemerge over the longer term as a smaller generation

of workers will be challenged to finance the costs of public programs for

baby boom retirees.

Our near-term fiscal policy will have a decided impact on the future

budgets and economy inherited by the next generations. Our simulations

suggest that preserving the anticipated budget surpluses now makes some

tangible difference for the long term, most notably by reducing the burden

of debt and interest passed on in future budgets. However, a sustainable

policy will, at some point in the future, require further fiscal actions to

avoid the vicious cycle of exploding deficits and debt—actions that could

be more or less painful based on our decisions today. A budget reporting

and accounting framework making the future implications of today’s

decisions more transparent would help the nation better understand the

stakes underlying the choices it faces.

Page 14 GAO/T-AIMD/OCE-98-83
Mr. Chairman, this concludes my written statement. I would be happy to

answer any questions you or your colleagues may have. We look forward

to working with you as you address the important long-term issues I have

discussed today.

Page 15 GAO/T-AIMD/OCE-98-83
Attachment I 

The Economic Model and Assumptions

This update of GAO’s work1 on the long-term economic and budget outlook

relies in large part on a model of economic growth developed by

economists at the Federal Reserve Bank of New York (FRBNY). The major

determinants of economic growth in the model include changes in the

labor force, capital formation, and the growth in total factor productivity.

To analyze the long-term effects of fiscal policy, we modified the FRBNY’s

model to include a set of relationships that describe the federal budget and

its links to the economy, using the framework of the National Income and

Product Accounts (NIPA). The simulations generated using the model

provide illustrations, not forecasts, of the budget or economic outcomes

associated with alternative policy paths. The model depicts the links

between the budget and the economy over the long-term, and does not

reflect their interrelationships during short-term business cycles.

The main influence of budget policy on long-term economic performance

in the model is through the effect of the federal deficit or surplus on

national saving. Higher federal deficits or lower surpluses reduce national

saving while lower deficits or higher surpluses increase national saving.

The level of saving affects investment and, hence, GDP growth.

GDP is determined by the labor force, capital stock, and total factor

productivity.2 GDP in turn influences nonfederal saving, which consists of

the saving of the private sector and state and local government surpluses

or deficits. Through its effects on federal revenues and spending, GDP also

helps determine the federal budget deficit or surplus. Nonfederal and

federal saving together comprise national saving, which influences private

investment and the next period’s capital stock. Capital combines with

labor and total factor productivity to determine GDP in the next period and

the process continues.

There are also important links between national saving and investment

and the international sector. In an open economy such as the United

States, a decrease in saving due to, for example, an increase in the federal

budget deficit, does not require an equivalent decrease in investment.

Instead, part of the saving shortfall may be filled by foreign capital inflows.

A portion of the net income that results from such investments flows

1

Budget Policy: Prompt Action Necessary To Avert Long-Term Damage to the Economy

(GAO/OCG-92-2, June 5, 1992), The Deficit and The Economy: An Update of Long-Term Simulations

(GAO/AIMD/OCE-95-119, April 26, 1995), and Budget Issues: Analysis of Long-Term Fiscal Outlook

(GAO/AIMD/OCE-98-19, October 22, 1997).

2

Total factor productivity reflects sources of growth not captured in aggregate labor and capital

measures, including technological change, labor quality improvements, and the reallocation of

resources to more productive uses.

Page 16 GAO/T-AIMD/OCE-98-83
Attachment I 

The Economic Model and Assumptions

abroad. In this update, we retained the assumption in our prior work that

net foreign capital inflows rise by one-third of any decrease in the national

saving rate.

Table I.1 lists the key assumptions incorporated in the model. The

assumptions used tend to provide conservative estimates of the benefit of

reducing deficits or running surpluses and of the harm of increasing

deficits. The interest rate on the national debt is held constant, for

example, even when deficits climb and the national saving rate plummets.

Under such conditions, the more likely result would be a rise in the rate of

interest and a more rapid increase in federal interest payments than our

results display. Another conservative assumption is that the rate of total

factor productivity growth is unaffected by the amount of investment.

Productivity is assumed to advance 1 percent each year even if investment

collapses. Such assumptions suggest that changes in deficits or surpluses

could have greater effects than our results suggest.

We have made several modifications to the model, but the model’s

essential structure remains the same as in our previous work. We have

incorporated the change in the definition of government saving in the NIPAs

adopted in late 1995 by adding a set of relationships determining

government investment, capital stock, and the consumption of fixed

capital.

The more recent data prompted several parameter changes. For example,

the long-term inflation rate is now assumed to be 2.5 percent, down from

2.7 in our October 1997 report, 3.4 percent in our 1995 report and

4.0 percent in our 1992 report. In this update, the average federal

borrowing rate steadily declines to 5.1 percent, compared to our

assumption of 7.2 percent in 1995 and 7.8 percent in 1992. Our work also

incorporates the marked improvement in the economic and budget

outlook reflected in the 10-year projections that CBO published in

January 1998.

As we use a broad NIPA framework for our long-term simulations, the

presentation of the mandatory and discretionary spending trends implied

by our results are only approximations. We adopted the NIPA-based budget

assumptions from CBO’s most recent 10-year economic and budget outlook,

which reflect the assumption that discretionary spending equals the

statutory caps from fiscal years 1998 through 2002 and increases at the

rate of inflation from fiscal years 2003 through 2008. For the period

following fiscal year 2008, we assumed that those NIPA categories broadly

Page 17 GAO/T-AIMD/OCE-98-83
Attachment I 

The Economic Model and Assumptions

corresponding to discretionary spending would keep pace with GDP

growth.

Mandatory spending includes Health (Medicare and Medicaid), Old Age

Survivors and Disability Insurance (OASDI, or Social Security), and a

residual category covering other mandatory spending. Following NIPA

definitions, we did not net out premiums and contributions from these

categories. Medicare reflects CBO’s assumptions through 2007, and

increases at the Health Care Financing Administration’s (HCFA) projected

rate in subsequent years. Medicaid is based on CBO’s January 1998

assumptions; thereafter it increases at the rates embodied in CBO’s

March 1997 report on the long-term budget outlook. OASDI reflects the

April 1997 Social Security Trustees’ Alternative II projections.

Other mandatory spending is a residual category consisting of non-health,

non-Social Security mandatory spending. It equals CBO’s NIPA projection for

Transfers, Grants, and Subsidies less Health, OASDI, and discretionary

spending that is included in NIPA projections for these items. Through 2007,

CBO assumptions are the main determinant of other mandatory spending,

after which its growth is linked to that of GDP.

The interest rates for 1997-2007 are consistent with the average effective

rate implied by CBO’s interest payment projections. We assume that the

average rate remains at the 2007 rate of 5.1 percent for the rest of the

simulation period.

Receipts follow CBO’s dollar projections through 2007. Thereafter, they

continue at 20.5 percent of GAO’s simulated GDP, which is the rate projected

for 2007.

As these assumptions differ somewhat from those used in our earlier

reports, only general comparisons of the results can be made.

Page 18 GAO/T-AIMD/OCE-98-83
Attachment I 

The Economic Model and Assumptions

Table I.1: Key Assumptions

Assumptions

Saving rate: gross saving of the private and

state and local government sectors

17.5 percent of GDP

Labor: growth in hours worked Follows the Social Security Trustees’

Alternative II projections

Total factor productivity growth 1 percent

Inflation rate Follows CBO through 2008; 2.5 percent

thereafter

Interest rate (average on the national debt) Average effective rate implied by CBO’s

interest payment projections through 2007;

5.1 percent (CBO’s 2007 implied rate)

thereafter

Surplus/Deficit Follows CBO’s budget surplus/deficit as a

percentage of GDP through 2007; GAO

projections thereafter

NIPA categories covering discretionary

spending and other mandatory spending

CBO through 2007; increases at the rate of

economic growth thereafter

Medicare CBO through 2007; increases at HCFA’s

projected rate thereafter

Medicaid CBO’s projections and simulation

OASDI Follows the Trustees’ Alternative II

projections

Receipts CBO’s assumed levels through 2007; in

subsequent years receipts equal 20.5

percent of GDP (2007 ratio)

Note: In our work, all CBO budget projections were converted from a fiscal year to a calendar

year basis. The last year of CBO’s projection period is fiscal year 2008, permitting the calculation

of calendar year values through 2007.

Page 19 GAO/T-AIMD/OCE-98-83
Attachment II 

Figures

Figure II.1: Deficit Paths Under GAO’s Past and Present No Action Simulations

1997 2002 2010 2020 2030 2040 2050

-5

0

5

10

15

20

25

Years

Percent of GDP

 No action 

1992

 No action 

1995

 No action 

Feb 1998

Page 20 GAO/T-AIMD/OCE-98-83
Attachment II 

Figures

Figure II.2: Long-Term Change in Composition of Spending as a Percentage of GDP Under No Action Simulation

1997 2030 2050

0

10

20

30

40

50

Years

Percent of GDP

Social Security Medicare & Medicaid Net interest All other spending 

Revenue

Page 21 GAO/T-AIMD/OCE-98-83
Attachment II 

Figures

Figure II.3: Alternative Deficit/Surplus Paths

1997 2002 2010 2020 2030 2040 2050

-5

0

5

10

15

20

25

30

35

Years

Percent of GDP

No Surplus No Action Maintain

 balance 

Page 22 GAO/T-AIMD/OCE-98-83
Attachment II 

Figures

Figure II.4: Net Interest as a Share of Total Spending in 2050 Under GAO’s Three Fiscal Policy Simulations

0

10

20

30

40

33.6

24.1

0.8

Net interest

Percent of total spending

No Surplus No Action Maintain

balance 

Page 23 GAO/T-AIMD/OCE-98-83
Attachment II 

Figures

Figure II.5: GDP Per Capita Projected Under GAO’s Three Fiscal Policy Simulations

1946 1955 1965 1975 1985 1997 2010 2020 2030 2040 2050

0

10,000

20,000

30,000

40,000

50,000

60,000

Per capita 1997 dollars

 Historical 

data

Maintain

Balance

No

Action

No

Surplus

Source: GAO analysis of 1946-1996 historical data, GAO’s GDP simulations, and Social Security

Administration population projections.

(935257) Page 24 GAO/T-AIMD/OCE-98-83
Ordering Information

The first copy of each GAO report and testimony is free.

Additional copies are $2 each. Orders should be sent to the

following address, accompanied by a check or money order

made out to the Superintendent of Documents, when

necessary. VISA and MasterCard credit cards are accepted, also.

Orders for 100 or more copies to be mailed to a single address

are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office

P.O. Box 37050

Washington, DC 20013

or visit:

Room 1100

700 4th St. NW (corner of 4th and G Sts. NW)

U.S. General Accounting Office

Washington, DC

Orders may also be placed by calling (202) 512-6000 

or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and

testimony. To receive facsimile copies of the daily list or any

list from the past 30 days, please call (202) 512-6000 using a

touchtone phone. A recorded menu will provide information on

how to obtain these lists.

For information on how to access GAO reports on the INTERNET,

send an e-mail message with "info" in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov

PRINTED ON RECYCLED PAPER
United States

General Accounting Office

Washington, D.C. 20548-0001

Official Business

Penalty for Private Use $300

Address Correction Requested

Bulk Rate

Postage & Fees Paid

GAO

Permit No. G100