Budget Issues: Analysis of Long-Term Fiscal Outlook
Released: 1997-10-22T00:00:00

Letter

Background

Economic growth—which is central to many of our major concerns as a society—requires investment, which, over the longer term, depends on saving. The nation’s saving consists of the private saving of households and businesses and the saving or dissaving of all levels of government. 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.

Since the 1970s, private saving has declined while federal budget deficits have consumed a large share of these increasingly scarce savings. The result has been to decrease the amount of national saving potentially available for investment. Since we last reported on this issue in 1995, private saving has remained low. However, federal budget deficits have declined significantly from the levels of the 1980s and early 1990s, freeing up some additional funds for investment. (See figure 1.) Nevertheless, total national saving and investment remain significantly below the levels experienced in the 1960s and 1970s. Economists have noted that these low levels of saving and investment raise concerns for the nation’s future productive capacity and future generations’ standard of living. As we have said in our earlier reports, 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 maintain a balanced federal budget. Running budget surpluses would further increase saving and allow the government to reduce the level of federal debt held by the public.

Our earlier work concluded that without further policy action, commitments in federal retirement and health programs would together become progressively unaffordable for the nation over time, and the economic consequences would force belated and painful policy choices. Growing deficits and the resulting lower saving would lead to dwindling investment, slower growth, and finally a decline in real GDP. Living standards, in turn, would at first stagnate and then fall. These findings supported our conclusion that action on the deficit might be postponed, but it could not be avoided.

The results of our past work have been very similar to the conclusions reached by other government entities and private analysts. Most notably, CBO published analyses based on its long-term model work in 1996 and 1997 that corresponded with our main findings. Also, in 1994-95, the Bipartisan Commission on Entitlement and Tax Reform reached similar conclusions in its study of future fiscal trends.

Since our 1995 report, robust economic growth and policy action have combined to sharply reduce the deficit and are projected by CBO to result in budget surpluses in the near term. This report addresses the outlook for the budget over the longer term. We will explore how recent progress affects this outlook and the fiscal and economic impacts associated with alternative long-term fiscal policy strategies.

Policy Action Contributes to Improved Fiscal Outlook

In recent years, the federal deficit has declined substantially from $290 billion in fiscal year 1992—4.7 percent of GDP—to a CBO projected level of $23 billion in fiscal year 1997—0.3 percent of GDP, which would be the lowest level since 1974. This improvement is due, in part, to deficit reduction initiatives enacted in 1990 and 1993 as well as to subsequent spending restraint. The Balanced Budget Act of 1997, coupled with the strong recent performance of the economy, is expected to extend this recent progress by achieving a balanced budget in 2002 followed by several years of budget surpluses on a unified budget basis. The decline in the deficit has significantly slowed growth in the federal debt held by the public. As a share of GDP, this commonly used measure of federal debt is projected by CBO to decline from about 50 percent in fiscal year 1993 to 30 percent in 2007.

The improving fiscal outlook over the near term carries longer term benefits as well, as illustrated by comparing our current “no action” simulation with our 1992 and 1995 modeling results. (See figure 2.) Our initial modeling work in 1992 indicated that even in the short term, prospective deficits would fuel a rapidly rising debt burden. Intervening economic and policy developments led to some improvement by the time we issued our 1995 report, as shown by a modest shift outward of the “no action” deficit path. Nonetheless, both our 1992 and 1995 “no action” simulations indicated that deficits would have reached 20 percent of GDP in the 2020s. In contrast, the 1997 “no action” path—which follows CBO’s 10-year forecast—indicates small and shrinking deficits over the next few years, followed by a decade of surpluses. Following the enactment of the BBA in 1997, our simulation indicates that deficits would not reach the 20-percent level until nearly 2050. For purposes of comparison, the highest deficit level reached since World War II was 6.1 percent of GDP in 1983. Figure 3 illustrates the improvement in the long-term outlook for the federal debt as a share of GDP stemming from recent policy actions and economic developments.

Long-Term Implications of Current Fiscal Policy Path

These recent fiscal improvements represent substantial progress in the near term toward a more sustainable fiscal policy. However, longer term problems remain. As in our earlier work, a “no action” policy remains unsustainable over the long term. (See figure 2.) While the federal budget would be in surplus in the first decade of the 21st century, deficits would reemerge in 2012, soon after the baby boom generation begins to retire. These deficits would then escalate, exceeding 6 percent of GDP before 2030 and exceeding 20 percent of GDP by 2050.

A comparison of federal debt to the size of the economy tells a similar story—near-term improvement followed by potentially unsustainable growth as the baby boomers retire. (See figure 3.) In the early years of the simulation period, budget surpluses produce a substantial reduction in the absolute size of the debt as well as in the relationship of debt to GDP, from today’s level of around 50 percent to about 20 percent in 2015. However, at that point, the debt to GDP ratio begins to rise rapidly, returning to today’s levels in the late 2020s and growing to more than 200 percent by 2050.

Such levels of deficits and debt imply a substantial reduction in national saving, private investment, and the capital stock. Given our labor force and productivity growth assumptions, GDP would inevitably begin to decline. These 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 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 in the future to address the nation’s long-term fiscal challenges.

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 faster growth in entitlement program spending, and (2) the rising costs of providing federal health care benefits. In 2008, 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 2025, the number of workers per Social Security beneficiary is projected to drop by 33 percent. Without a major increase in productivity, low labor force growth will inevitably lead to slower growth in the economy and in federal revenue. As slow growth in the labor force constrains revenue growth, the large retired population will place major expenditure demands on Social Security, Medicare, and Medicaid. In just 15 years, the Social Security trustees estimate that the program’s tax revenue is expected to be insufficient to cover current benefits. While the recent Balanced Budget Act included some actions to restrain growth in Medicare spending and increase income from beneficiary premiums, the program is still expected to grow faster than the economy over the next several years. According to CBO estimates, the Hospital Insurance Trust Fund portion of Medicare will be depleted in 2007, even before retiring baby boomers begin to swell the ranks of Medicare beneficiaries. Medicaid spending will also be under increasing pressure as the population ages because a large share of program spending goes to cover nursing home care.

In the “no action” simulation, Social Security spending as a share of GDP increases by nearly 50 percent between now and 2030. By 2050, it approaches twice today’s level. Health care spending, fueled by both an increased number of beneficiaries and (in the early years of the simulation period) rising per beneficiary costs, would grow even more rapidly—doubling as a share of GDP by 2030 and tripling by 2050. As Social Security and health spending rise, their share of federal spending grows tremendously. (See figure 4.) By the mid-2040s, spending for these programs alone would consume more than 100 percent of federal revenues.

After initially declining, interest spending also increases significantly in the “no action” simulation. In the early years of the simulation period, budget surpluses reduce the burden of interest spending on the economy. However, when the surpluses give way to deficits, this decline is reversed. Growing deficits add substantially to the national debt. Rising debt, in turn, raises spending on interest, which compounds the deficit problem, resulting in a vicious circle. The effects of compound interest are clearly visible in figure 5, as interest spending rises from about 3 percent of GDP in 1997 to over 12 percent in 2050.

Alternative Fiscal Policies Would Change Long-Term Economic Outcomes

Alternatives to a “no action” policy illustrate the fiscal and economic benefits associated with maintaining a sustainable course. According to one definition, under a sustainable fiscal policy, existing government programs can be maintained without a continual rise in the debt as a share of GDP. Under an unsustainable policy, such as “no action,” the debt continually rises as a share of GDP. As illustrated in our past reports and CBO’s work, a number of different policy paths could be sustained over the long term. In our current work, we tested three different long-term fiscal strategies, one that would allow for modest deficits, one that would maintain a balanced budget, and one that would include an extended period of surpluses. (See figure 6.)

The “constant debt burden” simulation follows the “no action” path through 2015. From this point on, the debt is held constant as a share of GDP, rather than increasing as in the “no action” simulation. To prevent the debt burden from rising from its 2015 level of about 20 percent of GDP, the federal government would have to hold annual deficits to roughly 1 percent of GDP. While not insignificant, this deficit level is relatively small compared to the federal deficits of recent years or to deficits in other industrial nations. For example, the European Union has established a deficit target of 3 percent of GDP for countries participating in the common currency arrangement.

The “maintain balance” simulation also follows the “no action” path for the early part of the simulation period. In 2012—the year that deficits reemerge under “no action”—a balanced unified budget would be achieved. Balance would then be sustained through the remainder of the simulation period.

Going beyond balance by running larger budget surpluses for a longer period of time than in the other simulations would yield additional economic benefits by further raising saving and investment levels. For our “surplus” simulation, we chose as a goal ensuring that annual Social Security surpluses (including interest that is credited to the fund) add to national saving. To achieve this goal, the federal government would run unified budget surpluses equal in size to the annual Social Security surpluses—which the Social Security Trustees estimate will peak at $140 billion in 2009. Such a policy means that the rest of the federal government’s budget would be in balance. Social Security’s surpluses (including interest income) are projected to end in 2018. Beginning in 2019, our simulation follows a unified budget balance identical to the path in our balance simulation.

Figure 7 shows the debt-to-GDP paths associated with the various simulations. Under the “constant debt burden” simulation, the debt-GDP ratio remains around 20 percent, which is the lowest point reached in “no action.” Under both the “balance” and “surplus” simulations, the debt-GDP measure would decline to less than 10 percent of GDP—levels that the United States has not experienced since before World War I.

Each of the alternative simulations 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. We recognize that such actions would not be taken without difficulty. They would require difficult 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, any of the three alternative simulations indicates a vast improvement over the “no action” path. 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. As noted above, after shrinking in the early years of the “no action” simulation, interest costs increase sharply over the long term. In contrast, under the alternative simulations, the interest burden shrinks dramatically. (See figure 8.) By 2050, under either a balance or surplus policy, interest payments would represent 1 percent or less of total spending. Even under the less austere “constant debt burden” simulation, interest would account for only about 5 percent of spending.

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 any of our alternative simulations, per capita GDP would nearly double between 1996 and 2050. In contrast, under “no action,” growth in living standards would slow considerably and living standards themselves would actually begin to decline around 2040. By 2050, they would be nearly 40 percent lower than under the balance simulation. This difference results from a wide gap in private investment. Under “no action,” large deficits eventually drive private investment spending down to zero while, for example, a balanced budget policy could produce a doubling of investment, as shown in table 1. In the “no action” simulation, capital depreciation would outweigh investment, resulting in a diminishing capital stock and, eventually, contributing to a falling GDP.

Figure 9 compares the path of per capita GDP under “no action” to a balanced budget policy. This difference graphically shows the emerging gap in long-term living standards that results from shifting 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. Such a rate would be extremely difficult to attain given the slowdown in productivity growth that has occurred in recent decades.

Long-Term Commitments Not Adequately Reflected in Budget Reporting and Process

Long-term economic simulations are a useful tool for examining the balance between the government’s future obligations and expected resources. This longer term perspective is necessary to understand the fiscal and spending implications of key government programs and commitments extending over a longer time horizon.

The future implications of current policy decisions reflected in our simulations and in other financial reports are generally not captured in the budget process. The budget is generally 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 all of the information on the longer term cost implications stemming from the government’s commitments when they are made. 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 unknowingly constrain the government’s future financial flexibility to meet all its commitments as well as any unanticipated or emerging needs.

Information about the cost of some of these commitments will be increasingly available as agencies produce audited financial statements. We anticipate that they will provide additional information on long-term commitments, including such items as environmental cleanup and insurance. For example, in its 1996 financial statements, the Department of Energy reported a cost of $229 billion to clean up its existing contaminated sites. The Department of Defense will also be developing and reporting cleanup costs in financial statements. The Office of Management and Budget has estimated that the government is likely to have to pay $31 billion in future claims resulting from the federal government’s insurance commitments. The first audited governmentwide financial statements will be issued for fiscal year 1997. This represents a key step in the government’s efforts to improve financial management and provide greater transparency and accountability for the costs of government commitments and programs.

The key challenge facing budget decisionmakers is to integrate this information into the budget process. A range of options can be considered. A logical first step would be to include understandable supplemental financial information on the government’s long-term commitments and responsibilities in the budget. For example, in a recent report we concluded that supplemental reporting of accrual-based costs of insurance programs would improve recognition of the government’s commitments.Other options to refine the budget process or budget reporting to improve the focus on these commitments and prompt early action to address potential problems can be explored. For example, long-term simulations of current or proposed budget policies could be prepared periodically to help the Congress and the public assess the future consequences of current decisions. Another option, which would supplement the current practice of tracking budget authority and outlays, would be to provide information to permit tracking the estimated cost of all long-term commitments created each year in the budget.

Objectives, Scope and Methodology

In this report, the analysis of alternative fiscal policy paths relies in substantial part on an economic growth model that we adapted from a model developed by economists at the FRBNY. The model reflects the interrelationships between the budget and the economy over the long term and does not capture their interaction during short-term business cycles.

The main influence of budget policy on long-term economic performance is through the effect of the federal deficit on national saving. Conversely, the rate of economic growth helps determine the overall federal deficit or surplus through its effect on revenues and spending. Federal deficits reduce national saving while federal surpluses increase national saving. The level of saving affects investment and, in turn, GDP growth.

Budget assumptions in the model rely, to the extent practicable, upon the baseline projections in CBO’s September 1997 report, The Economic and Budget Outlook: An Update, through 2006, the last year for which CBO projections are available in a format usable by our model. These estimates are used in conjunction with our model’s simulated levels of GDP. For Medicare, we assumed growth consistent with CBO’s projections and the Health Care Financing Administration’s long-term intermediate projections from the Medicare Trustees’ April 1997 report. For Medicaid through 2006, we similarly assumed growth consistent with CBO’s budget projections. For 2007 and thereafter, we used estimates of Medicaid growth from CBO’s March 1997 report, Long-Term Budgetary Pressures and Policy Options. For Social Security, we used the April 1997 intermediate projections from the Social Security Trustees throughout the simulation period. Other mandatory spending is held constant as a percentage of GDP after 2006. Discretionary spending and revenues are held constant as a share of GDP after 2006. Our interest rate assumptions are based on CBO through 2006 and then move to a fixed rate. (See appendix I for a more detailed description of the model and the assumptions we used.)

We conducted our work from September to October 1997 in accordance with generally accepted government auditing standards. We received comments from experts in fiscal and economic policy on a draft of this report and have incorporated them as appropriate.

We are sending copies of this report to the Ranking Minority Members of your Committees, interested congressional committees, the Director of the Congressional Budget Office, and the Director of the Office of Management and Budget. We will make copies available to others upon request. The major contributors to this report are listed in appendix II. If you have any questions concerning this report, please call me at (202) 512-9573.

The Economic Model and Assumptions

This update of GAO’s work 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. The simulations generated using the model provide qualitative illustrations, not quantitative 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 reduce national saving while lower deficits or surpluses increase national saving. The level of saving affects investment and, hence, gross domestic product (GDP) growth.

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

Interest rate (average on the national debt)

Average effective rate implied by CBO’s interest payment projections through 2006; 5.1% thereafter (CBO’s 2006 implied rate)

Follows CBO’s budget surplus/deficit as a percentage of GAO’s GDP through 2006; GAO simulations thereafter CBO through 2006; increases at the rate of economic growth thereafter CBO through 2006; increases at HCFA’s projected rate thereafter Follows the Social Security Trustees’ Alternative II projections CBO’s assumed levels through 2006; increases at the rate of economic growth thereafter CBO’s assumed levels through 2006; in subsequent years, receipts equal 19.9% of GDP (2006 ratio)

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 National Income and Product Accounts (NIPA) 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 2.7 percent, down from 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 budget outlook stemming from the Balanced Budget Act of 1997 reflected in the 10-year budget projections that CBO published in September 1997.

The distinction between the mandatory and discretionary components of the budget remains important. We adopted CBO’s assumption from their most recent 10-year forecast 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 2007. We assumed it would keep pace with GDP growth thereafter.

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. Medicare reflects CBO’s assumptions through 2006 and increases at HCFA’s projected rate in subsequent years. Medicaid is based on CBO’s September 1997 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 all nonhealth, non-Social Security mandatory spending. It equals CBO’s NIPA projection for Transfers, Grants, and Subsidies less Health, OASDI, and other discretionary spending. Through 2006, 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 through 2006 are consistent with the average effective rate implied by CBO’s interest payment projections. We assume that the average rate remains at the 2006 rate of 5.1 percent for the rest of the simulation period.

Receipts follow CBO’s dollar projections through 2006. Thereafter, they continue at 19.9 percent of GAO’s simulated GDP, which is the rate projected for 2006.

As these assumptions differ somewhat from those used in our earlier reports, only general comparisons of the results can be made.

Major Contributors to This Report

Accounting and Information Management Division, Washington, D.C.

Office of the Chief Economist

Related GAO Products

Budget Issues: Budgeting for Federal Insurance Programs (GAO/AIMD-97-16, September 30, 1997).

Retirement Income: Implications of Demographic Trends for Social Security and Pension Reform (GAO/HEHS-97-81, July 11, 1997).

Addressing the Deficit: Budgetary Implications of Selected GAO Work for Fiscal Year 1998 (GAO/OCG-97-2, March 14, 1997).

Federal Debt: Answers to Frequently Asked Questions (GAO/AIMD-97-12, November 27, 1996).

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

Deficit Reduction: Opportunities to Address Long-standing Government Performance Issues (GAO/T-OCG-95-6, September 13, 1995).

The Deficit and the Economy: An Update of Long-Term Simulations (GAO/AIMD/OCE-95-119, April 26, 1995).

Deficit Reduction: Experiences of Other Nations (GAO/AIMD-95-30, December 13, 1994).

Budget Issues: Incorporating an Investment Component in the Federal Budget (GAO/AIMD-94-40, November 9, 1993).

Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the Economy (GAO/OCG-92-2, June 5, 1992).

The Budget Deficit: Outlook, Implications, and Choices (GAO/OCG-90-5, September 12, 1990).

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