It is important to look at the President’s proposal in the context of the fiscal situation in which we find ourselves. After nearly 30 years of unified budget deficits, we look ahead to projections for “surpluses as far as the eye can see.” At the same time, we know that we face a demographic tsunami in the future that poses significant challenges for the Social Security system, Medicare, and our economy as a whole. In this context, we should recognize that the President uses a longer-term framework for resource allocation than has been customary in federal budgeting. Although all projections are uncertain—and they get more uncertain the farther out they go—we have long held that a long-term perspective is important in formulating fiscal policy for the nation. Each generation is in part the custodian for the economy it hands the next and the nation’s long- term economic future depends in large part on today’s budget decisions. This perspective is particularly important because our model and that of the Congressional Budget Office (CBO) continue to show that absent a change in policy, the changing demographics to which I referred above will lead to renewed deficits. This longer-term problem provides the critical backdrop for making decisions about today’s surpluses. Surpluses are the result of a good economy and difficult policy decisions. They also provide a unique opportunity to put our nation on a more sustainable path for the long term, both for fiscal policy and the Social Security program itself. Current decisions can help in several important respects: (1) current fiscal policy decisions can help expand the future capacity of our economy by increasing national savings and investment, (2) engaging in substantive reforms of retirement and health programs can reduce future claims, (3) by acting now, we have the opportunity of phasing in changes to Social Security and health programs over a sufficient period of time to enable our citizens to adjust, and (4) failure to achieve needed reforms in the Social Security and Medicare programs will drive future spending to unsustainable levels and eventually “squeeze out” most or all discretionary spending. If we let the achievement of a budget surplus lull us into complacency about the budget, then in the middle of the 21st century, we could face daunting demographic challenges without having built the economic capacity or program/policy reforms to handle them. Before turning to the context for and analysis of the President’s proposal, let me briefly describe it. The President proposes to use approximately two-thirds of the total projected unified budget surpluses over the next 15 years to reduce debt held by the public and to address Social Security’s financing problem. His approach to this, however, is extremely complex and confusing. The President proposes to “transfer” an amount equal to a portion of the projected surplus to the Social Security and Medicare trust funds. This transfer is projected to extend the solvency of Social Security from 2032 to 2049. His proposal to permit the trust fund to invest in equities is expected to further extend trust fund solvency to 2055. He calls on the Congress to work with him on program changes to get to 2075. To understand and evaluate this proposal, it is important to understand the nature of the federal budget, how trust funds fit into that budget, and the challenges of “saving” within the federal budget. The federal budget is a vehicle for making choices about the allocation of scarce resources. It is different from state budgets in ways important to this discussion. Most states use “fund budgeting” in which pension funds that are separate and distinct legal entities, build up surpluses that are routinely invested in assets outside the government (e.g., readily marketable securities held in separate funds). In contrast, the federal government’s unified budget shows all governmental transactions and all funds are available for current activities, including current-year activities of all trust funds. We cannot park our surplus in a cookie jar. The only way to save in the federal budget is to run a surplus or purchase a financial asset. When there is a cash surplus it is used to reduce debt held by the public. Therefore, to the extent that there is an actual cash surplus, debt held by the public falls. This presents a problem for any attempt to “advance fund” all or part of future Social Security benefits. Advance funding within the current program would mean increasing the flows to the SSTF. Although it is officially “off budget,” the fact remains that the SSTF is a governmental fund. In the federal budget, trust funds are not like private trust funds. They are simply budget accounts used to record receipts and expenditures earmarked for specific purposes. A private trust fund can set aside money for the future by increasing its assets. However, under current law, when the SSTF’s receipts exceed costs, they are invested in Treasury securities and used to meet current cash needs of the government. These securities are an asset to the trust fund, but they are a claim on the Treasury. Any increase in assets to the SSTF is an equal increase in claims on the Treasury. One government fund is lending to another. The transactions net out on the government’s books. Given this investment policy, any increase in the trust fund balances would only become an increase in saving if this increment were to add to the unified budget surplus (or decrease the unified budget deficit) and thereby reduce the debt held by the public. This is also the only way in which an increase in the SSTF balance could be a form of advance funding. How do these transactions affect the government’s debt? Gross federal debt is the sum of debt held by the public and debt held by governmental accounts—largely trust funds. This means that increases in the trust fund surplus will increase gross debt unless debt held by the public declines by at least the same amount. Any reform of Social Security that increases the annual SSTF surplus would increase debt held by government accounts since, under current law, any excess of revenues over benefit payments is loaned to Treasury for current needs. As a result, total government debt would go up unless these surpluses were used to reduce debt held by the public by an equivalent amount. For most people, the different types of “debt” in the federal budget may be confusing—especially since what is “good news” for a trust fund may be “bad news” for total debt and vice versa. This is so because total debt (or gross debt) is the sum of two very different types of debt—debt owed to the public and debt owed by one part of the government (general fund) to another part of the government (trust funds). Therefore, if a trust fund surplus grows faster than debt held by the public falls, total debt grows— even if the trust fund surplus is created as an attempt to “save” or to “pre- fund” some of the future benefit payments. These contradictory movements emphasize the need to differentiate between different types of debt and what they mean. Both debt held by the public and debt held by trust funds are important--but for different reasons. Analytically, therefore, what is most important is not whether total debt increases but rather the reasons behind the increase--does it represent an attempt to “advance fund” through substantive reform or merely the promise of future resources? Debt held by the public and debt held by trust funds represent very different concepts. Debt held by the public approximates the federal government’s competition with other sectors in the credit markets. This affects interest rates and private capital accumulation. Further, interest on debt held by the public is a current burden on taxpayers. Reducing this burden frees up capacity to meet future needs. In contrast, debt held by trust funds performs an accounting function and currently represents the cumulative annual surpluses of these funds (i.e., excess of receipts over disbursements plus accrued interest). Importantly, debt held by the SSTF does not represent the actuarial present value of expected future benefits for either current or future participants. Nor does this debt have any of the economic effects of borrowing from the public. It is not a current transaction of the government with the public; it does not compete with the private sector for available funds in the credit market. It reduces the need to borrow from the public and so may hold down interest rates. Unlike debt held by the public, debt held by trust funds does not represent an immediate burden on current taxpayers. Rather, it is a claim on future resources. The surplus is held in Treasury securities that give the SSTF a claim on the Treasury equal to the value of those securities. When the securities have to be redeemed, the Treasury must come up with the cash. At that time, taxpayers will see some combination of a lower surplus, lower spending, higher taxes, and/or greater borrowing from the public. If borrowing from the public is increased to cover this cash need, there could be upward pressure on interest rates. In addition, because debt held by the trust fund is not equal to future benefit payments--it is not a measure of the unfunded liability of the current system--it cannot be seen as a measure of this future burden. Nevertheless, it provides an important signal of the existence of this burden. Whether the debt constitutes a new economic burden for the future or merely recognizes an existing one depends on whether these currently promised benefits would be paid even in the absence of the securities. This information is important to understand the President’s proposal because, in large part, he proposes a set of transactions that, in effect, trade debt held by the public for debt held by the SSTF. By running a cash surplus over the next 15 years, debt held by the public falls. To “save” this surplus, the President proposes to “transfer” it to the trust fund in the form of increased Treasury securities. Under his proposal, debt held by the public falls, but debt held by the trust funds increases.