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, 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. After 10 years, we rely on the long-term actuarial assumptions for the Social Security and Medicare programs. For Medicaid, we use the growth rates assumed by CBO in its March 1997 report on long-term simulations. 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. 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. 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. 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 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. 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. 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. 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.