Economic growth—which is central to almost all our major concerns as a society—requires investment, which, over the longer term, depends on saving. Since the 1970s, nonfederal saving has declined while federal budget deficits have consumed ever-higher levels of these increasingly scarce savings. The result has been to decrease the amount of national saving potentially available for investment. (See figure 1.) Since we last reported on this issue in 1992, overall national saving has remained low. These conditions—less nonfederal saving and a greater share of this saving absorbed by deficits—do not bode well for the nation’s future productive capacity and future generations’ standard of living. The surest way to increase the resources available for investment is to increase national saving, and the surest way to increase national saving is to reduce the federal deficit. Our 1992 analysis showed that an indefinite continuation of then-current federal budget policy was not sustainable. Without policy change, the continuation of large increases in health care costs, a jump in Social Security costs after 2010 as the baby boom generation retires, and escalating interest costs would fuel progressively larger deficits. Growing deficits and the resulting lower saving would lead to dwindling investment, slower growth, and finally a decline of real GDP. Living standards, in turn, would at first stagnate and then fall. Our view was that a “no action” path with respect to the deficit was not sustainable. Action on the deficit might be postponed, but it could not be escaped. Our simulation of several hypothetical deficit reduction paths further showed that the timing and magnitude of deficit reduction would affect both the amount of sacrifice required and the economic benefits realized. Acting sooner would reduce future interest costs and therefore total deficit reduction required from other sources. Achieving and sustaining balance or surplus would yield long-term benefits in the form of higher national saving, higher investment, and more rapid economic growth. By promoting economic growth, deficit elimination would give future generations more resources to finance the baby boom’s retirement. Since our 1992 report, the Congress and the President have taken action on the deficit. According to Congressional Budget Office (CBO) estimates, the Omnibus Budget Reconciliation Act of 1993 (OBRA 93) will reduce the federal deficit cumulatively for fiscal years 1994 through 1998 by over $400 billion. Despite this short-term progress, however, OBRA 93 did not fundamentally alter the growth of the major entitlement programs driving the long-term deficit problem. The Bipartisan Commission on Entitlement and Tax Reform, created in late 1993, highlighted the nation’s vulnerability to the growth of these programs and their potential fiscal effects. Currently, the Congress and the administration are again considering proposals which could reduce future deficits. As in our 1992 work, our updated simulation results show that continuing current spending and taxation policies unimpeded over the long term would have major consequences for economic growth. A fiscal policy of “no action” through 2025 implies federal spending of nearly 44 percent of GDP and a deficit of over 23 percent of GDP. (See figure 2.) By drastically reducing national saving, rising deficits would shrink private investment and eventually result in a declining capital stock. Given our labor force and productivity growth assumptions, GDP would inevitably begin to decline. These negative effects of rapidly increasing deficits on the economy would, we believe, force action at some point before the end of the simulation period. If policymakers did not take the initiative, external events—for example, the unwillingness of foreign investors to sustain a deteriorating American economy—would compel action. While the “no action” simulation is not a prediction of what would actually happen, it illustrates the pressures to change the nation’s current fiscal course. The shift in the composition of federal spending by the end of the simulation period shows that, under a long-term “no action” path, health care, interest costs, and—after 2010—Social Security spending drive increasingly large and unsustainable deficits. (See figure 3.) As federal spending in the simulation heads toward 44 percent of GDP in 2025, the major federal health care programs—Medicare and Medicaid—would become the major programmatic driver of budget deficits. Their share of the economy would more than triple between 1994 and 2025. Health care cost inflation and the aging of the population work together to produce this rapid growth. At the same time, simulated interest spending increases dramatically. Escalating deficits resulting from the increased spending add substantially to the national debt. Rising debt, in turn, raises spending on interest, which compounds the deficit problem, driving a vicious circle. The effects of compound interest are clearly visible, as interest spending rises from about 3 percent of GDP in 1994 to over 13 percent in 2025. Social Security also grows, but its rise is much slower than health care. Its expansion occurs mainly after 2010 as the baby boom generation retires. The expansion of the three forces fueling budget deficits means that the federal government would find it increasingly difficult to fund other needs. The economic benefits of deficit reduction are illustrated by the three fiscal paths we simulate in our model. (See table 1.) As discussed above, a fiscal policy of “no action” is not economically sustainable over the long term. The “muddling through” and “balance” paths show that the further away fiscal policy moves from a path of “no action,” the better the outlook for the economy in the long term. The differences in GDP per capita at 2025 reflect major differences in the underlying capacity of the economy in our illustrative simulations to generate growth. Our “no action” simulation, when maintained unimpeded through 2025, portrays the potential long-term economic impact of a declining national saving rate. Under a policy of “no action” on the deficit, investment would peak in the next decade and then decline steadily due to the lack of national saving. Shortly thereafter, capital depreciation would outweigh investment, and the capital stock would actually begin to decline. Given our assumptions about labor force and productivity growth, the declining capital stock would lead inevitably to a decline in GDP. By 2025, investment would be entirely eliminated, the capital stock would have declined to less than half of its 1994 level, and per capita GDP—only about 5 percent greater in real terms than at the start of the 30-year period—would be poised for a precipitous drop. Compared to a policy of “no action,” more stringent fiscal policies would result in greater economic growth. Tighter fiscal policies can promote greater private investment in the long term, a larger capital stock, and therefore a larger future GDP. The “muddling through” simulation shows such GDP growth but because of persistent deficits, debt increases well above current levels. In the model, the larger debt requires increased foreign capital inflows. Our “balance” simulation, compared to “muddling through,” achieves greater deficit reduction and a larger GDP with lower debt and, accordingly, less reliance on foreign capital. And as we stated in 1992, a strongly growing economy will be needed to support present commitments to the future elderly and a rising standard of living for the future working population. In actuality, the differences between alternative fiscal policies would likely be even greater than our simulation results suggest. Our model incorporates conservative assumptions about the relationship between savings, investment, and GDP growth that tend to understate the differences between the economic outcomes associated with alternative fiscal policies. For example, in our model, interest rates, productivity, and foreign investment all hold steady regardless of economic change. In the “no action” simulation, we assumed that they all remain constant in the face of a collapsing U.S. economy; this is unlikely to be true. Similarly, under our “balance” simulation, interest rates, productivity, and foreign investment do not respond favorably to increased national savings and investment. While the magnitude of any response is difficult to predict, some change could be expected. To the extent that our assumptions are conservative, differences between a “balance” path and the other two paths would be larger than simulated. We recognize that deficit reduction would have costs in the short term. The deficit reduction necessary to achieve beneficial long-term economic outcomes and reduced interest costs would entail difficult budgetary reductions and require a greater share of national income to be devoted to saving, thus foregoing some consumption in the short term. The greater the fiscal austerity, the more consumption would need to be sacrificed. However, more stringent deficit reduction measures mean correspondingly larger increases in consumption in the long term. The decision policymakers face, then, involves a trade-off between the immediate sacrifice of deficit reduction and the deferred but more severe economic costs associated with continued deficits. The share of the federal budget devoted to interest costs would be reduced through deficit reduction, freeing up scarce resources to satisfy other public needs. This will be particularly important for future budgets when the aging of the population will prompt greater spending pressures. The dynamics of compound interest which, given no action on the deficit, lead inexorably to spiralling deficits, yield dividends under a balance simulation. The more rapidly real debt is reduced and real interest costs brought down, the less long-term programmatic sacrifice required. Action taken to achieve balance by 2002 and to sustain it shrinks interest as a percent of total outlays from 12 percent in 1994 to less than 5 percent in 2025, assuming a constant interest rate. (See figure 4.) In contrast, higher interest costs would approach 18 percent of outlays by 2025 under the “muddling through” path because the deficit is maintained at 3 percent of GDP, resulting in higher debt. Moreover, due to growing pressures from health and Social Security commitments, the “muddling through” path requires progressively greater spending reductions just to keep the deficit from growing above 3 percent of GDP. Not all spending cuts have the same impact over the long run. Decisions about how to reduce the deficit will reflect—among other considerations—judgments about the role of the federal government and the effectiveness of individual programs.