A great deal of budget reporting focuses on a single number—the unified budget deficit, which was $248 billion in fiscal year 2006. This largely cash-based number represents the difference between revenues and outlays for the government as a whole. It is an important measure since it is indicative of the government’s draw on today’s credit markets—and its claim on today’s economy. But it also masks the difference between Social Security’s cash flows and those for the rest of the budget. Therefore we also need to look beneath the unified deficit at the on-budget deficit— what I like to call the “operating deficit.” And, finally, we should be looking at the financial statements’ report of net operating cost—the accrual-based deficit. Social Security currently takes in more tax revenue than it needs to pay benefits. This cash surplus is invested in Treasury securities and earns interest in the form of additional securities. The difference between the on-budget deficit and the unified budget deficit is the total surplus in Social Security (cash and interest) and the U.S. Postal Service. Excluding consideration of the $185 billion surplus in Social Security and a $1 billion surplus in the Postal Service, the on-budget deficit was $434 billion in 2006. Figure 2 shows graphically how the on-budget deficit and the off- budget surplus have related and combine to lead to the unified deficit. Since the Social Security trust fund invests any receipts not needed to pay benefits in Treasury securities, its cash surplus reduces the amount the Treasury must borrow from the public. As I will note later, this pattern of cash flows is important—and it is projected to come to an end just 10 years from now. The third number, net operating cost, is the amount by which costs exceed revenue and it is reported in the federal government’s financial statements, which are prepared using generally accepted accounting principles. Costs are recorded on an accrual basis—namely, in the period when goods are used or services are performed as opposed to when the resulting cash payments are made. However, most revenues, on the other hand, are recorded on the modified cash basis—that is, they are recorded when collected. The net operating cost can be thought of as the accrual deficit. The accrual measure primarily provides more information on the longer- term implications of today’s policy decisions and operations by showing certain costs incurred today but not payable for years to come, such as civilian and military pensions and retiree health care. In fiscal year 2006 net operating cost was $450 billion. All three of these numbers are informative. However, neither accrual nor cash measures alone provide a full picture of the government’s fiscal condition or the cost of government. Used together, they present complementary information and provide a more comprehensive picture of the government’s financial condition today and fiscal position over time. For example, the unified budget deficit provides information on borrowing needs and current cash flow. The accrual deficit provides information on the current cost of government, but it does not provide information on how much the government has to borrow in the current year to finance government activities. Also, while accrual deficits provide more information on the longer-term consequences of current government activities, they do not include the longer-term cost associated with social insurance programs like Social Security and Medicare. In addition, they are not designed to provide information about the timing of payments and receipts, which can be very important. Therefore, just as investors need income statements, statements of cash flow, and balance sheets to understand a business’s financial condition, both cash and accrual measures are important for understanding the government’s financial condition. Although looking at both the cash and accrual measures provides a more complete picture of the government’s fiscal stance today and over time than looking at either alone, even these together do not tell us the full story. For example, as shown in table 1, all three of these deficits improved between fiscal year 2005 and fiscal year 2006. This improvement, however, did not result from a change in the fundamental drivers of our long-term challenge and did not signal an improvement in that outlook. To understand the long-term implications of our current path requires more than a single year’s snapshot. In this regard, the long- term outlook has worsened significantly in the last several years. That is why for more than a decade GAO has been running simulations to tell this longer-term story. As I mentioned, it is not the recent past shown in figure 1—nor the outlook for this year—that should concern us. Rather it is the picture in figure 3 that should worry us. Long-term fiscal simulations by GAO, CBO, and others all show that we face large and growing structural deficits driven primarily by rising health care costs and known demographic trends. GAO runs simulations under two sets of assumptions. One takes the legislatively-mandated baseline from CBO for the first 10 years and then keeps discretionary spending and revenues constant as a share of GDP while letting Social Security, Medicare, and Medicaid grow as projected by the Trustees and CBO under midrange assumptions. The other, perhaps more realistic, scenario based on the Administration’s announced policy preferences changes only two things in the first 10 years: discretionary spending grows with the economy and all expiring tax provisions are extended. Like the “Baseline Extended” scenario, after 10 years both revenues and discretionary spending remain constant as a share of the economy. As figure 3 shows, deficits spiral out of control under either scenario. We will be updating these figures with the release of the new CBO baseline later this month, but even with the lower deficit in 2006, the long-term picture will remain daunting. Looking more closely at each scenario gives a fuller understanding of what the impact of continuing these trends would have on what government does. And it shows us “Why Deficits Matter.” First, it makes sense to look back to 2001—it is worth understanding how much worse the situation has become. As I noted, despite some recent improvements in short-term deficits, the long-term outlook is moving in the wrong direction. Figures 4 and 5 show the composition of spending under our “Baseline Extended” scenario in 2001 and 2006. Even with short-term surpluses, we had a long-term problem in 2001, but it was more than 40 years out. Certainly an economic slowdown and various decisions driven by the attacks of 9/11 and the need to respond to natural disasters have contributed to the change in outlook. However, these items alone do not account for the dramatic worsening. Tax cuts played a major role, but the single largest contributor to the deterioration of our long-term outlook was the passage of the Medicare prescription drug benefit in 2003. Figure 5 illustrates today’s cold hard truth, that neither slowing the growth in discretionary spending nor allowing the tax provisions to expire—nor both together—would eliminate the imbalance. This is even clearer under the more realistic scenario as shown in figure 6. Estimated growth in the major entitlement programs results in an unsustainable fiscal future regardless of whether one assumes future revenue will be somewhat above historical levels as a share of the economy as in the first simulation (fig. 5) or lower as shown in figure 6. Both these simulations remind us “Why Deficits Matter.” They illustrate that without policy changes on the spending and revenue side of the budget, the growth in spending on federal retirement and health entitlements will encumber an escalating share of the government’s resources. A government that in our children’s lifetimes does nothing more than pay interest on its debt and mail checks to retirees and some of their health providers is unacceptable. Although Social Security is a major part of the fiscal challenge, contrary to popular perception, it is far from our biggest challenge. While today Social Security spending exceeds federal spending for Medicare and Medicaid, that will change. Over the past several decades, health care spending on average has grown much faster than the economy, absorbing increasing shares of the nation’s resources, and this rapid growth is projected to continue. CBO estimates that Medicare and Medicaid spending will reach 6.3 percent of GDP in 2016, up from 4.6 percent this year (2007), while spending for Social Security will only reach 4.7 percent of GDP in 2016 up from 4.2 percent this year. For this reason and others, rising health care costs pose a fiscal challenge not just to the federal budget but also to states, American business, and our society as a whole. While there is always some uncertainty in long-term projections, two things are certain: the population is aging and the baby boom generation is nearing retirement age. The aging population and rising health care spending will have significant implications not only for the budget but also for the economy as a whole. Figure 7 shows the total future draw on the economy represented by Social Security, Medicare, and Medicaid. Under the 2006 Trustees’ intermediate estimates and CBO’s long-term Medicaid estimates, federal spending for these entitlement programs combined will grow to 15.5 percent of GDP in 2030 from today’s 9 percent. This graphic is another illustration of why we have to act. I do not believe we are prepared to have programs that provide income for us in retirement and pay our doctors absorb this much of our children’s and grandchildren’s economy. It is clear that taken together, Social Security, Medicare, and Medicaid under current law represent an unsustainable burden on future generations. While Social Security, Medicare, and Medicaid dominate the long-term outlook, they are not the only federal programs or activities that bind the future. Part of what we owe the future is leaving enough flexibility to meet whatever challenges arise. So beyond dealing with the “big 3,” we need to look at other policies that limit that flexibility—not to eliminate all of them but to at least be aware of them and make a conscious decision about them.