View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

March 15, 1994

eOONOMIG
GOMMeiMTCIRY
Federal Reserve Bank of Cleveland

Back to the Future: Prospective
Deficits through the Prism of the Past
by David Altig and Jagadeesh Gokhale

-f*.pproaching the halfway mark of fiscal year (FY) 1994, the Clinton administration's first major piece of budget
legislation — the Omnibus Budget Reconciliation Act of 1993 (OBRA93) —
appears to be a smashing success. According to the Congressional Budget Office's (CBO) January estimate, this fiscal
year's federal deficit will be some $64
billion less than forecasted before the
legislation was passed.1
Furthermore, the President's FY1995
budget proposals hew closely to the
OBRA93 blueprint, and if all goes as
planned, the multiyear changes will be
even more dramatic. In fact, the longerrun outlook has actually improved since
last summer. In September, CBO calculations projected that the budget goals articulated in OBRA93 implied five-year
deficits for FY 1994-98 totaling about
$506 billion less than was "forecast" before the legislation was enacted.2 The
CBO's latest published figures now foresee cumulative FY 1994-98 totals that are
$ 115 billion below the shortfall expected
just a half-year ago.
This experience is in sharp contrast to the
Bush administration's major budget law,
the Omnibus Budget Reconciliation Act
of 1990 (OBRA90). After just over one
year as law of the land, the provisions of
OBRA90 had proven insufficient to avoid
an upward adjustment in the CBO's fiveyear FY 1992-96 deficit forecast of nearly
$540 billion. By January 1993, the initial
estimates of $273 billion in deficits for
FY 1994-96 had been increased to $862
billion.

ISSN 0428-1276

The radical differences in the periods
immediately following OBRA90 and
OBRA93 are all the more interesting
because of the important similarities in
the two pieces of legislation. Both bills
set budget goals designed, over fiveyear horizons, to reduce deficit accumulations by about $500 billion from
the paths expected in their absence.
Both provided for lower outlay and
higher revenue paths than did extant
law, including increases in marginal tax
rates for high-income taxpayers and a
rise in fuel-related excise taxes. And
both bills placed explicit multiyear
caps on certain types of expenditures,
as well as pay-as-you-go restrictions
on all potential entitlement programs.
Thus, the same approach widely believed to have failed in stemming a deterioration of our fiscal situation during
the previous administration is now being hailed as a significant step toward
the promised land of permanently lower
federal deficits. Before accepting this
conclusion, we should pause to ask
why OBRA90 did not live up to its
promises. Is OBRA93, by virtue of its
striking resemblance to OBRA90, destined to suffer the same fate? Or are
deficit outcomes largely a matter of circumstances unrelated to either piece of
legislation, suggesting that, when it
comes to recent budget policy, it's better to be lucky than good?
These are the questions explored in this
Economic Commentary. We begin by
noting that, judged against actual deficit
outcomes, OBRA90 delivered during

The Omnibus Budget Reconciliation
Act of 1993 — the framework for the
Clinton administration's current and
future budget proposals — seems to be
a success. However, the details of the
Act are very similar to the long-term
budget plan passed in 1990, legislation
that failed to deliver the deficit reduction it promised. This article documents
the fact that the failure of the 1990 law
is, to a significant degree, attributable
to "technical" problems that were
largely unanticipated and that are not
yet well understood. Thus, the prospects
for declining deficits may be as much a
matter of luck as of design.

its first three years almost exactly what
was promised when signed into law by
President Bush. But this measure of
success was obviously misleading and
satisfied no one. Temporary factors
over the FY1991-93 period had helped
to offset more fundamental problems
with basic outlay and revenue trends,
and the outlook for the future had deteriorated substantially.
Even more disturbing is that most of
the problems encountered by OBRA90
were of a technical nature, meaning
changes in revenue and spending that
cannot be directly attributed to policy
decisions or economic conditions. Under this terminology, technical factors
are a measure of our ignorance — ignorance of extraordinary events that we
cannot foretell, such as military conflict, and ignorance of why some policies do not deliver as expected, such as
the failure of tax rate increases to raise
revenues as projected.
These observations together provide yet
another illustration of why deficits are a
seriously deficient focal point for fiscal
policy.3 The downfall of OBRA90 was
not its failure to meet immediate deficit
targets, but its lack of reliable mechanisms for implementing desired revenue and expenditure plans in light of
changing circumstances. As we emphasize below, nothing in OBRA93 has
corrected this fundamental weakness.
• In What Sense Did OBRA90 Fail?
By most accounts, OBRA90 was not a
successful experiment. Acknowledging
the arguable proposition that things
would have been worse without it, and
conceding that some — maybe most —
of the discipline imposed on the FY1994
and FY1995 budget processes is a direct
result of restrictions put in place by the
1990 legislation, OBRA90 is still widely
seen as a major disappointment.
On one level, this view is somewhat
surprising. In January 1991, just after
OBRA90 was signed into law, the
CBO projected that the new legislation
would result in deficits totaling $797
billion over the first three years of the
plan. The actual total for FY 1991-93

TABLE 1 ACTUAL VS. PROJECTED
BUDGET ITEMS, FY1991-93
(Billions of dollars)
Contribution to Changes
Projected
Actual
in Projected Deficits
The good news
Deposit insurance outlays
Net interest
Offsetting receipts
The bad news
Discretionary outlays
Mandatory outlays
Revenue collection

249
624
193

40.9
592.8
241.9

-208.1
-31.2
-48.9

1,583
2,050
3,515

1,605.2
2,107.0
3,298.0

31.2
57.0
217.0

NOTE: Projected totals are as of January 1991. Actual totals are as of January 1994.
SOURCE: Congressional Budget Office.

turned out to be about $815 billion.
Thus, OBRA90 delivered deficit outcomes that were, cumulatively, a mere
2 percent higher than promised, hardly
the stuff of a complete breakdown.
The frustration with the 1990 legislation lies, of course, in deeper structural
problems looming just behind this
otherwise quite reasonable performance.
In particular, it is perfectly clear that realized deficits came close to projections
only by chance, and that despite nearly
hitting the target in the early years of
the plan, no rational case could be made
for continued success into 1994 and
beyond. Although we would expect the
accuracy of the OBRA90 projections
to diminish as we moved into its fiveyear horizon, thus requiring some adjustment in the initial budget plans, the
deficit prospects were so far off track
that marginal tinkering with the original legislation no longer seemed a
viable alternative.
• OBRA90: The First Three Years
Table 1 illustrates why OBRA90 won
few converts despite largely delivering
on its promises through FY1993. In the
key areas of revenue collection, mandatory spending (primarily entitlement
outlays), and discretionary spending
(expenditures on defense, infrastructure,
education, and so on), the OBRA90 estimates were extremely wide of the mark:
Initial projections underestimated the
outlay categories by nearly $90 billion

and overestimated federal receipts by a
whopping $217 billion.
These "mistakes" were effectively
masked in the budget totals by fortuitous
offsetting outcomes in other parts of the
budget: Falling market interest rates reduced net interest payments below anticipated levels. Foreign contributions for
Operation Desert Storm provided a windfall in offsetting receipts, a category that
under normal circumstances primarily
comprises retirement fund contributions
within the federal government and voluntary Medicare premium payments. Most
important, however, was the huge difference between the initial 1991 estimates of
deposit insurance outlays and the actual
totals realized from FY 1991 through
FY1993.
None of these positive developments —
positive from a budgetary perspective,
anyway — were expected to continue
into the future. Unfortunately, at the
time the Clinton administration began
developing its first budget, the same
could not be said of the bad-news categories listed in table 1. As of January
1993, the CBO foresaw deficits for
FY 1994-96 approaching some $600 billion more than they had expected immediately after passage of OBRA90. The
interesting question is, why?

FIGURE 1

CUMULATIVE CHANGES IN FY1994 DEFICIT PROJECTION

Billions of dollars
140
[33 Cumulate i- L'IMII'.I1 in ikTk ii piuj
120
C u m u l a t e i- k v l i i i i i :il : i i l | u - i i i u - n l
100
80
60
40
20
March

August

January

March

August

January

March

1991

1991

1992

1992

1992

1993

1993

In the years since 1991, these changes
have mainly been associated with shortfalls in revenue collections, deposit
insurance outlays, and higher-thanprojected entitlement spending. Although a great deal of attention has
been focused on problems in the thrift
industry, expected deposit insurance
spending for FY1994 — changes in
which are designated as technical adjustments by the CBO — has actually
fallen since the passage of OBRA90,
therefore playing no real role in the
worsening outlook.

Date of projection
NOTE: All changes are relative to January 1991 projections.
SOURCE: Congressional Budget Office.

• Deconstructing the
EndofOBRA90
As part of its ongoing analytical responsibilities, the CBO regularly provides a breakdown of the sources of
changes in deficit projections. These
sources are broadly divided into three
major categories: economic changes,
technical changes, and policy changes.
As implied by the terminology, economic changes result from shifts in
general economic conditions relative to
those expected at the time the projection was made. For example, higherthan-expected real economic growth results in higher-than-expected revenue
collections, and hence lower-thanexpected deficits.
Technical changes incorporate all adjustments that are not related to explicit
policy changes or to estimates of the
effects of variations in the economic environment. Recent examples of important technical modifications include
lower-than-anticipated deposit insurance outlays, higher-than-expected
health care outlays, and lower tax collections than can be explained on the
basis of the weak economy alone.

In fact, these technical factors loom
large in the post-OBRA90 story. As illustrated by figure 1, nearly 76 percent
of the cumulative rise in the FY1994
deficit projections from January 1991
to January 1993 resulted from technical
revisions in revenue and outlay totals.
While it is true that, prior to OBRA93,
policy and economic factors played a
role in the worsening outlook for this
year's deficit (unexpected weakness in
the macroeconomy was certainly a contributing factor), it is clear from figure 1
that most of the upward increase in the
projected FY1994 deficit is directly traceable to technical adjustments.
• What's in a
Technical Adjustment?
We might think of technical changes in
deficit projections, along with economic
adjustments, as a measure of policymakers' luck: Such changes capture factors
that are not a direct result of deliberate
policy choices. While this interpretation
certainly overstates the case — many
technical factors involve government policy of some sort, even if that policy is
one of benign neglect — technical
changes in deficit projections primarily
involve the effects of events that are, for
the most part, unanticipated.

The same cannot be said for entitlement outlays and tax collections. In
fact, the difference between the current
estimate of the FY1994 deficit and the
level expected at the beginning of 1991
is almost exactly equal to the difference in technical adjustments to these
two budget items.4
• OBRA93: Have Our
Fortunes Turned?
These observations effectively mean that
the undoing of OBRA90 was a result of
miscalculations that cannot be directly
accounted for by legislation or by changing economic conditions. The real lesson
of this history is that the budgetary safeguards of OBRA90 were insufficient to
the task of surviving shocks that we
could not fully control before the fact and
could little understand after the fact.
It is true that our best projections suggest that, for the next several years,
OBRA93 will reduce deficit totals below what they otherwise would have
been. However, even with the legislation's budget corrections, deficits over
the next three years will be almost
three times as large as the levels suggested by our best projections following passage of OBRA90.
It is further true that prospects for economic growth are decidedly rosier in
1994 than they were in 1991. However,
the very fact that the fiscal strategies
implemented in 1993 are so similar to
those adopted in 1990 is just cause to
suspect our understanding of the shortrun nexus of budget policy and macroeconomic activity. Thus, the burden of

proof is on those who would claim that
in OBRA93 we have averted the potential for near-term economic weakness.
Finally, it is also true that, while technical problems with the OBRA90 forecasts began to manifest themselves almost at once, policy, economic, and
technical factors have all served to improve the budget outlook.5 However, the
largest part of the nonpolicy revisions in
deficit forecasts since last January have
been further fortuitous reductions in estimated deposit insurance outlays, stemming from a general improvement in the
economic well-being of the thrift industry. This budget improvement, by its nature, is nonrecurring.

OBRA93, like OBRA90 before it, also
contains pay-as-you-go restrictions on
mandatory spending that require new
entitlement programs to be financed
with added revenues or offsetting
spending reductions. However, these requirements do not address the issue of
escalating costs in existing programs,
which, as we have identified, were a
substantial contributor to the perceived
failure of OBRA90.

Most important, OBRA93 has not
changed the OBRA90 budget mechanisms that experience has proven incapable of ensuring an adequate response
to adverse, and unanticipated, fiscal
developments. Maybe our luck has
changed. Maybe our future surprises
will, like this year's, all be good ones.
But maybe not, and a roll of the dice
seems an inadequate basis for sound
policy.

There is a clear political understanding
of this problem, manifested in both the
administration's health care plan and
the President's executive order to establish the Bipartisan Commission on Entitlement Reform. Although the ultimate
health care package that comes out of
Congress, or the eventual results of executive orders, may not prove to be the
Holy Grail of budget reform, some
mechanism to require ex post discipline
on existing entitlement obligations is
clearly necessary. In addition, meaningful fiscal policy reform will require establishing a framework to address the
broader problems of entitlement spending, such as implied redistributions of
wealth across and within generations.

• The Next Step
OBRA90 was not without its accomplishments. In particular, the legislated
caps on discretionary spending for
FY1991-95 have exerted real discipline
on this part of the budget, which includes most expenditures subject to the
annual appropriations process.6 Wisely,
Congress and the President chose to
leave the OBRA90 spending limits in
place and to extend the discretionary
cap concept through FY1998. The impact of this approach is obvious in the
administration's FY1995 budget proposal: The spending limits have forced
the President to propose significant
reductions in many discretionary programs in order to accommodate favored spending increases in others.

The ability of OBRA93 to deliver deficit reduction also depends critically on
meeting estimated revenue paths: Almost half of the projected decline in
federal red ink for FY1994 and FY1995
is attributed to the legislation's tax increases. Unfortunately, as we have
seen, the recent record in this area is
less than stellar. We believe that this
stems from fundamental weakness in
the way policy is analyzed in typical
budget exercises, which for the most
part ignore the sensitivity of economic
behavior to changes in taxation. A large
amount of evidence has now accumulated indicating that these behavioral effects are substantial, a fact that does
not generally bode well for a successful run over OBRA93 's horizon.7

This is not to say that deficits will fail
to decline over the short term. The improving economy alone should prove a
salve to some of the budgetary ailments
of recent years. However, current law
is no cure for the more basic problems
that OBRA90 exposed all too clearly.
Without a budget process that more effectively links outcomes with objectives, our luck will, sooner or later,
surely run out.

• Footnotes
1. This figure is the difference between the
CBO's March 1993 and January 1994 deficit
projections (total deficit assuming discretionary caps). Throughout this article, all projections are from the CBO. January projections
are taken from The Economic and Budget
Outlook, published annually. July, August,
and September projections are taken from
midyear updates of the same publication. Except for 1993, March figures are from the
annual Analysis of the President's Budget
Proposals. The March 1993 projections were
obtained by request from the CBO's Projections Unit.
2. Policy analysts often draw a distinction
between a "projection" and a "forecast."
Both terms, by definition, refer to estimates
of economic outcomes under particular assumptions about policy. However, unlike
forecasts, projections are not necessarily
based on the belief that the assumed policies
will be realized. Although this somewhat subtle distinction can be important, the terms
will be used interchangeably here.
3. In this article, we take at face value the
implication that deficit reduction per se is a
sensible goal of public policy. We do not,
however, subscribe to this position. Specifically, it is our belief that the essential issues
of fiscal policy involve the allocative consequences of government command over real
resources, including the level of resource absorption, the distribution of transfers, and the
manner in which these activities are financed.
Conceptually, the measured deficit associated
with any particular configuration of these activities is arbitrary. For a more detailed discussion of some of these issues, see Alan J.
Auerbach, Jagadeesh Gokhale, and Laurence
J. Kotlikoff, "Generational Accounts: A New
Approach to Fiscal Policy Evaluation," Federal Reserve Bank of Cleveland, Economic
Commentary, November 15, 1991. See also
Laurence J. Kotlikoff, Generational Accounts:
Knowing Who Pays, and When, For What
We Spend, New York: The Free Press, 1992.

4. It is true that reestimates of deposit insurance outlays for FY1995-96 have, since
1991, contributed to higher deficit forecasts.
However, adverse revisions in the outlook for
entitlements and revenues remain the largest
source of upward revisions in projected deficits for these two years.
5. The economic assumptions underlying
the Clinton administration's original budget
projections were pessimistic by design. For
example, the budget calculations were based
on an assumed GDP growth path that declined to a meager 1.8 percent by 1998. In
light of this, improvements in the deficit outlook were to be expected as the administration brought its own economic assumptions
more in line with mainstream forecasts.
6. The discretionary spending caps are formally a part of the Budget Enforcement Act
of 1990.
7. See, for instance, Lawrence B. Lindsey,
The Growth Experiment: How the New Tax
Policy Is Transforming the U.S. Economy,
New York: Basic Books, 1990; Daniel R.
Feenberg and James M. Poterba, "Income Inequality and the Incomes of High-Income
Taxpayers: Evidence from Tax Returns," in
James M. Poterba, ed., Ta,v Policy and the
Economy, vol. 7, Cambridge, Mass.: National Bureau of Economic Research and
MIT Press, 1993, pp. 145-77; Martin Feldstein, "The Effect of Marginal Tax Rates on
Taxable Income: A Panel Study of the 1986
Tax Reform Act," Cambridge, Mass.: National Bureau of Economic Research Working Paper No. 4496, October 1993; and
David Altig and Charles T. Carlstrom, "Marginal Tax Rates, Income Inequality, and the
Laffer Curve: A Quantitative-Theoretic Welfare Analysis," Federal Reserve Bank of
Cleveland, Working Paper (forthcoming).

David Altig is an assistant vice president
and economist and Jagadeesh Gokhale is an
economic advisor at the Federal Reserve
Bank of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

Economic Commentary is a semimonthly periodical published by the Federal Reserve Bank of Cleveland. Copies of the titles listed
below are available through the Corporate Communications and Community Affairs Department. Call 1-800-543-3489, then key in
1-5-3 on your touch-tone phone to reach the publication request option. If you prefer to fax your order, the number is 216-579-2477.
Do Deficits Matter?
by Owen F. Humpage
June 15, 1993
Enterprise Liability: A Prescription
for Health Care Reform?
by Charles T. Carlstrom
July 1, 1993
The Evolving Loan Sales Market
by Joseph G. Haubrich and
James B. Thomson
July 15, 1993
Free Markets and Price Stability:
Opportunities for Mexico
by Jerry L. Jordan
August 1, 1993
Assessing Real Interest Rates
by John B. Carlson
August 15, 1993
Airline Deregulation: Is It
Time to Finish the Job?
by Paul W. Bauer and Ian Gale
September 1, 1993

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

The Decline in U.S. Saving Rates:
A Cause for Concern?
by Jagadeesh Gokhale
September 15, 1993
Credibility Begins with a Clear
Commitment to Price Stability
by Jerry L. Jordan
October 1, 1993
The Budget Reconciliation Act
of 1993: A Summary Report
by David Altig and
Jagadeesh Gokhale
October 15, 1993
Making the SAIF Safe for Taxpayers
by William P. Osterberg and
James B. Thomson
November 1, 1993

Long-Term Health Care:
Is Social Insurance Desirable?
by Jagadeesh Gokhale and
Lydia K. Leovic
December 15, 1993
Monetary Policy and Inflation:
1993 in Perspective
by Gregory A. Bauer and
John B. Carlson
January 1, 1994
Report of the Fourth District
Economists' Roundtable
by Michael F. Bryan and John B. Martin
January 15, 1994
Are Service-Sector Jobs Inferior?
by Max Dupuy and Mark E. Schweitzer
February 1, 1994

Community Lending and
Economic Development
by Jerry L. Jordan
November 15, 1993

The National Depositor
Preference Law
by James B. Thomson
February 15, 1994

Replacing Reserve Requirements
by E.J. Stevens
December 1, 1993

Issues in CRA Reform
by Mark S. Sniderman
March 1, 1994

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385