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January 15, 1996

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

Making Sense of the
Federal Budget hnpasse
by David Altig

L

November, the U.S. Congress passed
the Balanced Budget Act of 1995. The
bill provided a fiscal package that would,
according to Congressional Budget
Office projections, balance the federal
budget by fiscal year 2002. On November 20, President Clinton signed into law
a Continuing Resolution for Fiscal Year
1996 that provided short-term financing
for most federal government operations.
It also heralded an agreement between
the President and Congress on the goal of
producing a long-term budget plan that
would eliminate the federal deficit on the
seven-year schedule proposed in the Balanced Budget Act.
On December 6, the President vetoed the
Balanced Budget Act, at the same time
proposing the Administration's own
seven-year plan. Consistent with the
November Continuing Resolution, the
President's plan undertook to eliminate
the government deficit by 2002.
Although they concur on the balancedbudget goal and the time frame for
achieving it, Congress and the President
have been unable to agree on a specific
plan that is mutually satisfactory. It now
appears that no long-term budget plan
will be passed in 1996, and that federal
budget policy will consist of a series of
short-term agreements to fund operations and avoid the liquidity crises associated with the Treasury 's debt limit.

ISSN 0428- 1276

To many Americans, this impasse seems
frustrating and confusing. Indeed, the
popular press is often quick to characterize the problem as political gamesmanship, typical of an election year and
devoid of substantive content. As long
as there is consensus on the balancedbudget objective and the time needed to
achieve it, isn ' t it silly to haggle over a
few trivial details? Why not just split
the difference between the Administration's plan and Congress's and let the
economy begin enjoying the return to
lower deficits?
This Economic Commentary has a simple message: All balanced-budget plans
are not created equal, and broad agreement on a zero deficit by a given date
does not preclude serious, reason_ed differences of opinion on the economic
consequences of a particular fiscal p~ck­
age. Central to this message is the proposition that changes in deficits per se provide few clues about the effects of fiscal
policy changes. Put more directly, we
should concentrate on the specifics of
spending and tax policies: The total
amount of federal expenditures matters
less than what we spend and how we
spend it. How much revenue we collect
is less important than what we tax and
how we tax it.
Although this is a fairly obvious point,
readily acknowledged by almost anyone
who thinks seriously about the issue, it is
often overlooked in policy discussions.

-

I f Congress and the President can
agree that they need to balance the
budget, why are they still fighting
over how to implement their goal?
The continuing debate is not simply
irresponsible posturing in the political silly season, but the result of serious, reasoned differences of opinion
on the details of federal fiscal policy - the economic consequences of
specific spending and tax decisions.

In this Commentary, I use three simple
examples to illustrate the problems that
arise from focusing on the magnitude of
the federal deficit rather than the fundamental tax and spending policies that underlie it. The three examples correspond
to fi scal policy types that have already
been considered, are currently being considered, or are likely to be contemplated
in the future: a shift in discretionary
spending from one activity to another,
unfunded pay-as-you-go Social Security
transfers, and a flat-tax proposal. All of
them share the characteristic of having
potentially large effects on the macroeconomy without making any impact at
all on the federal budget deficit.

•

Spending Is as Spending Does

Consider the following change in government spending policy: One billion
dollars that had historically been spent on
constructing monuments to great leaders
is shifted to the financing of public infrastructure projects like highways. The
overall level of spending is, of course,
completely unchanged by this policy.
Consequently, the policy has no effect
whatsoever on the federal deficit.
Would you be willing to argue that this
policy is irrelevant simply because the
deficit stayed the same? I would guess
not. Then let's make the problem a bit
more complicated. Suppose the $1 billion expenditure on monuments was
replaced with $1.5 billion in infrastructure spending. In this case, the deficit
rises by $500 million, but does that
make the policy a bad one? That is, will
the policy have a deleterious impact on
the economy? Again, we would likely
conclude that a shift in federal spending
from useless monuments to public capital investment is a positive development,
despite the fact that the deficit becomes
larger in the bai:gain. 1
One possible objection to this example
is that it involves false alternatives,
since lawmakers rarely have the choice
of replacing monuments with bridges
and roads. More typically, the trade-off
will be bridges and roads versus defense
spending, education programs, research
and development subsidies, or any number of other items, each of which has its
own reasoned claim to the wallets, if not

the hearts and minds, of taxpayers. But
that is really beside the point. We ultimately judge the government's expenditure policy as we do our own - less by
whether that spending causes us to borrow more or less today, and more by
whether the spending is consistent with
the overall goals and desires that the
policy supports.

•

The Burden of the Nondebt

This standard suggests that the evaluation of fiscal policy should be forwardlooking. In one sense, projected paths of
future deficits, provided and updated frequently as a standard part of ongoing
federal budget activities, satisfy this criterion. In another sense, however, such
projections miss the boat entirely.
Consider another example: When

Mr. A is age 50, the government collects
$4,000 from him. When he is 65, the
government transfers $5,000 back to
him. Where does the government obtain
the $5,000 for this payment? Assuming
that it has long since spent the original
$4,000 it collected from Mr. A, there is
a simple option: Tax Ms. B.
On its face, this policy seems fiscally
responsible. In the year that Mr. A turns
65 , the government's payment to him is
completely balanced by receipts from
Ms. B. But suppose that Ms. B has reason to believe that she wiJI get the same
deal as Mr. A. That is, for his "contribution" of $4,000 at age 50, Mr. A was
ultimately repaid principal plus "interest" amounting to roughly 1.5 percent
for each of the 15 years up to age 65. 2
If Ms. B expects to be compensated in
like fashion-paid the principal amount
of $5 ,000 plus annual interest of 1.5 percent after 15 years-then the balancedbudget transaction involving Mr. A and
Ms. B actually creates an implicit liability equaling about $6,250.
This simple example captures the more
general fact that deficits per se are often
meaningless signals of the burdens that
current fiscal policies place on future
generations. A stark reminder of this was
provided in a recent Federal Reserve
Bank of Cleveland study noting that,
under current spending policies, future
generations would face lifetime average

tax rates of more than 84 percent. 3
Spending reductions of a magnitude
comparable to those in recent budget
proposals would reduce this figure to
about 75 percent.
As in the example given earlier, these
large liabilities on future generations
result primarily from implied socialinsurance liabilities, specifically Old
Age and Survivors Insurance and Disability Insurance (Social Security),
Medicare, and Medicaid. Thus, a "simple" balancing of the budget by the year
2002 does not eliminate the enormous
burdens that existing and potential fiscal
policies will place on future generations.
Redistributing resources to current generations has the inevitable consequence of
increasing current consumption relative
to investment. Lower investment means
that future generations will inherit a lower capital stock than they would otherwise have enjoyed, which in tum will
decrease their consumption opportunities. The normative aspects of these
wealth shifts must, of course, be resolved
in the context of the political process and
the overriding social goals that inform it.
Debate about the magnitude of the deficit, however, misses the point entirely,
and does not address important issues
that arise in the discussion of fiscal policy and intergenerational equity.

•

What If the World Were Flat?

One more example. Suppose that we
replaced the current personal income
tax code with a flat-tax system consistent with many of the proposals currently in vogue. Figure 1 illustrates one
forecasting agency 's estimates of how
shifting to such a system would affect
GDP growth, under the assumption that
the tax change is revenue neutral at current income levels.4
Although not endorsing the particulars
of these estimates-which, in any event,
depend heavily on specifics such as
nondeductibility of home-mortgage
interest payments that are not in every
flat-tax proposal-the example clarifies
a basic truth about fiscal policy. Even
when tax reform is deficit neutral, its
economic impact can be large. In the
early years, these projections suggest

FIGURE 1 THE EFFECT OF FLAT-TAX
LEGISLATION ON REAL GDP3
GDP growth, percent
2.0

1.5
1.0
0.5
0.0

--0.5
- 1.0
- 1.5

- 2·0 L-1L.st--2...Jn_d_ _.J.___J..h___ _ _6.J.th___J. th___
3rd
4t
5tLh
7.
8t'-h--9-'th--"'."10:"'.th---'
Year
a. The estimate for years 5- 10 is an average growth rate for that period .
SOURCE: Roger Brinner, Mark Lasky, and David Wyss, "Market Impacts of Flat Tax Legislation"
(footnote 4).

TABLE 1 THE COMPETING BALANCED-BUDGET PLANS
(savings in billions of dollars, 1996-2002)3
Congress's Proposal

President's Proposal

Medicare

$168

$102

Medicaid

85

52

Welfare

60

43

69

60

Tax cuts

203

87

Discretionary expendituresb

349

295

Other mandatory expenditures

a. Entries represent cuts relative to current pobcy baseline.
b. Expenditures subject to annual appropriations.
SOURCE: Congressional Quarterly (weekly report), vol. 54, no. 2 (January 13, 1996), p. 90.

that GDP growth would fall substantially below the rate that would be realized without tax reform. In later years,
GDP would grow at a rate that is permanently higher than it would be otherwise.
The estimates shown in figure 1 illustrate that the levels of marginal tax rates,
tax preferences for engaging in some
activities (like owning homes), and tax
penalties for engaging in others (like
early withdrawal of funds from certain
retirement accounts) all exert a powerfu.l
influence on when and how much people work, how much they save, and how
they save it. These effects occur not
because the deficit is rising or fa.I.ling,

but because altering the tax system fundamentaJly changes the incentives to
engage in particuJar economic activities.
These incentives are at the heart of the
economic effects of tax policy, and they
bear little or no relation to the size of the
federal deficit.

• Past the Deficit, into the Policy
Each of our three examples emphasizes
the critical importance of looking past
the deficit when assessing federal fiscaJ
policy. From this perspective, the latest
budget proposals from Congress and the
President appear far apart indeed.

Table 1 outlines the contours of the two
plans. Each proposal would balance the
budget in seven years. However, the
devilish details include major differences in revenue and expenditure policies. Compared with current policy,
Congress's plan would reduce spending
on nonwelfare entitlement programs
(including Medicare and Medicaid) by
$322 billion over the seven-year horizon. The President's plan would reduce
that number to $214 billion. Welfare
would grow by $60 billion Jess under the
House and Senate proposal, but by $43
billion less under the Clinton budget.
Savings on discretionary spending
would equaJ $349 billion if the congressional budget is adopted, compared to
$295 billion if the President's plan prevails. Tax cuts sum to $203 billion in the
latest fiscal blueprint from the legislative
branch; the corresponding totaJ from the
Administration is $87 billion.
Even these gross numbers mask substantial policy differences. For example, in
contrast to the President's proposed
changes, Congress would end the entitlement status of the nation's welfare system. The elimination of guaranteed
coverage for all qualified applicants obviously cou.ld have a significant impact
on the implied future liability of the system. This difference goes far beyond the
$17 bilhon spending gap that separates
the two proposals.
Nor is this example likely to be unique.
Compared with Congress's budget, are
the different discretionary spending priorities in the President's budget more
like shifting resources from monuments
to infrastructure, or vice versa? For the
same amount of deficit reduction, what
do the two budgets imply about the
future habilities of the federaJ government and the degree of intergenerationaJ
redistribution? Independent of the dol lars involved, how do the two plans' tax
changes differ in terms of the economic
activities that they favor or disfavor?

These are exactly the issues that must
inform any rigorous examination of fiscal policies. In the end, policies must be
measured by the incentives and disincentives for wealth creation that they present. This Economic Commentary serves
as a caution against interpreting the
inability of Congress and the Administration to implement the agreed-upon budget balance as standard irresponsibility in
the political silly season. On the contrary,
the lack of a final long-term fiscal package can easily be seen as part of an honest, responsible debate about the parts of
fiscal policy that really matter.

•

Footnotes

1. This is not to say that the economic consequences of infrastructure spending are
unambiguous. See, for instance, Kevin J.
Lansing, "Is Public Capital Productive? A
Review of the Evidence," Federal Reserve
Bank of Cleveland, Economic Commentary,
March 1, 1995.
2. Although the 1.5 percent return may
seem meager, it very likely overstates substantially the rate of return that future Social
Security recipients can reasonably anticipate. See Jagadeesh Gokhale and Kevin J.
Lansing, "Social Security: Are We Getting
Our Money 's Worth?" Federal Reserve
Bank of Cleveland, Economic Commentary,
January 1, 1996.

-

David Altig is a vice president and economist

at the Federal Reserve Bank of Clevland.
The views stated herein are those of the

author and not necessarily those of the Fed·
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Economic Commentary is now available

electronically through the Cleveland Fed's
home page on the World Wide Web:
http://www.clev.frb.org.

3. See Alan J. Auerbach, Jagadeesh
Gokhale, and Laurence J. Kotlikoff, "Restoring Generational Balance in U.S. Fiscal Policy: What Will It Take?" Federal Reserve
Bank of Cleveland, Economic Review,
vol. 31 , no. 1 (Quarter 1 1995), pp. 2-12.

4. These estimates were taken from "Market Impacts of Flat Tax Legislation," by
Roger Brinner, Mark Lasky, and David
Wyss, DRl!McGraw-Hill Review of the U.S.
Economy, June 1995, pp. 29- 37.-

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