Originally published in The Boston Globe
Tuesday, April 25, 2000

Sorting out the budget surplus
By Martin and Kathleen Feldstein

"Whether we cut taxes or spend, nation's debt will shrink"

The congressional budget season is opening early this year. House members, in particular, would like to wrap up the federal budget this summer and get back to their home districts to campaign for the fall elections. While the final budget will undoubtedly include both tax cuts and spending increases, there is likely to be strident debate and some confusion over the use of the budget surplus.

The debate will focus on that part of the surplus not dedicated to Social Security and Medicare. Revenue from Social Security and Medicare taxes is segregated in trust funds; that portion of the surplus - affectionately known as the "off budget" surplus -has been put off limits by bipartisan agreement. But that still leaves money on the table that can be used for tax cuts or additional spending.

Despite the accusations likely to be hurled from both sides of the aisle, neither choice is per se irresponsible, because there will be very substantial surplus funds available in the Social Security and Medicare programs. No matter how the currently projected "on budget" surplus is used, the coming decade will witness significant reductions in the national debt.

We have a choice today of tax cuts or spending increases because the total surplus has shifted remarkably over the past few years. There has been a surplus in the Social Security and Medicare trust funds for nearly 20 years. Until two years ago, however, Congress simply used those surplus funds to finance increased spending on other programs. Congress in effect used the trust fund surplus to help offset the deficit in the rest of the budget.

But additional revenue from several years of strong economic growth, major cuts in defense spending, and lower interest rates have led to the shift in the budget balance. There were essentially no cuts in domestic spending, yet the balance has shifted by 4 percent of GDP since 1995. The surplus this year is expected to be about 1.8 percent of GDP.

While the government had long been absorbing national savings to finance the budget deficit, now the government is contributing to national savings. So even though household saving has been declining, overall national saving has gone up, permitting higher investment in new plants and equipment.

Over the next decade, the outlook for the federal budget is quite bright. We base this on projections from the bipartisan Congressional Budget Office, which traditionally has been quite reluctant to forecast optimistic scenarios. Even their most conservative scenario, as of January, projects a rising surplus over the next decade, if there are no changes in tax laws or entitlement programs and assuming "discretionary" spending rises with inflation. This scenario projects the federal surplus to rise from 1.8 percent of GDP this year to 2.2 percent in 2005 and 3.3 percent in 2010. If this path is followed, the nation will have paid off virtually all of the accumulated national debt by the end of this decade.

As the government uses surplus funds to replenish the Social Security and Medicare trust funds, it buys back government bonds from the private sector, freeing private savings to be invested in corporate bonds and stocks that will in turn enlarge the nations productive capital stock. It also means less dependence on borrowing from abroad.

These projections are based on quite conservative economic forecasts, with real growth assumed to decline from 3.3 percent this year to an average 2.8 percent over the next decade. The economys strength has convinced most private forecasters that growth will be higher than the Congressional Budget Office forecasts. The CBO also assumes unemployment will rise to over 5 percent in the second half of the next decade; private forecasts show more optimism. So it is more likely than not that the budget surplus would be even greater than 3.3 percent of GDP 10 years from now.

The current national debt of $3.3 trillion is equivalent to 36 percent of GDP. If the country were to follow current tax and spending policies, the CBO forecasts, debt 10 years from now would be a remarkably low 3 percent of GDP. But even if all of the "on budget" surplus is eliminated to finance new spending programs or tax cuts, large surpluses in Social Security and Medicare will reduce the national debt to a low 8 percent of GDP.

So the hue and cry about using the surplus to reduce the debt is really beside the point. It will be reduced. But that still leaves a whole lot to debate about tax cuts or spending increases.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.