Originally published in


Friday, August 6, 1999

The Truth About the Surplus

Board of Contributors

"Some critics of the Republican plan tax plan argue that it would force big cuts in a wide range of spending programs. That is simply false."

By Martin Feldstein

President Clintons threat to veto the Republican tax plan makes it clear that the choice now facing Congress and the American public is whether to use one-third of the projected 10-year budget surplus to cut tax rates or to increase the size of government. Contrary to widespread public perception, the question has nothing to do with reducing the national debt or 'saving' Social Security and Medicare. Republicans and Democrats alike agree that two-thirds of the projected surplus will be used for those purposes. What they disagree on is whether the remaining third should stay with the taxpayers themselves or be given over to new government spending and income-redistribution schemes.

The White House and the Congressional Budget Office now forecast that the projected 10-year surplus will likely amount to about $3 trillion. That figure, which assumes no changes in the current tax rules or spending laws, is the result of rapidly rising incomes that will contribute an additional $5 trillion in future tax revenue. Although the future government spending implied in current laws will also rise substantially, the even more rapid increase in tax revenue will furnish the unprecedented surplus.

Extra Revenue

The House and Senate Republican tax plans would reduce the extra revenue flowing to Washington by $792 billion over the next decade. If one includes the effect of the tax cut on national debt interest payments, the plan would absorb about one-third of the projected surplus.

By contrast, President Clinton would increase government spending by an additional $850 billion over the same period on top of the $2.5 trillion increase already called for in current law. This includes some $250 billion of new transfer payments for the proposed Universal Savings Accounts and an expansion of Medicare that would make it even harder to finance future Medicare benefits. Mr. Clinton would also raise taxes by about $95 billion during those years. The net cost of the presidents program would therefore be about $750 billion, very similar to the size of the Republican $792 billion tax plan.

Since any tax revenue the government does not spend is automatically used to pay down some of the national debt, both the Republican tax plan and the presidents spending plan imply that the national debt would decline by about $2 trillion over the next decade. Either way, the national debt would be cut by more than 50% in the next 10 years, from the current $3.6 trillion.

The fact that both plans call for similar reductions in the national debt is no coincidence. It reflects a mutuals commitment to save all of the future Social Security and Medicare surpluses to strengthen the future solvency of those programs. These are the so-called off-budget surpluses that both Republicans and Democrats agree should not be used to finance other spending or tax cuts. Unless Congress enacts either the presidents plan to use a portion of this surplus to buy corporate stocks or one of the Republican plans to help fund individual Social Security investment accounts, all of the Social Security and Medicare surpluses will be used to buy back government bonds, thereby reducing the national debt.

Although an economic case can be made for using even more than $2 trillion of the projected surpluses to reduce national debt, that is not a politically available option. The Democrats want to use the money for new spending. And if the Republicans were to forgo the tax cut, they would be accepting the risk that the Democrats would simply spend the money if they retook control of Congress. So the tax cut is the only feasible alternative to further government spending.

Some critics of the Republican tax plan argue that it would force big cuts in a wide range of spending programs. That is simply false. According to the CBO, the Republican proposal is consistent with increasing each of the governments four major spending categories: (1) raising Social Security and Medicare outlays to $1.063 trillion in 2009 from $597 billion this year, (2) nearly doubling the spending on all means-tested mandatory programs like food stamps and student loans, to $416 billion in 2009 from $222 billion, (3) increasing spending on non-means-tested mandatory programs (including military retirement programs and farm price supports) to $210 billion from $158 billion and (4) raising the remaining budget outlays for discretionary programs that Congress must approve each year (including defense, transportation and environment) in line with inflation, implying a rise to $677 billion a decade from now from $574 billion this year. In short, even with the $792 billion tax cut and the $2 trillion-plus cut in the national debt, spending can still rise to $2.4 trillion in 2009--a 25% rise after adjusting for inflation.

The projected surpluses are, of course, just estimates. Actual future surpluses could be either larger or smaller, though the CBOs assumptions seem to me quite cautious. Their latest analysis assumes that real gross domestic product will increase at 2.4% a year over the next decade, lower than the 2.6% growth rate of 1990-96, the 2.8% rate from 1970 to 1990 and the 4.69k rate from 1960 to 1970. The budget forecasts also make no allowance for the favorable effects that tax cuts would have on economic behavior and therefore on tax revenue.

Even so, its prudent to provide an automatic mechanism for limiting the tax cut if surplus projections turn out to be too optimistic. The gradual phase-in of the proposed tax cut makes such a conditional adjustment possible. However, the House Republicans last-minute decision to use the governments interest bill to adjust future tax cuts is the wrong way to do it. An increase in inflation that raises interest rates would inappropriately block the tax cut. The tax cut would also be held hostage to future spending increases that raise the national debt and therefore interest payments. A better way would be to tie the future tax cuts to cyclically adjusted tax receipts, scaling back the tax cut only if the CBO finds that tax receipts adjusted for the level of unemployment are less than they now project.

A Better Tool

Federal Reserve Chairman Alan Greenspan has suggested postponing the tax cut completely until the next recession. But waiting for some future downturn is not a good reason to delay enacting a gradually phased-in tax cut. Because recessions are short-lived, averaging only about a year from the start of the downturn until the next expansion begins, its hard to provide the fiscal stimulus at the time its needed. Monetary policy offers a better tool, since the Fed can adjust interest rates at will to suit the economys immediate needs.

The Democrats also seem eager to postpone any tax cuts, although their motives differ widely from Mr. Greenspans. They hope to use future surpluses for increased government spending or redistributive tax cuts. But each such increase in government spending and each such wave of tax-based income redistribution brings America closer to the problems that have been dragging down Europe: double-digit unemployment rates, weak economic incentives and a lack of new businesses and new jobs. America must avoid that trap.

Congress should craft a bill that improves economic incentives by lowering marginal tax rates and that avoids the populist temptation to increase the share of taxes paid by those with above-average incomes. Doing so would encourage growth, limit government and strengthen the American economy.

Mr. Feldstein, former chairman of the presidents Council of Economic Advisers, is a professor of economics at Harvard.