Budget Surpluses: Economic Effects of Debt Repayment, Tax Cuts, or Spending — An Overview

Budget Surpluses: Economic Effects of Debt Repayment, Tax Cuts, or Spending — An Overview

98-96 E
Updated July 23, 1998
CRS Report for Congress
Received through the CRS Web
Budget Surpluses: Economic Effects of Debt
Repayment, Tax Cuts, or Spending — An
Overview
William Cox
Senior Specialist in Economic Policy
Economics Division
Summary
Updated projections released on July 15 by the Congressional Budget Office (CBO)
indicate budget surpluses rising from $63 billion (0.9% of GDP) in FY1998 to more
than $100 billion (1.3% to 1.5% of GDP) from FY2002 through FY2005 and over $200
billion (1.8% to 1.9%) from FY2006 through FY2008.1 Tax cuts or spending increases
now being discussed would erode these estimates. Surpluses would increase national
saving, reduce federal debt and release funds for use by private investors and other
levels of government. Part would be transferred abroad, but domestic investment should
rise by a sizeable fraction of the surpluses, and economic growth should quicken
slightly. Transferring surpluses to Social Security or to related retirement accounts
could have much the same effect. If projected surpluses occurred, the interest share of
federal outlays and the federal-debt/GDP ratio would decline by 2006 to below the
levels of the mid-1970s.
Eliminating surpluses through tax cuts would channel funds partly to increased
consumption, but the interest share of federal outlays and the debt/GDP ratio would fall
substantially with balanced budgets even without surpluses. Eliminating surpluses
through increases (or smaller cuts) in federal entitlement spending would foster
consumption, but using them to fund investment projects could boost economic growth
somewhat, provided that the investments had social rates of return rivaling those of
private investments. Surpluses are expected to vanish after 2010; tax cuts or spending
boosts not then repealed or offset would increase future deficits.
After three decades of federal budget deficits, analysts now foresee a possibility of
several years of black ink on the federal bottom line. Under current policy CBO projects
surpluses just under 1% of GDP for this and the next 3 fiscal years, followed by larger
1 This report presents an overview of CRS Report 98-346, which spells out the analysis in
greater detail.
Congressional Research Service ˜ The Library of Congress

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surpluses that rise to 1.8% or 1.9% of GDP from FY2006 through FY2008 (CBO, The
Economic and Budget Outlook for Fiscal Years 1999-2008: A Preliminary Update, July
15, 1998). Current policy includes future spending cuts agreed to in the Balanced Budget
Act of 1997 but not yet specified. After FY2010 surpluses are likely to decline and vanish
because of steep rises in outlays for Social Security and Medicare as the baby boomers
begin to retire. Hence the prospective surpluses are of limited size and duration. This
report examines economic and budget implications of alternative responses to them.
Repaying Federal Debt
Federal debt peaked after World War II compared to the size of the economy that
generates revenues to meet federal obligations. In FY1946 debt held by the public was
109% of GDP. During the early postwar years GDP grew faster than the debt until by
FY1974 the debt stood at 24% of GDP. The percentage rose again, however, from 26%
of GDP in FY1981 to 50% by FY1993, where it remained in FY1996.
Heavy federal borrowing since 1982 is thought to have resulted in higher real interest
rates (nominal rates minus expected inflation), somewhat less investment than otherwise
and slightly slower real economic growth. While the economy has generated many jobs
and attained full employment in two long business expansions since 1982, average
productivity and income per hour worked have grown slowly until the last year or so.
Real interest rates remain high, as risk-free Treasury bills pay 5% while inflation is
running at less than 2%. With the federal budget now in surplus, these high rates must
be traced to low private saving together with heavy private credit demand at an advanced
stage of a business expansion.
The Arithmetic of Reducing Federal Debt. So long as GDP is growing, the budget
need not be in surplus for the ratio of federal debt to GDP to fall. The ratio declines
whenever the outstanding debt rises by a smaller percentage than GDP, including
inflation. The ratio of publically held debt to GDP fell from 50.1% in FY1995 to 47.3%
in FY1997, even though the budget remained in deficit.
Figure 1 shows federal debt as percents of GDP from FY1975 through FY1998, plus
two projections for FY1999-FY2008. A cash buildup in Treasury accounts would go to
debt reduction in the normal
Figure 1. Federal Debt Held By the Public
course of Treasury cash and debt
management. As the line labeled
“proj’d surpluses” indicates, the
debt-GDP ratio would fall under
CBO’s baseline projection from
47.3% in FY1997 to 18% in
FY2008. From FY1996 through
FY2008 the ratio would more than
reverse the upward course it had
taken in the equal time period
from FY1981 through FY1993,
even though the surpluses would
be much smaller than the earlier
deficits. The downward course is

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quicker and easier because the denominator of the ratio — the GDP — grows steadily.
The debt-GDP ratio would fall substantially, however, even if the projected surpluses
were eliminated through tax reduction or additional spending. With no surpluses, as seen
in Figure 1, the debt at the end of FY2008 would be 29.9% of GDP. (The debt would
remain roughly constant, but GDP would grow by 62% between FY1997 and FY2008.)
The Economic Effects of Reducing the Debt. The baby-boomers’ retirement will
impose heavy stress for many years on the federal budget and economy, and many
economists believe that the nation should brace itself for the challenge. Debt reduction
would simultaneously (1) add to private investment and expand national income from
which to pay the heavy fiscal obligations ahead and (2) reduce the share of federal
spending taken by interest payments.
Debt Reduction and Economic Growth. Maintaining budget surpluses and retiring
federal debt would release funds for investment in other assets. Income would rise by the
return to capital created by this investment. One should not, however, overstate the size
of this increase in the context of the national economy.
CBO projected in 1995 that elimination over 7 years of a deficit equal to about 3.5%
of GDP could reduce real interest rates by one to two percentage points but might boost
the growth of real GDP by only 0.1% annually. While this acceleration of growth would
accumulate over time, it would raise GDP by little more than 1% in 10 years.2
In contrast to that earlier scenario, surpluses in CBO’s latest baseline projection
would rise to less than 2% of GDP over 11 years (FY1998-FY2008 inclusive) and soon
thereafter are likely to decline. Compared to balanced budgets with no surpluses, the
surpluses now projected are likely to have only slight effects on economic growth. When
added to those of deficit elimination since 1992, however, the effects could be discernible.
Reducing the Outlay Share of Interest Payments. Net interest payments have risen
since FY1980 from 9% to 15% of the federal spending pie. This placed steady upward
pressure on deficits and on tax rates and downward pressure on program expenditures.
Surpluses projected in CBO’s baseline through FY2008 would reduce the interest share
of outlays back to 6.1%. A balanced budget with no surpluses would scale them back to
about 9.4% or less.
By reducing the budget pressure posed by interest payments, a period of balanced or
surplus budgets would permit the federal government to shoulder the initial burden of
entitlements for retiring baby boomers with somewhat lower spending levels and lower
taxes. Less debt also would position it better to finance future entitlements in part by
borrowing and to rely less heavily on tax increases and cuts in other spending programs.
Congre
2
ssional Budget Office, The Economic and Budget Outlook: An Update, September
1995, p. 42 f.

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Channeling Surpluses into Social Security
Several proposals have been made to channel budget surpluses at least in part into
Social Security’s trust fund or into government-mandated retirement accounts. Either
option would direct surplus revenues into saving and investment with equal benefits for
economic growth, provided it does not become a substitute for other measures raising
revenues or trimming benefits that otherwise would be taken. Either option could defray
future government liability to pay retirement benefits, although they would not reduce
outstanding federal debt or interest payments in the short run.
Cutting Taxes
As shown in Figure 2,
Figure 2. Federal Revenues as Percents of GDP:
Federal revenues as a share of
FY1960 to FY1997 with Projections to FY2008
GDP have fluctuated since
1960 between 17.0% and
19.8%. These amounts include
not only personal income
taxes but also social-security
taxes, corporate taxes, excises,
estate taxes, and other
receipts. The upper end of the
range was reached, at 19.7%,
in FY1969 and again in
FY1981. Since FY1993 the
tax burden has climbed
steadily from 17.8% of GDP
to a post-World-War-II high of
19.8% in FY1997. This rise
occurred because of increased
top-bracket tax rates and rising incomes, including capital gains, among high-bracket
taxpayers. CBO projects that the ratio will reach 20.5% this year and 20.6% next year
before subsiding to 19.8% by FY2003 if no further tax changes are made. It would
remain above the high end of the historical range.
Tax Rates in Historical Perspective. In 1981 the personal tax code had 15 rate
brackets with marginal rates rising from 16% to 70%. The Economic Recovery Tax Act
of 1981 reduced marginal rates by nearly one-fourth across the spectrum. The top rate
dropped by slightly more to 50%. The Tax Reform Act of 1986 reduced the number of
statutory marginal tax rates to only two and cut the top marginal rate on personal income
sharply from 50% to 28%. Despite the dramatic reduction in the top marginal tax rate,
3
however, some 40% of taxpayers are estimated to have faced higher marginal rates after
the 1986 Act than before. The top rate on corporate income was scaled back from 46%
4
3 Because of the phaseout of the personal exemption over a certain high income span, the
effective marginal tax rate rose to 33% on income within that span but then reverted to 28%.
Jerry
4
A. Hausman and James M. Poterba, Household Behavior and the Tax Reform Act of
(continued...)

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to 34%. Losses of revenue due to lower tax rates enacted in 1986 were made up by
limiting or eliminating various tax preferences, thereby increasing the amount of income
that was taxed.
Since 1990, in the quest to curtail budget deficits, top marginal tax rates on personal
income were raised in two steps from 28% to 39.6%, although the higher rates apply only
to taxpayers in roughly the top 5% of the personal income distribution. The rate on most
corporate income was boosted slightly from 34% to 35%. The Taxpayer Relief Act of
1997 affected marginal tax rates only by lowering those on capital gains from assets held
more than 18 months. It created new tax preferences — a child tax credit, a tuition tax
deduction and credit, and new variants of individual retirement accounts — reversing
some of the tax-base-broadening effect of the Tax Reform Act of 1986.
Economic Effects of Cutting Taxes. Unlike budget surpluses, which go into
saving, tax reductions are likely to go in substantial part into consumption. Cuts in
middle-class income taxes, payroll taxes or excise taxes, for instance, go primarily into
consumption with little effect on the growth of production capacity. Cuts in corporate
income taxes and those on other income from saving and investment may go to a larger
extent into saving, although evidence of this is inconclusive.
Beyond redirecting surplus revenues from the Treasury into private hands for
consumption or saving/investment, tax reductions can affect future productive behavior.
By permitting workers, savers, and investors to keep larger shares of the income from
additional productive activity, lower marginal tax rates raise the monetary reward of extra
work compared to the pleasure of leisure — an incentive to substitute work for leisure.
Likewise, they boost the future reward for more saving and investing compared to utility
of present consumption. This argument is the basis of the “supply-side theory” relating
levels of taxation to economic growth. Aside from questions about the strength of these
incentives, basic economics indicates that this is only half of the story.
Lower taxes also mean that workers and/or savers would have more after-tax income
without more work or more saving. They could even have more income and more leisure,
or more consumption today and in the future. Under economists’ standard assumptions
the desire to work or to save would be weaker because of the increase in after-tax income.
This so-called “income effect” of a tax cut offsets the “substitution effect” emphasized
by the supply-side theory. Workers or savers with fixed income targets could actually
reach their targets with less work or less saving and might even be motivated to cut back
their effort. Hence, the net effect of lower taxes on work, saving and investment is not
clear in theory. Efforts to measure an effect statistically also have reached inconclusive
results.5
In conclusion, maintenance of surpluses and reduction of debt (or diversion of
surpluses into retirement accounts) are likely to contribute more than tax reduction to
capital formation as well as to the government’s fiscal position. Debt reduction,
4(...continued)
1986, Journal of Economic Perspectives, v. 1, n. 1 (summer 1987).
Alan
5
J. Auerbach and Joel Slemrod, The Economic Effects of the Tax Reform Act of 1986,
Journal of Economic Literature, v. 35, n. 2 (June 1997), p. 626.

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moreover, would begin when surpluses occur and would end when they end. Taxes could
be cut in expectation of budget surpluses and, unless raised again when deficits return or
offset then by spending cuts, would reduce private investment from what it would be with
balanced budgets.
Tax cuts envisioned by the concurrent resolutions on the FY1998 budget passed by
the House and Senate (H.Con.Res. 284 and S.Con.Res. 86) are to be offset by spending
cuts and should not affect potential surpluses. In light of new projections showing larger
budget surpluses, however, some Republican leaders, especially in the House, favor
substantially larger tax cuts financed by dipping into expected surpluses.
Boosting Spending
Increases in government transfer payments can add directly to private consumption.
Increases in other government spending can boost communal consumption and investment
through provision of “public goods” like national defense, basic research and the
administration of justice.
Federal Programs Fostering Consumption. Federal programs fostering
consumption are mainly transfer programs to the elderly, the unemployed, the disabled
and the poor. Since 1981 most changes in law and policy have curtailed spending on
these transfers from what it otherwise would have been. While legislation increasing
entitlements seems unlikely, budget surpluses could be devoted to moderating future
cutbacks. They could provide relief only for a few years, however, because of the
likelihood that surpluses will not persist beyond 2010. Longer-term increases in
entitlements, unless offset by additional revenues or by spending cuts elsewhere, would
mean larger deficits in future years.
Some social programs enhance productivity and thus have the nature of investment.
Among these may be health-care, nutrition and education programs for poor children,
which foster healthier, better educated future workers, and child care for children of low-
paid workers, which may be critical to allowing such workers to join the labor force.
Federal Investment Spending. Many programs in the federal government’s
discretionary budget contribute to national investment and to economic and social
progress. Examples are those adding to research, technology development, education,
training, and physical infrastructure. To the extent that these investments yield social
returns equal to or greater than those of marginal private investments, spending on them
should be regarded as high-return investments and as additions to national saving.
The Transportation Equity Act (P.L. 105-178), signed into law on June 9, will
increase spending for transportation capital for 6 years by an average of about $3 billion
per year above amounts envisioned by the Balanced Budget Act of 1997. This added
spending for roads and mass transit is to be offset, in part by reversing a ruling of the
Veterans Administration allowing disability benefits for veterans with smoking-related
illnesses who began smoking in the military. The Emergency Supplemental
Appropriation Act of 1998 (P.L. 105-174) alloted $5.6 billion in this fiscal year for
disaster relief and for military operations in Bosnia and the Persian Gulf. About $3 billion
for military operations will not be offset and will reduce the FY1998 surplus.