Budget Deficits: Causes, Effects and Some Remedial Options

In 1981 Congress enacted extensive changes in taxing and spending policies that supporters of these changes expected to generate sufficient revenues, despite a series of tax rate cuts, to balance the budget by FY84. After the onset of recession in early 1982, however, the Reagan Administration's projections showed widening budget deficits, which culminated in an actual FY83 deficit of $195.4 billion. Despite enactment of the Tax Equity and Fiscal Responsibility Act of 1982, and, more recently, the Deficit Reduction Act of 1984, large deficits are expected to persist, even under continued favorable economic conditions, unless Federal taxing and spending policies are altered dramatically.

Order C o d e I B 8 4 0 0 5 BUDGET DEFICITS: CAUSES, E F F E C T S AND S O M E R E M E D I A L O P T I O N S U P D A T E D 07/15/85 BY David Grinnell William Cox O f f i c e of S e n i o r S p e c i a l i s t s Congressional Research Service CRS- 1 ISSUE DEFINITION In 1981 Congress enacted extensive changes i n taxing a n d spending policies that supporters of these changes expected to g e n e r a t e s u f f i c i e n t r e v e n u e s , despite a series o f t a x r a t e c u t s , t o balance t h e budget by FY84. After the onset o f recession i n early 1 9 8 2 , however, t h e Reagan Administration's projections showed widening budget deficits, which culminated in an actual FY83 deficit of $195.4 billion. D e s p i t e enactment of the T a x Equity a n d Fiscal Responsibility Act of 1 9 8 2 , a n d , more r e c e n t l y , the D e f i c i t Reduction Act of 1 9 8 4 , large deficits are expected t o persist, even under continued favorable economic conditions, u n l e s s Federal taxing and s p e n d i n g policies a r e altered dramatically. How did this unprecedented situation come about? What i t have f o r the Nation? What remedial actions could questions a r e addressed i n this brief. consequences does be taken? These BACKGROUND AND POLICY ANALYSIS Earlier Trends a n d P r e s e n t Policies From F Y 6 5 to F Y 8 1 , growth i n F e d e r a l budget outlays exceeded that of receipts (See T a b l e 1). Defense outlays rose a t a compound a n n u a l r a t e of 7.4% during this p e r i o d , somewhat slower than t h e 10.8% growth i n r e c e i p t s , while total nondefense spending g r e w a t a 13.0% rate. Outlays for entitlements a n d other mandatory spending (largely Social S e c u r i t y , Medicare, and unemployment compensation) soared a t a 14.8% rate, while growth i n net interest payments a l s o exceeded that of receipts. Nondefense discretionary spending (outlays for transportation, a g r i c u l t u r e , environmental protection, s c i e n c e , s p a c e , technology, revenue sharing a n d other purposes) grew less quickly than revenues at a 10.1% a n n u a l rate. Policies enacted s i n c e 1 9 8 1 , a s well as unforeseen economic circumstances, have altered these patterns markedly. Annual growth in revenues slowed sharply during the FY81-85 p e r i o d , due t o enactment o f t a x cuts f o r individuals and businesses continued in the E c o n o m i c Recovery Tax Act o f 1 9 8 1 and to the s e v e r e 1981-1982 recession. Growth i n total o u t l a y s slowed during this period, but by f a r less than revenues, w h i l e spending growth for some categories actually accelerated. Tabie 1 shows that annual growth i n defense outlays jumped from 7.4% during the FY65-81 period to 12.5% during the FY81-85, while that f o r net i n t e r e s t outlays r o s e from 13.9% to 17.3%. Annual growth i n nondefense discretionary spending declined abruptly from 10.1% to 3.3%. President Reagan's F Y 8 6 Budget proposes tax a n d spending policies w h i c h , under the administration's economic assumptions, would r e s u l t i n deficits totaling $705.2 billion during the FY85-88 period. The P r e s i d e n t ' s budget envisions 12.2% a n n u a l growth i n d e f e n s e spending and 6.9% growth i n net interest outlays during the FY85-90 period. Entitlements a n d other mandatory a n n u a l rate while nondefense discretionary spending would r i s e a t a 4.5% spending would a c t u a l l y decline 4.4% annually d u r i n g this period. This would continue the trend observed during t h e FY81-84 period of increasing the share of Federal outlays f o r national d e f e n s e amid a steady fall i n the portion devoted to entitlements and other nondefense discretionary programs (See CRS- 2 IB84005 UPDATE-07/15/85 Table 1). TABLE 1, Time Period Total Projected* FY85-88 Reagan 2/85 4.5 CBO 2/85 7.7 Hse Bud Res 5/85 4.2 Sen Bud Res 3.7 5/85 Growth of Revenues and Outlays FY65-90 (Compound annual percentage rates) NatDl Defense Total O U T L A Y S Non-Defense Spending EntitheNet Offset . ments & Othr Non-Def. Mandatory Discretionary Int. Receipts 12.2 1.4 4.0 11.2 6.4 5.4 6.4 3.5 4.3 7.5 2.6 3.1 R E V E N U E S Time Period Total Ind. Inc. Tax Corp. Inc. Tax Social Ins. Tax Excise Taxes Other Taxes Projected* FY85-88 Reagan 8.8 2/85 CBO 2/85 8.3 H s e Bud Res 5/85 9.1 Sen Bud Res 5/85 9.1 * T h e Reagan Budget projections assume that the President's F Y 8 6 Budget proposal will be enacted while C B O assumes the continuation of current policies. Source: Congress of the United States. Congressional Budget Offices. T h e Economic a n d Budget Outlook: Fiscal Years 1986-1990. A report to the Senate a n d House Committees on the Budget. February 1985. Executive Office of the President, Office of Management a n d Budget. Budget of the United States Government FY86. Feb. 4, 1985. United States Congress. House of Representatives. Report o f the Committee on the Budget. First Concurrent Resolution o n the Budget--FYB6 United States Congress. Senate. Report of the Committee CRS- 3 IB84005 on t h e Budget. First Concurrent Resolution on the Budget May 1985. March 2 0 ( l e g i s l a t i v e d a y , F e b r u a r y 1 8 1 , 1985. UPDATE-07/15/85 -- FY86. CRS- 4 T h e projected s l o w r i s e in net interest outlays i s predicated on the' optimistic assumption that real interest rates d e c l i n e significantly; if interest rates a r e higher, a s is assumed by C B O , net interest payments could grow much faster. T h e Congressional Budget Office (CBO) projects t h a t the unified budget deficit will rise steadily to $ 2 4 0 billion i n F Y 8 8 a n d to $ 2 9 0 billion i n F Y 9 0 under current policies and economic assumptions that a r e somewhat less optimistic than those o f the Reagan Administration. CBO's projections o f nondefense discretionary spending exceed those contained i n the Reagan budget because they d o not reflect the Administration's proposed c u t s i n these programs. Similarly, CBO's forecasts of net interest outlays a r e higher d u e to higher projected deficits and interest-rate assumptions. On May 1 0 , the Senate approved its F Y 8 6 Budget Resolution by a 50-49 vote. The Senate Resolution (SBR) outlines policies, which would reduce cumulative Federal budget deficits over the FY86-FY88 period by $ 2 9 5 billion under the Senate's economic assumptions. D e f e n s e budget authority i s allowed to rise with inflation in F Y 8 6 , then by 3 % more than inflation i n F Y 8 7 and FY88. This contrasts with President R e a g a n ' s proposed 8 % r e a l annual growth during the same period. Cost-of-Living Adjustments (COLAS) for Social S e c u r i t y , Federal civilian a n d military pensions, and veterans benefits would be suspended in FY86, a measure not included i n the R e a g a n Budget. Although the Senate version c a l l s for substantial domestic s p e n d i n g reductions and numerous program terminations, s o m e domestic cuts advocated by the Reagan Administration have been scaled back: e.g., Federal subsidies t o AMTRAK a r e to be reduced over the FY86-FY88 period rather than terminated i n FY86. The FY86 House Budget Resolution (HBR) approved o n May 23 would reduce Federal Budget deficits from $173.2 billion in F Y 8 6 to $124.4 billion in FY88. Under the House plan, budget authority for nacional defense would remain a t its FY85 l e v e l in F Y 8 6 , then rise 3 % above inflation in F Y 8 7 and FY88. Cost-of-living Adjustments f o r Social S e c u r i t y , Federal retirement programs and veterans benefits would be provided under current l a w , in contrast to the. Senate Budget Resolution. The HBR recommends less severe reductions in nondefense discretionary programs than does the Senate: the HBR calls for the elimination of o n e such program -- General Revenue Sharing - - whereas the Senate recommends that thirteen be ended. Table 2 shows deficits, outlays a n d receipts ensuing from the F Y 8 6 Budget Resolutions approved by the Senate and House respectively. T h e economic assumptions which underly these projections a r e similar to those of the Reagan Administration shown in Table 3. Evolution of Budget Forecasts Since 1 9 8 1 President Reagan amended President Carter's F Y 8 2 budget request in February 1 9 8 1 , proposing to cut both revenues and o u t l a y s i n f u t u r e years from the levels requested by President Carter, but t o cut revenues by more. Based on a forecast for economic recovery and growth that immediately was dubbed " a rosy scenario," the budget w a s projected t o reach balance i n FY84. Seven months l a t e r , however, after passage o f the Economic Recovery Tax Act of 1 9 8 1 and approval of some, but not a l l , o f t h e President's requested spending cuts, t h e Congressional Budget Office (CBO) projected lower revenues, higher o u t l a y s , and a $ 5 0 billion deficit f o r F Y 8 4 (see Table 2). These changes reflected (1) less rosy assumptions a b o u t the economy, (2) the decision of Congress to refuse s o m e of the requested spending c u t s , a n d (3) CRS- 5 IB84005 UPDATE-07/15/85 t,he enactment of tax reductions larger than the President had proposed. TABLE 2. Successive projections of unified budget deficits, outlays, and receipts, FY82-88 ( $ billions) 1982 Source 1983 F I S C A L Y E A R S 1984 1985 1986 1987 1988 Deficits Carter - 1/81 Reagan - 2/81 CBO 9/81 2/82 Reagan CBO 9/82 Reagan 1/83 10/83 c CBO CBO 8/84 2/85 Reagan CBO - 2/85 SBR 5/85 HBR-5/85 - Outlays - 1/81 Carter Reagan - 2/81 9/81 CBO 2/82 Reagan CBO - 9/82 Reagan - 1/83 ZBO - 10/83 CBO 8/84 Reagan - 2/85 CEO-2/85 SBR-5/85 HBR-5/85 - - - Receipts Carter - 1/81 Reagan 2/81 CBO - 9/81 Reagan - 2/82 CBO 9/82 Reagan 1/83 CBO - 10/83 c CBO - 8/84 Reagan-2/85 CBO-2/85 SBR-5/85 HBR-5/85 - - - 711.8 650.3 655 626.8 618 617.8 a --- ----- 809.2 709.1 698 666.1 633 597.5 600.6 a ------ 922.3 1052.6 1188.5 940.2 770.7 849.9 -748 723.0 796.6 861.0 692 757 659.7 724.3 841.9 b 842 b 677 748 673 751 811 666.5 a 736.9 793.7 666 a 735 788 -793.6 794.1 -- -- --- -- ---- --916.3 b -- 881 861.7 855 866.3 866.0 * The CBO forecasts assume the continuation of current taxing and spending policies whereas the Carter and Reagan projections assume enactment of the President's policy proposals. ---- ------ 950.4 934 955.9 955.6 CRS- a/ b/ c/ - 6 IB84005 UPDATE-07/15/85 T h e s e figures a r e actual historical results. These figures include revenues from the contingency surtax p r o p o s e d f o r 1 9 8 6 t h r o u g h 1 9 8 8 by t h e R e a g a n A d m i n i s t r a t i o n . Without reserve funding for economic assistance and including a s i z e a b l e t a x i n c r e a s e i n FY86. CRS- 7 IB84005 UPDATE-O~/~~ As T a b l e 2 shows, President Reagan's F Y 8 3 budget, submitted i n F.ebruary 1 9 8 2 , again foresaw sharply lower revenues a n d slightly h i g h e r . o u t l a y s , this time because the economy had slumped decisively into recession. T h e d e f i c i t was projected to subside only gradually even with a r o b u s t economic recovery. Because interest rates i n mid-1982 remained h i g h , this p r o s p e c t aroused c a l l s i n Congress and elsewhere for tax increases a n d more s p e n d i n g curbs to r e d u c e the Federal Government's demands f o r credit. Even though taxes were increased by a n a v e r a g e o f a b o u t $33 billion per year f r o m F Y 8 3 through F Y 8 5 by the T a x Equity a n d Fiscal Responsibility Act of 1 9 8 2 , updated budget projections by C B O i n September, 1 9 8 2 , indicated that r e v e n u e estimates had by m o r e than this a m o u n t , d u e to the prolonged been scaled down -- not u p recession. Meanwhile spending projections had been increased by r o u g h l y equivalent sums. T h e deficit was projected t o grow to a b o u t $ 1 5 0 billion in FY83 and t o remain i n that range. Projected deficits continued to swell through the end o f 1 9 8 2 a s the deepening recession f u r t h e r depressed revenues. -- economy has Since the recession's trough i n November of 1 9 8 2 , the U.S. 11. Real GNP experienced one of i t s strongest recoveries s i n c e World War grew 6.3% in 1983 (on a 4th-quarter o v e r 4th-quarter basis) a n d 5.9% in 1 9 8 4 , while inflation remained quiescent. Nevertheless, the d e f i c i t amounted to CBO projects that this s h a r e 6.1% of GNP in FY83 a n d 4.9% of G N P i n FY84. will rise under current policy to 5.3% i n F Y 8 5 and remain a t o r above 5.0% throughout the remainder of this decade. T h e s e shares would be greater than 11, n o t t o mention f o r several y e a r s i n i n any year since World War succession. T a b l e 2 shows the unprecedented nature o f the C u r r e n t fiscal plight. Receipts and outlays a r e not expected t o approach balance even i f the Given the economic expansion continues steadily f o r 5 o r 6 years. three-stage personal tax rate r e d u c t i o n , increasing a m o u n t s of business capital eligible for depreciation under generous new f o r m u l a s , the indexation of the personal income tax brackets a n d exemption amounts beginning in 1 9 5 5 , and the setback ensuing from the 1 9 8 1 - 8 2 r e c e s s i o n , the economy simply cannot generate Federal Government revenues sufficient to catch up with projected outlays without further major changes in budget policies. Even after tax increases enacted s i n c e 1 9 8 2 , tax code changes since the a d v e n t of the Reagan Presidency resulted in revenue losses o f a b o u t $99 billion i n F Y 8 4 and this gap is expected to widen in the future. Recouping such r e v e n u e losses would have been difficult even amid steady economic growth throughout the early 1 9 8 0 s , but the l o n g , harsh recession that occurred instead deferred the growth of revenue-raising capacity. Unless additional tax = n c r e a s e s or spending reductions a r e enacted, CBO projects that cumulative deficits over the FY85-90 period will amount to $1.4 trillion. The Economic Outlook and Current Budget Forecasts Assumptions regarding future economic conditions profoundly affect projections of Federal revenues, outlays a n d deficits. I n d e e d , CBO's most recent baseline budget forecast shows net interest outlays rising to $ 2 3 0 billion i n FY90 while the Office o f Management and Budget (OMB) projects that this figure will be $164.2 billion. This discrepancy i s l a r g e l y attributable to differences i n assumptions regarding interest rates, a l t h o u g h it is partly a result o f differences i n estimation techniques. How plausible a r e the economic scenarios set forth by C B O a n d OMB? What CRS- 8 a r e the implications of alternative scenarios for fiscal policy? Business Cycles Conventional business cycle wisdom h o l d s that consumer purchases of housing, automobiles a n d other big-ticket durable goods lead economic recovery, precipitating increased demand f o r goods and services a n d a buildup i n business inventories throughout the economy. Inflation rises a s the economy approaches full employment. As a g g r e g a t e demand f o r goods threatens to strain existing capacity, business investment in plant and equipment r i s e s , which sustains the latter part of the expansion. H o w e v e r , the competing credit demands o f consumers and businesses tend t o raise interest rates, ultimately slowing both consumption and investment. The economy's behavior during recession mirrors its rise. As aggregate demand slows, businesses deplete their inventories, rather than placing n e w o r d e r s , further dampening economic activity. Unemployment t e n d s - t o r i s e a s increasing amounts of capacity a r e i d l e d , wage and price pressures a b a t e , and interest rates tend to fall. T h e Economic Assumptions of CBO and OMB CBO assumes that real GNP growth slows to 3.5% i n 1 9 8 5 and to 1 9 8 6 , while inflation (as measured by the GNP deflator) accelerates Interest rates (as measured by the 91-day i n 1986 (see Table 3). bill rate) rise i n 1 9 8 6 , a s i s typical of the latter phase of a cycle expansion. 3.2% in to 4.6% Treasury business In its longer-term o u t l o o k , C B O assumes a trend growth r a t e (about 3.4%) f o r 1987-90 with stable inflation and interest rates. T h e small decline in unemployment in this scenario is consistent with this modest real growth the 6% -rate. Furthermore, because unemployment remains above ttfull-employmentt'rate a b o v e which inflationary pressures a r e thought to accelerate -- the assumption of stable inflation i s plausible. Real interest rates (as measured by the 91-day Treasury bill rate less the increase i n the GNP deflator) remain high by historical standards a t about 4% throughout this period. This scenario i s predicated o n the following assumptions: (1) the current highly stimulative fiscal policy amid restrained growth in the Nation's money supply continues; (2) the exchange value o f t h e dollar remains a t its present elevated level throughout the forecast p e r i o d , and ( 3 ) productivity increases almost 2% per year during the 1987-90 period. The continuation of current fiscal and monetary policies assumed by C B O would serve to keep real interest rates h i g h , a s envisioned i n this scenario. This would tend to raise o r maintain the present high exchange value of the real dollar, which a c t s as a brake on inflation. However, even if U.S. interest rates remain h i g h , economic recovery a n d higher real interest rates abroad or a rise i n U.S. inflation or a default by a major debtor country, could precipitate decline i n the dollar. Realization of CBO's third assumption would represent a substantial improvement in productivity performance from t h e 1973-81 e r a , during Which nonfarm business productivity grew a t a 0.6% a n n u a l rate. Productivity r o s e 3.9% over the f o u r quarters of 1 9 8 3 , then slowed t o 2.4% i n 1 9 8 4 ; i t declined 2.5% during the f i r s t quarter of 1985. T h u s , it is unclear whether the CRS- 9 IB84005 UPDATE-O~/~~ sluggish productivity growth o f the seventies has been f u l l y remedied. O M B 1 s economic assumptions a r e considerably more optimistic than those of CBO. Real GNP growth is assumed to remain a t a b o u t 4 % throughout the declines f o r e c a s t period while inflation (as measured by the GNP deflator), steadily f r o m 4.3% i n 1 9 8 6 to 3.3% in 1990. Interest rates (as measured by Such the 91-day Treasury bill rate) f a l l from 8.1% i n 1 9 8 5 t o 5.0% i n 1990. a business expansion would be unprecedented. A decline in inflation during a long period o f strong r e a l growth i s implausible, partly because o f the normal upward pressures that such a boom would place o n w a g e and price levels. Inflation i s projected to c o n t i n u e f a l l i n g even a s the economy n e a r s full employment -- currently considered to In be a b o u t 6 % -- i n 1 9 8 9 , and d r o p s below this threshhold i n 1990. a d d i t i o n , even without t h e rapid decline i n interest rates assumed i n this f o r e c a s t , it is likely that t h e dollar's current high exchange rate, which serves to check inflation by making imports cheap, will deciine. T h e steady decline in interest rates pictured i n this scenario a l s o Such appears unlikely, given OMB's assumption of continued strong growth. growth presumes continually increasing consumption a n d investment amid heavy F e d e r a l borrowing, which would serve to r a i s e credit demand rapidly a n d , h e n c e , interest rates. The likelihood of a rise in inflation would a l s o s e r v e t o boost interest r a t e s , s i n c e lenders must be compensated for expected inflation. H o w e v e r , a d e c l i n e i n interest rates would be plausible, given assumptions o f l e s s robust growth. T h e difference between nominal rates a n d inflation during 1983 w a s very high by historical standards,' possibly because lenders expected inflation to accelerate eventually. If inflation rises moderately and stabilizes i n t h e near f u t u r e , interest rates may decline a s l e n d e r s ' expectations of f u t u r e inflation fall. (1) enactment of the T h e following assumptions underlie the O M B scenario: President's FY86 budget request and the continued gradual tightening o f money supply g r o w t h , ( 2 ) strong growth in employment due to assumptions of strong labor-force growth and a n assumed decline in the unemployment r a t e to 5 . 8 % in 1 9 9 0 , (3) r e a l interest rates returning to their long-term levels by the end o f t h e forecast period, and (4) productivity growth o f 2% per y e a r during the f o r e c a s t period. Even assuming enactment of the President's budget a n d t h e realization of by OMB's real growth assumptions, budget deficits would remain high historical s t a n d a r d s , which, in conjunction with a n ever tightening monetary policy and robustly growing economy, i s inconsistent with O M B ' s assumption of continually declining real interest rates. Moreover, the steadily falling inflation envisioned during the forecast period is implausible given OMB's assumption of rapid increases i n employment. Both the CBO and OMB economic scenarios a r e optimistic i n that they assume n o recession during the next 5 years. H o w e v e r , CBO indicates t h e potential magnitude of the fiscal crisis should a downturn occur i n the n e a r future. Assuming that a recession of the same depth and duration a s the 1973-75 downturn begins in 1 9 8 7 , and that a similar recovery f o l l o w s , the F Y 9 0 budget deficit would total $425 billion under current policies. (See CBO. The Economic and Budget Outlook -- P a r t 1. pp. 7 1 , 72-73.) T A B L E 3, The Economic Assumptions sf CBQ a n d OMB (Calendar Years) Short-term 1986 1985 1987 Long-term 1988 1989 1990 Real GNP (Growth ( % ch.) CBO OMB Inflation ( % ch.) GNP Defl. CBO OMB CPI CBO OMB Interest Rates: 91-day T-Bill ( % ) CBO OMB Unemployment CBO OMB (%) Sources: Executive Office of the President. Office of Management and Budget. Current Budget Estimates. Apr. 1 5 , 1985. Also, Congress of the United States. Congressional Budget Office. The Economic and Budget Outlook. A Report to the Senate and House Committees on the Budget P a r t 1. February 1985. -- POLICY H o w serious is t h e fiscal situation i n which the Nation f i n d s itself? H o w urgent i s the need t o t a k e forceful action t o alter the budget outlook? What k i n d s of action could b e taken? Implications f o r the Economy In F Y 7 5 , with a 16-month recession ending i n the middle of the fiscal y e a r , the Federal deficit rose t o 3.1% of G N P and in F Y 7 6 to 4.0%. T h e peak unemployment r a t e w a s 9.0% i n May, 1975; manufacturing capacity utilization, according t o the F e d e r a l Reserve Board, f e l l t o 71%. In F Y 8 3 , by comparison, with a n 18-month recession following closely o n a brief earlier o n e , the deficit r o s e t o 6.1% of GNP. Unemployment peaked a t 10.7% i n December 1 9 8 2 , and nearly one-third of the Nation's manufacturing capacity w a s idle. After two recessions i n 3 y e a r s , separated by only 1 2 months of recovery, a Federal deficit of this magnitude may have been appropriate in FY83 to forestall further declines i n economic activity and help t o f o s t e r recovery. It i s partly a product of the fiscal system's so-called "automatic stabilizers," including the progressive i n c o m e tax rate structure a n d the commitment t o a substantial d e g r e e of income maintenance f o r the unemployed. Ironically, the Economic Recovery Tax Act of 1 9 8 1 , passed for quite different purposes, may have constituted one of the most timely countercyclical fiscal actions taken by government s i n c e c o n c e p t s of fiscal stabilization policy were first implemented i n the 1950s. It marked o n e o f the f e w occasions o n which deliberate fiscal changes h a v e been made with timing appropriate to s l o w a recession rather than to speed a recovery. Even greater fiscal stimulus was applied in F Y 8 3 largely through the personal income tax cuts. T h e aspect o f the f i s c a l situation that causes much c o n c e r n , however, i s that t h e Federal budget Continued to inject stimulus i n t o the economy far beyond the period of economic recovery and i n t o the expansion, a n d will not retract this stimulus unless further significant actions a r e taken to narrow the budget gap. Under current policies, the wfull-employmentw or w s t r u c t u r a l w deficit (with unemployment hypothetically held constant a t 6%) will r i s e steadily i n t o the later 1980s; signifying heavy f i s c a l stimulus throughout the period. The persistence of l a r g e deficits during periods of economic expansion constitutes a pro-cyclical policy which works t,o maintain interest rates at extraordinarily high levels and ultimately could aggravate inflation. Such high interest rates handicap credit-dependent industries a n d , through their influence on exchange r a t e s , hamper trade-related sectors. R e a l GNP grew 0.7% during the first quarter of 1985 while the Unemployment rate has remained a t 7.3% since January 1985. Nevertheless, if the recovery f a l t e r s , proposals t o curtail the deficit sharply in F Y 8 6 a n d after could be timed to a g g r a v a t e a renewed business cycle downturn. T h e growth phases of the last seven business cycles have lasted a n average of nearly 4 years. Only o n e expansion -- i n the 1 9 6 0 s -- lasted more than 5 years. The present expansion will be 4 years old i n late 1986. T h e proper timing of fiscal actions therefore is critical. The worst situation would be o n e in Which a new recession occurs before the existing f i s c a l imbalance i s brought under b e t t e r control. In this case, deficits t h i s would imply would r i s e r a p i d l y from a l r e a d y v e r y h i g h l e v e l s w i t h a l l Attempts at f o r t h e size of t h e n a t i o n a l d e b t and i n t e r e s t payments on it. s u c h a t i m e t o r e d u c e t h e d e f i c i t w o u l d t e n d t o be s e l f - d e f e a t i n g and could t u r n economic r e c e s s i o n i n t o depression. An E v a l u a t i o n o f P r o p o s a l s t o R e d u c e D e f i c i t s The f o l l o w i n g s e c t i o n s s u r v e y c e r t a i n d e f i c i t - c u t t i n g p r o p o s a l s from t h e The review i s limited t o budget impact and many t h a t c o u l d b e c o n s i d e r e d . such measures b a s e d upon equity, does not treat t h e pros and cons of e f f i c i e n c y , program needs o r n a t i c n a l d e f e n s e c o n s i d e r a t i o n s . Table 4 shows t h e t i m e p a t t e r n s of revenues and o u t l a y savings projected t o ensue from A comprehensive review of proposals to various deficit-reducing measures. r e d u c e t h e d e f i c i t i s p r e s e n t e d by CBO i n R e d u c i n g t h e D e f i c i t : S p e n d i n g a n d A R e p o r t t o t h e S e n a t e a n d House Committees on the Budget Revenue O p t i o n s . -- P a r t I I . Tax I n c r e a s e s revenue Changes i n tax p o l i c y s i n c e 1981 have r e s u l t e d i n s u b s t a n t i a l n e t losses over the past three fiscal years. Phased reductions i n personal other provisions sf income t a x rates, g e n e r o u s d e p r e c i a t i o n a l l o w a n c e s and (ERTA) have resulted in cumulative t h e Economic Recovery Tax A c t of 1 9 8 1 a r e v e n u e l o s s e s o f $ 2 7 6 b i l l i o n d u r i n g t h e FY82-84 period. Since 1982, v a r i e t y of measures t o c l o s e tax loopholes, e l i m i n a t e unintended p r e f e r e n c e s , t o e n s u r e t h e s o l v e n c y of t h e S o c i a l S e c u r i t y T r u s t Fund, and raise monies r e p a i r t h e N a t i o n ' s highways have g e n e r a l l y s e r v e d t o i n c r e a s e revenues. (An e x c e p t i o n i s t h e r e p e a l o f t a x w i t h h o l d i n g on i n t e r e s t a n d d i v i d e n d i n c o m e , which r e d u c e d r e v e n u e s by $ 3 b i l l i o n i n FY84.) D e s p i t e t h e s e a c t i o n s , F e d e r a l t a x policy changes s i n c e 1981 r e s u l t e d i n n e t revenue l o s s e s of $99 b i l l i o n i n F Y 8 4 , a n d t h i s g a p i s e x p e c t e d t o w i d e n t o $ 2 2 8 b i l l i o n i n FY90. R e v e r s a l o r m o d i f i c a t i o n of t h e s e p o l i c y changes could boost revenues considerably. Raising personal income tax rates by 1 0 % would increase raise $48.7 r e v e n u e s by $ 8 3 . 8 b i l l i o n , w h i l e e l i m i n a t i o n o f i n d e x i n g w o u l d A less d r a s t i c approach would be a 10% b i l l i o n d u r i n g t h e FY86-88 p e r i o d . i n c r e a s e i n m a r g i n a l r a t e s on income i n excess of $70,000 f o r a n i n d i v i d u a l r e t u r n and on income o v e r $100,000 f o r j o i n t r e t u r n s , which would r e s u l t i n a $14.6 b i l l i o n g a i n d u r i n g t h i s p e r i o d . Indexing p e r s o n a l income t a x b r a c k e t s b y t w o - t h i r d s o f t h e CPI i n c r e a s e o r 2 percentage points less than this . i n c r e a s e a l s o would r e s u l t i n s i g n i f i c a n t r e v e n u e g a i n s (s,ee T a b l e 4 . ) . C o r p o r a t e income t a x r e c e i p t s have declined during the past 3 years, p a r t l y because of liberalized depreciation allowances enacted i n ERTA. Modification of t h e s e r u l e s could i n c r e a s e revenues, while reducing t h e wide d i s p a r i t i e s i n e f f e c t i v e t a x r a t e s among d i f f e r e n t i n d u s t r i e s , which result law. Repeal of the I n v e s t m e n t Tax C r e d i t , for which under current would add i n v e s t m e n t s i n equipment b u t n o t t h o s e i n b u i l d i n g s are e l i g i b l e , $ 6 4 . 8 b i l l i o n t o r e v e n u e s o v e r t h e FY86-88 p e r i o d . Corporate tax receipts c o u l d b e f u r t h e r e n h a n c e d b y e x p a n d i n g t h e e x i s t i n g c o r p o r a t e minimum t a x o r by i m p o s i n g a s u r t a x o n c u r r e n t c o r p o r a t e t a x l i a b i l i t y . T h e D e f i c i t Reduction Act of 1984 imposed r e s t r i c t i o n s E l i m i n a t i o n of a l l i n d u s t r i a l development bonds ( I D B ' s ) . tax-exempt bonds, i n c l u d i n g Mortgage Revenue Bonds, S t u d e n t on the use of private purpose Loan Bonds a n d A Hospital Bonds, a s w e l l a s I D B 6 s , would result i n higher r e v e n u e gains. <ax o n a l l f o r m s of domestic energy consumption set a t 5 % o f value would swell revenues by $9.8, $14.8 and $15.9 billion over the next 3 years respectively, while a $5-per barrel t a x on domestic a n d imported o i l would result i n lower but still substantial revenue gains (see T a b l e 4). Appropriations T h e potential f o r deficit reduction through savings o n nondefense discretionary programs i s limited by (1) the relatively small share o f the budget devoted to such spending; and (2) the f a c t that spending growth for many such programs has been constrained or reversed during t h e past 3 years. S t i l l , savings could be achieved by curtailing outlays f o r transportation, energy, a n d other federally funded programs. Alternatively, n e w or increased charges f o r such program services could be levied o n beneficiaries, provided that the identification o f users a n d a collection mechanism were feasible. Defense spending accounts for a much larger share (30%) of Federal outlays than nondefense discretionary programs, and has experienced substantial real T h u s , significant growth i n budget authority during the past 4 years. long-term savings could be achieved by limiting the growth of such spending. Reductions i n annual outlays could be achieved by lengthening the period over which n e w weapons systems a r e purchased, cancellation of certain i t e m s , In a d d i t i o n , spending and/or a delay o r f r e e z e on military pay raises. increases f o r operations and maintenance, a s well a s f o r research and development, could be constrained. Of c o u r s e , these decisions involve judgments concerning the appropriate level of defense spending and the optimal allocation of such resources among the various defense activitiess. Many k i n d s of appropriation actions apply Only t o the current o r coming fiscal year and not to those beyond. T h u s , while Congress could vote to exclude or limit the general cost-of-living pay increase for Federal employees i n F Y 8 6 , it would S e unusual for Congress to make a binding commitment now to d o so in F Y 8 7 or beyond. In the case of defense procurement, public w o r k s , and other such multi-year projects, however, Members of Congress should be a w a r e of the timing with which budget authority approved o r cut back this year f o r big-ticket projects would affect spending throughout the balance of the decade. Entitlements This category includes payments for health care (Medicare and Medicaid), Social Security and other retirement and disability programs, unemployment insurance, agricultural price supports, General Revenue S h a r i n g , and others. Outlays for these programs are determined by legislated eligibility criteria and benefit levels i n conjunction with prevailing economic conditions. For example, expenditures for Federal retirement programs are directly affected by the a g e distribution of the population, outlays f o r Unemp'loyment Insurance depend o n the level of unemployment, and the rate of inflation determines cost-of-living adjustments (COLAS) f o r Federal compensation a n d retirement Pay Outlays f o r programs not involving means test, which include Social Security a n d Railroad Retirement, Federal Military a n d Civilian Employee Retirement and Disability, and o t h e r s , could be substantially reduced by eliminating the automatic COLA for F Y 8 6 , projected to be 3.7%. T h i s would s a v e $24.4 billion during the FY86-88 period. Limiting a n n u a l COLAs to two-thirds of the C P I inc,rease would result i n projected s a v i n g s of $2.2 billion i n FY86 a n d $9.6 billion i n F Y 8 8 , while setting COLAs equal to t h e C P I minus two percentage points would save $3.6 billion i n F Y 8 6 a n d $ 1 4 . 8 billion i n FY88. I t should be noted that setting COLAs b e l o w the CPP increase would r e s u l t i n a steady erosion of beneficiaries' r e a l purchasing power. F u r t h e r actions to reduce budget outlays f o r a n d to i n c r e a s e revenues f l o w i n g into the health care system could r e s u l t i n significant deficit (HI) reductions. Employers a n d employees covered by the Hospital Insurance program each currently contribute 9.35% of wages a n d salaries, o n the f i r s t $39,600 of earnings; taxable earnings ceiling rises automatically with a v e r a g e wages. By raising this contribution t o 1.5% i n 1 9 8 6 , r a t h e r than to the scheduled 1.45%, f u t u r e deficits would be substantially reduced while maintaining the solvency of the HI trust fund. A variation of o n e measure passed a s part o f the Deficit Reduction Act of 1984 would be to increase the s h a r e o f the program c o s t s covered by Supplementary Medical Insurance (SMI) premiums from 25% t o 35%. This would result i n cumulative savings of $ 7 , 5 billion over the next 3 years. Elimination of "deficiency p a y m e n t s w to compensate f a r m e r s where crop prices fall below target levels would result i n cumulative s a v i n g s of $14.2 billion during the FY86-88 period, if f i r s t applied to 1 9 8 6 crops. Termination of General Revenue Sharing would r e d u c e Federal outlays by $14.2 billion during FY86-88. T h e Grace Commission T h e President's P r i v a t e Sector Survey o n Cost Control, commonly k n o w n a s the Grace Commission, has made recommendations w h i c h , i t c l a i m s , would save the Government over $400 billion during a n unspecified 3-year period. Although the C o m m i s s i o n ' s original mission was to survey methods for improving efficiency and reducing waste in Government programs, the three iargest cost-saving measures would involve substantive policy changes. A joint study by the Congressional Budget Office (CBO) and the General Accounting Office (GAO) indicates that implementation of many of these proposals during t h e FY85-97 period would r e s u l t i n savings considerably below the Commission's original estimates. F o r example, while t h e Commission estimates that denationalizing Federal power-marketing administrations, such a s the Bonneville P'ower Administration, would yield a n estimated $19.1 billion, CBO projects cumulative savings of $1.2 billion over this period. F u r t h e r m o r e , GAO w a s critical of some policy changes advocated by the Commission, such a s the proposal to limit Federal employee's compensation a n d benefits. Other proposals were too vague f o r C B O to re-estimate, e.g. the Commission estimated savings from improved management procedures i n the procurement process based on their "largely judgmental" assumption that 7% of such costs could be eliminated. [ ~ n a l y s i sof the Grace Commission's Major Proposals for Cost Control. A Joint Study by the Congressional Budget Office and General Accounting Office. February 1984.1 A number of the Commission's proposals for which CBO w a s u n a b l e to to estimate budgetary i m p a c t s were deemed conceptually sound by t h e CBO/GAo report. Recommendations for improving Government procurement practices a n d r e a l property management, especially i n defense programs, could result i n significant savings. However, more specific proposals a r e necessary to estimate their budgetary impacts (Analysis of the Proposals, p . 16). Grace Commission's Major The Deficit Reduction Act included Commi,ssion proposals concerning income and eligibility verification procedures, collection and deposit of payments to executive agencies and collection of debts owed to Federal agencies. The-se measures, aimed a t improving government efficiency and management, a r e projected to yield savings of $3.2 billion over the FY85-87 period. TABLE 4. Projected results of various measures to reduce the Federal budget deficit ( $ billions) Potential Policy Changes FY86 Revenue Increases Raise Marginal T a x Rates 1 0 % (P. 226) 21.1 Raise Marginal Rates 10% income over $70,000 for single return, $100,000 f o r joint return (p. 226) 2.2 Repeal Indexing (p. 228) 5.3 Index for inflation over 3% (P. 228) 4.3 Delay further indexing until Jan. 1 9 8 7 (p. 228) 5.3 Impose Corp. S u r t a x of (p. 231): 10% 5% 6.6 3.3 Impose $ 5 tax o n domestic a n d imported o i l (p. 238) Impose $5 tax o n imported oil (P. 238) 6.6 Impose tax o n domestic energy consumption (5% of value) (P. 238) 9.8 Revise depreciation rules and repeal ITC (p. 246) 15.5 Eliminate private-purpose tax-exempt bonds (p. 25,9) Increase taxation of non-means-tested entitlement benefits (p. 296) 4.0 Reduce tax preferences across the board (p. 303) 8.0 Impose 1 5 % alternative minimum corporate tax (p. 304) 3.3 FY87 FY88 Spending R e d u c t i o n s National D e f e n s e Cancel the MX (p. 66) Cancel the F-15 (PO 75) Limit spending f o r supporting procurement (P. 85) Limit growth i n D o D R&D (p. 87) Limit FY86 O&M spending to F Y 8 5 level (p. 97) Entitlements Limit COLAS f o r non-means-tested benefits program (P. 135) Eliminate COLA for FY86 Limit COLA t o 2/3 of CPI for 5 y e a r s Limit COLA t o CPI-2 for 5 years 3.6 Terminate General Revenue Sharing (p. 151) 3.7 Phase out deficiency payments f o r farmers (p. 159) 0.7 Increase SMI premiums to cover 35% o f program costs (P. 122) 1.6 Increase hospital insurance payroll tax (p. 132) 13.9 Nondefense Discretionary Spending End eximbank direct loan program (p. 164) Reduce Federal mass transit a i d (p. 182) 0.7 Raise aviation user fees to cover Air Traffic Control costs (p. 185) 0.4 Initiatives to reduce Federal Government Costs Modify Federal Work Force (P. 2 0 7 ) 0.4 0.8 1.2 E l i m i n a t e a n n u a l pay adjustment for Federal civilian employees ( p . 213) 1.5 1.8 1.9 Source: C o n g r e s s of t h e United States. Congressional Budget Office. R e d u c i n g t h e Deficit: Spending and Revenue Options. A Report to the Senate and House C o m m i t t e e s o n t h e B u d g e t -- P a r t 1 1 . ADDITIONAL REFERENCE SOURCES CRS reports dealing with effects of deficits include "Large and Continuing Deficits: Their Influence on Macroeconomic Performancew (Report no. 83-1563) by G. Thomas Woodward (August 1983), and "Do Deficits Influence the Level of Interest Rates?" "Reducing the Federal Deficit: The Macroeconomic Effects of Expenditure Cuts versus Tax Increases" (Report no. 83-47E) by Brian Cashell (January 1983). For information on major congressional actions on the FY85 budget, see Issue Brief entitled "The Federal Budget for FY85" (IB84071), by Philip D. Winters. For a review of proposed major revisions to the U.S. Tax System, see CRS MB84211 -- "Tax Revisions: An Economic Overvieww by Donald Kiefer. Various other issue briefs deal with budget requests and congressional actions affecting budgets for particular programs and functions (see CRS Update).