A multiple-choice question (from Regis Philbin’s show): What is the best thing to do with the budget surplus? –(a) Reduce the debt –(b) Increase government spending –(c) Cut taxes –(d) All of the above

The correct answer is (d), “all of the above” If that was your answer, then the next question is: –In what proportions? –For debt reduction, for spending increase, for tax cut 2-1-1? 2-2-0? 4-0-0? Before you answer, let’s look at a few facts about the surplus.

Is there really a surplus? Look at the handout: in the columns at the right, you see many, many, negative numbers, which are deficits. –tax revenues were less than government spending. But, starting in 1998, the minus sign disappears; there is a surplus. –tax revenues are now greater than spending.

Surplus and debt When the government runs a deficit, it increases its debt When the government runs a surplus, it reduces its debt surplus (‘98) = debt (end ‘97) - debt (end ‘98) 69 = (+ 18 in new loans) Government borrows by issuing bonds –and retires or buys back bonds when in has a surplus

What happened? How could forecasters have been so wrong? Tax increases? –No that was in 1993, –and was small compared to the tax cuts in the early 1980s.

Income growth for upper income taxpayers was very high. From 1994 to 1998 the percentage of taxpayers with more than $200,000 in income rose rapidly from 1.1 percent to 1.6 percent. The percentage of all income in the United States earned by this group also increased, from 15 percent to 22 percent. And the share of taxes paid by this group rose from 30 percent to 40 percent.

Federal budget summary (billions of dollars) Fiscal year 1998 versus 1995

Debt as a share of GDP Debt/GDP can stay constant or even fall when there is a budget deficit Example –5% growth of GDP –then ratio stays constant if Debt/GDP = Debt(1.05)/GDP(1.05) thus $3.7 trillion times (.05) = $185 billion deficit Debt/GDP ratio falls with balanced budget

Ratio declining again 2000

What is the forecast for the future? Look at the bottom row of the handout. Forecast of the budget surplus in the future—as far as the eye can see. Note that there are two parts to this –on-budget –off-budget Many assumptions go into this forecast.

Assumptions for revenues The strength of the economy The extent to which people will move into higher brackets The CBO assumptions for both are conservative. Most likely the economy will be stronger—Blue Chip is at 4.1 versus 3.3 for CBO in 2000.

Assumptions for spending Discretionary spending depends on what Congress does, on who the next president is, etc. CBO has three alternatives (see charts in handout): –Inflated baseline –Capped baseline –Freeze baseline None are obviously good goals

Time for an answer

Debt Reduction A bipartisan consensus has developed that we should run an overall surplus no smaller than the off-budget surplus—that is the social security surplus. Now that is a good idea. The important thing to notice is that even if the budget is no greater than this there is still a tremendous amount of debt reduction. –Is it enough?

Spending Proposal: Increase spending by more than the capped baseline scenario, though not as rapidly as the inflated baseline –see handout. Would expect government to achieve some gains in productivity.

Taxes Look at handout again: –as a share of GDP, federal taxes are as high as they have been since WWII. –It certainly seems feasible to reduce them, say by about 1 percent of GDP. Would also be helpful for the economy – would lower marginal tax rates.

Conclusion and summary We have projections of surpluses over the next 10 years of about $4 trillion. –That is based on pretty sound assumptions. A balanced approach to these surpluses: –drawing down debt by 1/2 of that. –a spending increase for another 1/4, –tax cut that is about 1/4 The proportions are 2-1-1, –Not or –So there is room for a good debate

The End