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Budget and tax policy

owever uncertain the size and time pattern of the surpluses may be, they are surely having a big influence on the political process. Amidst the surplus hoopla there are some aspects of the current discussion that strike me as muddled or misleading.

Proposals to "Save Social Security" have become the most politically popular use of the surplus. However, Social Security is a pay-as-you-go system in which the benefits of current retirees are paid by the taxes of current workers. The financial problem that these proposals presumably address is the shortfall in payroll taxes that is expected to occur when the baby boomers retire and the number of beneficiaries per worker will be much greater than it is today.

But the "Save Social Security" proposals are deceptive in this regard. They do not propose any reforms that would directly correct these future imbalances. In fact they have little direct connection with Social Security at all. They imply that the government has the ability to store up current surpluses in a fund that can be drawn down in the future to cover gaps between payroll taxes and benefit obligations. But there is no existing mechanism to do this. The Social Security Trust Fund is not a trust fund in the usual sense, but instead simply holds the ious of the Department of the Treasury. Once payroll tax revenues fall short of benefit obligations — and that is expected to occur around 2015 — the government will have to make up the difference by borrowing from the public (unless taxes are raised or spending reduced in other programs).

One sometimes hears that the current Social Security surplus could be invested in private assets to ease the future problem. But putting the government in the business of investing taxpayer dollars in private stocks and bonds is simply not a viable option given the size of the funds involved and the potential for serious government intrusion in private business.

What the "Save Social Security" proposals actually do is guarantee that the Social Security surplus is used to retire the publicly held national debt. The Social Security surplus, which is the difference between Social Security taxes and benefits, is expected to account for about 85 percent of the total surplus this year. Therefore, by placing it off limits for spending or reducing taxes, the pressure for fiscal prudence will be greatly increased. That is not a bad thing if it deters wasteful spending. However, it will be a bad thing if it obscures the long-term problems in the Social Security system and deters efforts to develop structural reform.

One controversial economic issue is whether there are significant benefits to be gained from retiring the debt and whether those benefits are worth the sacrifice of other potential uses of the surplus. One argument given for running large surpluses to retire the debt is that in the process it would add to national savings, which in turn would increase growth and the nation’s standard of living in the future. This effect, however, depends on linkages between debt retirement, savings, and productivity growth that are not well understood. Clearly debt reduction will tend to lower interest rates and make it somewhat easier for business to borrow for investment. But lower interest rates are probably not an important determinant of the rate of innovation that spurs productivity growth. Indeed, economists have been unable to explain the causes of the productivity boom in the 1950s and ’60s, the slowdown in the 1970s and ’80s, or the apparent return of high productivity in the past few years — a period of declining saving.

A second argument for retiring the debt is that even if it had no effect on growth, it certainly would reduce or eliminate the portion of the budget that today is used to pay interest on the debt. Interest payments on the national debt currently consume 2.5 percent of GDP. With no interest payments in the federal budget, the taxes of future generations of workers will be lower than they would otherwise be. It will therefore be easier for these future generations to pay the added taxes needed for the Social Security benefits of retired baby boomers. But there is no way to guarantee that the no-interest dividend would be used for that purpose.

This argument also raises issues of intergenerational equity. Although we are often told of our obligation to future generations, those future generations probably will be richer than we are. Moreover, they will be benefiting from many of the activities or programs that the debt helped to finance (for example, medical research and the defense buildup during the 1980s that helped to end the Cold War). Shouldn’t future generations be willing to pay for some of these benefits?

Another possible and important use of the surplus would be to make structural reforms in Social Security through conversion to a partially privatized system of individual accounts. That could be achieved by reducing the payroll tax and diverting the proceeds to individual accounts.

In my view, Medicare is in even more serious need of structural reform than Social Security. Yet the bulk of the discussion of Medicare centers on using surplus funds to shore up or even fatten the program with new benefits such as prescription drugs. The Breaux Commission pointed the way to genuine reform, though not much has been heard about it of late. (The Breaux Commission’s proposal would move Medicare from a defined benefit program towards a defined contribution program.)

Fast to feast

f course, there are myriad ways to lay claim to the surplus, and after a decade of relative fasting, many are ready for the feast. However, what I find quite amazing is the apparent willingness of a large segment of the public to accept further restraint in the form of paying down the debt as an end in itself. This is certainly prudent if the only viable political alternative is a grab bag of spending programs that would be inefficient uses of the GDP.

However, there are worthy alternative policies to debt reduction. As I see it, the major contender is a general cut in marginal tax rates combined with tax reform that would correct some of the distortions that have emerged since the 1986 tax reform legislation. One reason for a tax cut is that without it, effective tax rates will continue to rise as real income increases, boosted by productivity gains. The individual income tax was indexed for inflation, but not for real wage growth. In a progressive tax system, indexing for real income growth is needed just to maintain a constant share of taxes to GDP. A second reason for favoring a tax cut is that popular proposals for spending — such as more federal funds for education — are in areas that are appropriately financed at the state and local level. A federal tax cut leaves room for smaller government units to raise taxes, if lack of tax money is believed to be the real problem. A third reason for tax cuts is that they may be more effective for stimulating growth than debt retirement would be.

But in the short run — certainly for this budget season — I see little downside to waiting and allowing the surplus to reduce the debt further. It would give us more time to gauge whether we have really reached a new "plateau of prosperity" — in the immortally mistaken words of Irving Fisher in 1929.



Note: All of the figures include data originating from the annual budget reports of the Congressional Budget Office and the Office of Management and Budget. Historical data came from the Bureau of the Census and the Bureau of Economic Analysis at the Department of Commerce.



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June E. O’Neill is Wollman professor of economics and director of the Center for the Study of Business and Government at Baruch College, City University of New York, and an adjunct scholar at the American Enterprise Institute. She was Director of the Congressional Budget Office from 1995 to 1999.


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