The Story of the Surplus

By June E. O'Neill

ictory has a hundred fathers and defeat is an orphan," as JFK said after the Bay of Pigs fiasco. As an illustration of this dictum, there are many claiming fatherhood, or claiming to know the father, of the current golden economy and one of its apparent progeny — the federal budget surplus. Unfortunately, there is no dna test for determining the real father of the economic successes of the past five years. The popular nominees — among them Alan Greenspan, Bill Clinton, Ronald Reagan — are likely to be found to have had an influence. But many people and things, known and unknown, planned and accidental, were players in the outcome. It’s high time to ask and try to answer the basic questions about the surprising appearance of a federal surplus two years ago. Where did it come from? How closely tied is it to the economy or to the policy actions of Congress and the president? How realistic are the assumptions underlying the projections of huge surpluses over the next decade? And what should we do with these surpluses?

The history

n fiscal 1998, total revenues taken in by the federal government exceeded total federal spending, producing a surplus of $69 billion. (This is not the only definition of the surplus — but more about that below.) In 1999 the total surplus grew to $124 billion. According to projections of the Congressional Budget Office (CBO), it is expected to be $179 billion (1.4 percent of GDP) this year and grow to about $500 billion in 2010. Over the period 2000-2010, the annual surplus is predicted to average more than 3 percent of GDP.

If this projection should be realized, it would be a marked departure from the past seven decades. As Figure 1 shows, we have not had many years of surplus since 1930 (10 to be exact). It is true that surpluses were more the rule than the exception during the first 30 years of the 20th century. (There was an unbroken string of 11 years of surpluses in the 1920s.) But those surpluses were generally less than 1 percent of GDP. Evidently, before surpluses could grow too large, they were reduced or eliminated by downturns in the economy or by tax cuts (before the 1930s) or spending increases (after World War II).

Figure 1

The historical data make it clear that wars and deep recessions have always been major causes of large deficits. The deficit reached 16 percent of GNP in World War I and 30 percent of GDP in World War II; and when the depression of the 1930s replaced the Roaring ’20s, Calvin Coolidge’s surpluses gave way to large deficits.

Lesser recessions and smaller wars (Korea, Vietnam) were also associated with deficits in the postwar period. But they cannot account for the trend of a widening deficit that began in the 1970s and grew to an annual average of 4 percent of GDP during the 15 year period 1980-94. That story is complex, involving the huge increase in the size and scope of the federal government after World War II and the rise of entitlement programs to a dominant share of budget outlays. The Reagan presidency marked the beginning of an ongoing national struggle over continuing growth in government, which likely had the effect of temporarily increasing the deficit. Rising federal outlays were not matched with rising taxes. But to do that likely would have put a permanent seal on higher spending levels.

Deficits if unchecked enlarge the national debt. Wartime deficits unavoidably increase the debt, which soared during World War II to a level well in excess of GDP (see Figure 2). Rapid growth in GDP during the 1950s and ’60s reduced the ratio of debt to GDP, even though in absolute size the debt increased in most years because of continuing deficits. However, with growing deficits and slower growth in the economy, the debt eventually rose as a percentage of GDP from its post-World War II low point of 24 percent in 1974 to top out at almost 50 percent from 1993 to 1995. The recent shift from deficit to surplus has already had a favorable impact on the debt. By the end of 1999 the debt had declined to 40 percent of GDP and, if the CBO projections materialize, it would almost disappear, declining to 6 percent of GDP by the end of the decade. The CBO projections assume adherence to current budget policy — that is, no new legislation affecting taxes or spending — and therefore they assume that all of the projected surplus will be used to retire the debt. However, even if the projected surplus is eliminated by tax cuts or spending increases, current projections indicate that simply balancing the budget would reduce the ratio of debt to GDP to about 26 percent by 2010.

Figure 2

Putting aside the tough question of what debt level presents an economic problem, it is worth noting that although the current level of U.S. debt is around 40 percent of GDP, it is not high in comparison with other major developed countries. In 1998 the average debt to GDP ratio of the members of the European Monetary Union was about 70 percent, and in three of those countries — Belgium, Greece, and Italy — the debt exceeded 100 percent of GDP. (These countries recently have been been reducing their deficits and debt to meet the membership terms of the Maastricht Treaty on monetary union, which require a debt no higher than 60 percent of GDP.)

From ’80s deficits to ’90s surpluses

n order to understand where the current surplus came from, it is useful to examine the factors that contribute to budget outcomes generally and therefore to both the widening deficits of the 1980s and early 1990s and the recent surplus. The following factors are important in any account of the budget:

· The economy — in particular, the rate of growth of real GDP, the rate of inflation, and the level of interest rates. The distribution of income is also key because the larger the share earned by the rich, the more income is taxed at the tax code’s highest rates — therefore, the higher the effective tax rate on all income.

· Budget policy — tax and spending legislation affecting present and future levels of revenues and outlays and budget rules that have explicitly attempted to control tax and spending legislation and limit the deficit.

· Unexpected events that affect the economy or the budget. Such exigencies as wars, oil shocks, a savings and loan crisis, or a surge or collapse in the stock market can have a huge effect on the federal budget.

· Economic and budget forecasts. These set the baseline for all budget legislation. When forecasts are overly optimistic, as they were in the 1980s, budgets are more prone to yield deficits because expectations of good times allow higher budgetary spending than is actually affordable. When forecasts are overly pessimistic, the reverse occurs. The cbo forecasts of the middle 1990s were famously off course as the stock market and other factors produced unexpected bumper crops of tax receipts.

During the 1970s there were two negative economic developments that had major effects on the nation and the budget. One was a sharp slowdown in productivity growth from the high levels of the 1950s and 1960s. The other was a major inflation that had gathered steam over the decade, soaring to an annual rate of increase in consumer prices of 13.5 percent by 1980. The productivity slowdown reduced the growth in national income at the same time that Social Security and other entitlement programs were growing rapidly. The budget deficit widened to 2.7 percent of GDP in the last years of the ’70s.

The high and accelerating rate of inflation had a direct influence on the budget at the end of the 1970s and early 1980s by sharply raising the effective personal income tax rate: Inflation raised nominal incomes, pushing people into higher tax brackets (the income tax was not indexed at that time). Because marginal and average tax rates for a large portion of taxpayers had increased to unprecedented levels, there was growing taxpayer discontent (recall the limitations placed by voters on state taxing power) and popular support for a cut in the federal income tax. Under the circumstances, a tax cut of some kind likely would have been on any president’s agenda.