A Dose of Policy

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I was off the campaign trail for an interview late last week with Office of Management and Budget Director Rob Portman on the budget. He has good news and bad news. The good news is that the budget deficit has gone down far more than any model has predicted and seems headed to go down even further. The bad news is that in the longer term, we face a "train wreck" with rising spending on entitlements–Social Security, Medicare, and Medicaid.

Let's look at Portman's good news. George W. Bush promised to cut the 2004 budget deficit of $521 billion in half by 2009. He has met this goal three years ahead of time. The deficit, projected at $423 billion for this year, is actually only $248 billion. That's 1.9 percent of gross domestic product, in line with the norm for the past 40 years and not particularly difficult to finance. And, Portman says, both OMB and Congressional Budget Office projections are that the deficit will continue to decline, even though CBO operates under different assumptions (that the tax cuts won't be extended and that there will be emergency spending at Katrina levels every year).

Why has the budget deficit declined so much more than anyone projected? The short answer is: gushers of revenue. Federal revenue was up 14 percent in 2005 and 12 percent in 2006. Portman credits the Bush tax cuts, especially the 2003 cuts in capital gains and dividend taxes, with producing more economic activity and therefore government revenues. Well and good, but that leaves me with the question: Why, given the sophistication of economists, have the projections so often been wrong? Portman, who served on the House Budget and Ways and Means committees before he was appointed special trade representative and then OMB director, says that the projections overestimated the surplus in the late 1990s and overestimated the deficit in recent years.

"Now, as the economy is growing, the model is stuck in the earlier part of the decade."

This leaves me wondering why we make these projections at all–and why so much of the legislative process hinges on them (because budget rules require tax and spending measures to be limited by the projections). I am old enough to remember when the government got along without OMB and CBO projections. The criticism then was that it was hard to control spending with the Appropriations committees and their subcommittees spending money and the Ways and Means and Finance committees setting tax rates without any formal coordination. Thus, it was said, the government could wind up with large deficits or overlarge surpluses without intending to. The remedy was to beef up OMB (this in the Nixon administration), create the budget process with the Budget committees and CBO, and require Congress to coordinate spending with revenues. But it has turned out that we had fewer deficits and more surpluses under the old system than we have had since the new system came into effect in the 1970s. Under the new system, we had surpluses only briefly in the 1990s, and I wonder in retrospect whether they might not have happened without the high-tech boom, which turned out to be a bubble.

If the projections are almost always wrong, why not just go by the seat of our pants, as Congress did for 180 years?

Evidently we have moved some small distance in that direction. Portman says that OMB and CBO used to produce 10-year projections but now limit themselves to five-year projections. People seemed to realize that the projections for years six through 10 were so unreliable as to be useless. But, as Portman says, "years one and two are more accurate than years three, four, and five."

Conservatives have long called for dynamic scoring–projecting revenues by taking into account changes in economic behavior resulting from tax changes. Tax cuts, they argue, spur more economic activity, which in turn generates more revenue that static scoring–assuming that tax law changes have no effect on behavior–predicts. That's surely true. The recent gushers of revenue are proof, as is the fact that capital-gains-tax revenues actually increased when capital-gains rates were cut in 1964, 1978, 1997, and 2003. The arguments against dynamic scoring are that economists are not sure how to project dynamic effects and that the numbers would be subject to political manipulation. Those arguments have mostly prevailed, even after Republicans won majorities in both houses of Congress in 1994. But recently Congress required the Treasury to produce a separate dynamic analysis, though it won't be used for scoring.

So much for the good news. The bad news is long term: that entitlements are on schedule to squeeze out the rest of the budget. How, you might ask, can one be so sure about long-range forecasts on entitlements when one is so dismissive of the value of three- to five-year projections about budget deficits? A fair question. The answer is that they are measuring two different things. When you have a progressive tax system, budget projections depend on things that are hard to predict–like profits. Profits are inherently more volatile than business revenues. And our tax system taxes high earners at higher rates than low earners, and it taxes capital gains, which are by definition profits. California's progressive state tax system reaped huge gushers of revenues in 1999, when the dot-com boom was on. Gov. Gray Davis tried to prevent his Democratic legislators from spending too much of this windfall, recognizing correctly that future revenues might not be enough to pay for continuing the spending levels. But, as it turned out, he didn't try hard enough, and when the dot-com boom went bust and state capital-gains revenues plummeted, the state faced a huge fiscal shortfall, which is one of the reasons Davis was recalled from office in 2003.

In contrast, Social Security is an entitlement program with a set schedule of benefits, and we know with considerable precision the number of people who will be eligible for them not just for the next few years but for the next 40. We don't know for sure how much Medicare and Medicaid expenditures are slated to rise, since that depends on the rise in healthcare costs, but we do have a pretty good idea of the number of beneficiaries, and we know that, with the exception of a few years, healthcare costs have tended to rise more rapidly than GDP. An exception came as a result of the Clinton-Gingrich budget deal of 1997, which resulted in an expansion of HMOs. But resentment of HMOs percolated within the political system and produced regulation proposals like the Dingell-Norwood bill, which came very close to passage. The political oomph behind it fizzled as HMOs stopped clamping down so much on spending and as employees took the option of exit and chose other medical plans. We may have similar episodes of clamping down on healthcare spending rises in the future. But our experiences in 1997–2002 suggest that they will not be allowed to last for any extended period of time.

Portman argues that, if revenues keep steady at about 18 percent of GDP, entitlements will rise to the point that they and interest on the national debt will amount to 18 percent of GDP sometime between 2030 and 2040. That's not so far away. A college graduate of 21 today will be 52 in 2037. At that point, all discretionary spending will have to be paid for by higher taxes or higher borrowing. Politicians know this point is coming. But they don't want to address it. Democrats were happy to refuse totally to engage George W. Bush's Social Security proposals in 2005, and House Republicans were only too happy to deep-six the issue after Hurricane Katrina hit. The political stars were in alignment for Social Security reform back in 1999, when Bill Clinton was a lame-duck Democratic president, Republicans had majorities in Congress, and leading Democrats like Daniel Patrick Moynihan, John Breaux, and Bob Kerrey backed reform.

But Clinton decided in early 1999 not to take up the issue. The stars were not really in alignment in 2005: The pro-reform Democrats were no longer in Congress, and Republicans were afraid to take the issue up on a nonpartisan basis. An interesting question is whether Democrats, if they win control of the House or get a majority in the Senate, will be willing to take up the issue. Bush, Portman, and Treasury Secretary Hank Paulson have said they still want to bring it up, and a few Democrats have said they're ready to talk. But I'll be surprised, pleasantly, if anyone does more than that.