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The Administration has released its updated economic forecast. The top line number--the annual rate of growth in real GDP--has been revised downward from 2.9 percent to 2.3 percent for the four quarters of 2007 (the prior forecast is here). The forecast is dated June 4, 2007, so it incorporates the latest news on GDP growth for the first quarter. This suggests that forecast is based on the view that we will return to 2.9 percent growth in the second through fourth quarters (since (1.006*1.029*1.029*1.029)^(1/4) is roughly 1.023). Here's the relevant excerpt:

The forecast revises the projection of real gross domestic product (GDP) down from 2.9 percent growth to 2.3 percent during the four quarters of 2007. This revision incorporates the slower growth that occurred in the first quarter of the year with the expectation that solid growth will resume for the rest of 2007. The economy has now experienced over five years of uninterrupted growth, averaging 2.9 percent per year since the expansion began in 2001. Real GDP is projected to grow at about the historic average in 2008 and for the remaining years of the forecast.

I doubt many people will see this forecast as "too pessimistic," but I'm almost three years removed from spending a lot of time following the macroeconomy. The next stop for this forecast is to be used as an input into the Mid-Session Review of the budget by Treasury and OMB. The projected budget deficit will widen, but we have to wait until July (usually) to find out how much.

On Tuesday, I had the opportunity to attend the annual conference of the Committee for a Responsible Federal Budget and participate in a roundtable with its Board of Directors and others. The president of CRFB is Maya MacGuineas, the "M" from the LMS plan. Here are the points I made:

1) Articulating a Budget Target

Some of the discussion referred to the possibility of a budget summit. (The CRFB's co-chairman have called for this publicly.) I think that the critical element of budget policy is setting the target. I think the target has (at least) two parts.

First, the government budget should be in balance over the course of business cycle, where budget here refers to the General Fund, excluding surpluses or deficits in entitlement programs. As an alternative, I would accept a weaker standard that there be no trend in the ratio of total federal debt to GDP. (This debt figure includes any debt held by government trust funds.)

Second, all entitlement programs like Social Security and Medicare should be sustainably solvent using enumerated and dedicated revenue sources. Sustainably solvent means that the program's trust fund is projected to have a positive and non-decreasing balance at the end of the relevant projection period. Enumerated and dedicated revenue sources means that the practice of relying on the General Fund to finance upwards of 75 percent of Medicare Part B and D should end--no open-ended commitments. Enumerate a revenue source to pay for it.

Personally, I won't work actively for the election of any political candidate or the in the administration of any politician who espouses a budget policy at odds with these targets.

2) All Dollars Matter

I still give the current Administration great credit for being willing to engage on Social Security's solvency. But I remain disappointed in the way that engagement was undermined by policies toward other entitlement programs and the General Fund (leaving aside design and marketing issues in the personal accounts). The public was supposed to be concerned about Social Security reform because the program is projected to shift from surpluses to deficits as the Boomers retire, life expectancy continues to increase, and fertility rates remain around 2. I acknowledge that's why I'm concerned. That's why the President said he was concerned, or at least one of the reasons.

If concern over tax burdens on future generations is what motivates you, then it is completely inconsistent with that motivation to pass a Medicare prescription drug bill that generates a projected unfunded obligation that is bigger than the projected unfunded obligation in Social Security. It is also completely inconsistent with that motivation to run General Fund deficits that are not balanced by later surpluses, raising the debt burden on future generations. This sort of inconsistency will doom any chance at prudent reform of any of the programs.

3) What If This Becomes a Class Conflict?

I've been working on Social Security and its reform for over a decade, closer to two. I have always framed the issue as a matter of conflict between generations over resources. The inconsistencies in #2 are starting to frame the debate in terms of class. For example, those who want to preserve entitlement programs as they are currently structured think that debt finance of entitlement programs is not so bad. Debt is serviced primarily through the income tax, and of all taxes (other than inheritance taxes), the income tax is the most progressive. So why accept any increase in payroll taxes or mandatory broad-based contributions to personal accounts now? The normal answer would be so that we can reduce the tax burden on future generations. But they don't see it that way. High future income taxes fall on the highest-income members of future generations. According to this view, those people are largely the children of the highest-income members of the current generation who, again according to this view, are not paying enough income taxes today. Sure, they would rather have the current highest-income people pay more today, but the second-best alternative for them is the highest-income people some other time. When this becomes an issue of class divide, I think we'll have an even tougher time bridging it.

I'd like to take this opportunity to thank people who have given me feedback through the blog about these issues. Anyone who's been reading for a while can see how my views have been shaped through these productive and polite exchanges of ideas.

The title of this post harkens back to a post two years ago, in which a commenter admonished me for not doing more to bring the Republican Party more in line with my own views about budget policy.

Reading stories like "Democrats Face Limits in Changing Bush's Budget" in yesterday's New York Times makes me wonder whether the anonymous commenter would come back and ask the same question of the Democratic Party's new majorities in Congress. Consider the following:

In theory, the budget presents the Democrats their first real opportunity to rewrite the administration’s policies, especially on tax cuts, that they have been attacking for six years.

But in practice, Democrats know that the only way they can find the revenue to restore the administration’s proposed spending cuts would be to cut back on military spending, delay their stated intentions to balance the budget or rescind the Bush tax cuts in future years. They are not especially eager to do any of these.

The most likely result, even some Democrats acknowledge, will be a limited reshaping of the budget by restoring some proposed cuts in a variety of domestic programs, including children’s health care, Head Start and home heating
assistance for the poor and the elderly.

But few Democrats are expected to look for new revenues by calling for an end to Mr. Bush’s tax cuts, instead of extending them as the president proposed Monday, or to deal with the looming costs of Social Security and Medicare as the postwar generation retires, all of which pose huge budget problems in future years.

This would be sad if true. The Democrats are not constrained in the budget they pass. They could declare the President's budget DoA and write their own from a different template. It wouldn't have to extend the tax cuts. It could redo the defense budget. It could raise taxes to fund all of the social programs they want. They need only have the creativity to write such a budget and the will to defend it.

Since the Democrats can't guarantee 60 votes in the Senate, there will be negotiations before the Congress can pass their budget. Since the Democrats cannot override a veto, there will be further negotiations after they pass it. So what? That's the way the system is supposed to work ... unless the Democrats really do feel they are powerless to fight.

Dean Baker's post this week criticizing Fed Chairman Bernanke's Senate Budget Committee testimony has generated quite a buzz (see here, here, here, and here). I don't think the criticism is reasonable.

First, let's start with the testimony. This is almost exactly what I would have given as testimony in Bernanke's position (assuming I had his staff of excellent economists to help me prepare it). You should read the whole thing, but if I had to pick out my favorite two paragraphs, here they are:

An important element in ensuring that we leave behind a stronger economy than we inherited, as did virtually all previous generations in this country, will be to move over time toward fiscal policies that are sustainable, efficient, and equitable across generations. Policies that promote private as well as public saving would also help us leave a more productive economy to our children and grandchildren. In addition, we should explore ways to make the labor market as accommodating as possible to older people who wish to continue working, as many will as longevity increases and health improves.

Addressing the country's fiscal problems will take persistence and a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including transfer programs such as Social Security, Medicare, and Medicaid. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. Thus, members of the Congress who put special emphasis on keeping tax rates low must accept that low tax rates can be sustained only if outlays, including those on entitlements, are kept low as well. Likewise, members who favor a more expansive role of the government, including relatively more-generous benefits payments, must recognize the burden imposed by the additional taxes needed to pay for the higher spending, a burden that includes not only the resources transferred from the private sector but also any adverse economic incentives associated with higher tax rates.

The first sentence of this excerpt is what motivates me on matters of national fiscal policy. So what's got Dean so agitated? You should read his whole post, but I think these two paragraphs capture his argument:

The most recent projections from the non-partisan Congressional Budget Office show that Social Security will have enough money between projected taxes and the bonds in the trust fund to pay all benefits through the year 2046, with no changes whatsoever.

This is very important to understand when someone like Federal Reserve Board Chairman Ben Bernanke proposes cuts to Social Security. Workers have already paid for these benefits. The Social Security tax is very regressive. Its regressivity can be justified by the progressive payback structure of the program. However, if the benefits are cut, at appoint when the program can still easily afford the benefits (e.g. 10-20 years), then the government has effectively stolen from the people who paid Social Security taxes.

You will note that in Bernanke's testimony, he never mentions the magnitude of the Social Security trust fund as a guide to budget policy. Dean leads with it. That's a big difference. Dean's statement in the first paragraph that uses the phrase "has enough money ... to pay benefits" would more appropriately be stated as "has the authorization ... to pay benefits." By law, the Social Security Administration can continue to pay full benefits on schedule for as long as there is a positive balance in the trust fund. When that balance goes to zero, it can only pay benefits as it gets in tax revenues. Dean is describing what will happen to benefit payments. Ben's discussion focuses on what it will take for future generations of workers to actually make those payments.

As I discuss in this previous post, the Social Security trust fund balance represents the current value of the Social Security surpluses that have been run to date. When the surpluses are run, the trust fund is augmented with special issue Treasuries, and over time, the trust fund is credited with appropriate interest on those Treasuries. However, the magnitude of this trust fund balance does NOT represent the extent to which debt held by the public is now lower because of these historic surpluses. That would only be the case if every special issue Treasury bond put into the trust fund was associated with the repurchase of a Treasury bond from the public.

In practice, that's not what happens. The federal government simply puts a new Treasury in the trust fund and spends the Social Security surplus on things other than buying back its existing debt from the public, as if the Social Security surplus were just like any other tax revenue at its disposal. How can I assert this? The federal government targets the unified budget deficit, which treats the Social Security surplus in this way. In my memory (which may not be perfect), the only time in the last 25 years when we did not do this was when the on-budget deficit tipped into balance and then surplus in the Clinton Administration. President Bush did it when he pledged "to cut the deficit in half in 5 years" (see this earlier post.) His Administration is doing it again with the more recent statements about budget balance by 2012. In all cases, the deficit in question is net of the Social Security surplus, and thus the policy presumes that the Social Security surplus is available to spend on general government expenditures.

I have in an earlier post argued that the government should be targeting the on-budget deficit and have Social Security in long-term balance. Bernanke stops short of saying this. That's the first way in which his testimony was not exactly what I would have said. There are two other things that I hope he stresses in his future public statements:

First, it is inconsistent for would-be Social Security reformers to be preoccupied with the debt burden placed on future generations due to Social Security's projected annual deficits but not with the debt burden placed on them by continued deficits in the General Fund. What is the rationale for running any deficit in the on-budget account when the economy is in the up side of a business cycle?

Second, it is inconsistent for would-be Social Security reformers to be preoccupied with the debt burden placed on future generations due to Social Security's projected annual deficits while at the same time enacting legislation, like Medicare Part D, that will generate even larger annual deficits to be financed by these same future generations.

Readers of this blog know that I don't exhibit these inconsistencies. I have precious few compatriots among would-be Social Security reformers on the political right.

Returning now to Dean's second paragraph, he regards cutting Social Security benefits as theft, asserting that "workers have already paid for these benefits." I might believe that if the Social Security surpluses were actually being saved rather than spent. But they aren't. It would be more appropriate to say that what the workers--Dean, me, you, all of us--have paid for is all of the government services that the Social Security surpluses have purchased in the past 20 years. We've already consumed them. We have no compelling justification to assert that future generations of workers, who were not party to these decisions, should have to pay higher taxes to honor promises that our generation has made to itself.

But something has to be done, and the sooner it happens, the less disruptive it will be. As always, I recommend that policy makers start here.

To anyone in the Administration who may read this blog, I have one small wish for the new year. Please stop your boss from writing or saying the following:

It is also a fact that our tax cuts have fueled robust economic growth and record revenues.

You are smart people. You know that the tax cuts have not fueled record revenues. You know what it takes to establish causality. You know that the first order effect of cutting taxes is to lower tax revenues. We all agree that the ultimate reduction in tax revenues can be less than this first order effect, because lower tax rates encourage greater economic activity and thus expand the tax base. No thoughtful person believes that this possible offset more than compensated for the first effect for these tax cuts. Not a single one.

If I'm wrong, show me the evidence ... and tell me why the tax cuts were so small given their effects on revenues.

The AP reports that Peter Orszag will be nominated to become the next Director of the Congressional Budget Office. Here is the press release from the Senate Budget Committee. This is an exceptionally good appointment, and Peter is to be commended for being willing to serve. From time to time, I've commented on his Social Security reform plan, co-authored with Peter Diamond.

In addition to the many compliments given to Peter in the press release and the AP story, I would add from my own interactions with him that he is meticulous in his work and in his evaluation of research. This will serve him (and the rest of us) well in his new job. Looking ahead, I will be very curious to see how he addresses the budgetary issues of dynamic scoring and old-age entitlement programs.

David Leonhardt tells us in today's New York Times that it's time to get back to reality, now that the election (if not the vote counting) is behind us:

It should be a good day regardless of whether you’re elated or disappointed by last night’s results, because a campaign that included almost no serious discussion of these issues has now ended. Today marks the start of the 2008 presidential race.

Hard to argue with that. He continues:

We could use some fresh economic ideas right now. An honest accounting of the budget deficit would show it to be even larger than the government says it is. High oil prices have helped finance extremist governments across the Middle East, while the five warmest years on record have all occurred in the last decade. Health care costs, like the numbers of the uninsured, keep rising. Wages for most Americans have failed to keep pace with inflation over the last five years.

In some cases, the outlines of a potential — even bipartisan — solution have already begun to take shape outside of Washington. In other cases, the two parties each have a chance to claim a big issue as their own. With an eye toward Nov. 4, 2008, here is a breakdown of the four biggest[.]

He goes on to list the deficit, health care, global warming, and living standards, and to outline some places where reform could start. Read the whole thing.

Robert Pear reports in today's New York Times about a little known feature of the 2003 Medicare Act: the premiums for Medicare Part B will now be an increasing function of a beneficiary's income. Part B is a voluntary supplement to Part A--the hospital insurance part that is covered by payroll taxes. Historically, the premiums for Part B have covered about 25 percent of program costs. The rest come out of the General Fund.

According to the article:

It is expected to affect one million to two million beneficiaries: individuals with incomes exceeding $80,000 and married couples with more than $160,000 of income. For individuals with incomes over $200,000, the premium, now $88.50 a month, is expected to quadruple by 2009.

[...]

When the transition is complete in January 2009, according to Medicare actuaries, the total premium for a person with income of $80,000 to $100,000 will be 1.4 times the standard premium. A person with income of $100,000 to 150,000 will pay twice the standard premium. A person with income of $150,000 to $200,000 will pay 2.6 times the standard premium, and a beneficiary with more than $200,000 of income will pay 3.2 times the standard amount.

If the basic premium rises 10 percent a year — a relatively conservative forecast — the most affluent beneficiaries will be paying premiums of more than $375 a month in 2009.

[...]

The Congressional Budget Office says 5 percent of beneficiaries will be affected.

[...]

The Congressional Budget Office estimates that the surcharge will raise $15 billion from 2007 to 2013.

The last excerpt suggests that we are not going to raise big money here. The reaction to the means-testing when it becomes known is likely to be as quoted here:

Theodore R. Marmor, a professor of political science at Yale, said the surcharge was more important for the politics of Medicare than for the financing of the program.

“The new income-related premium is fundamentally at odds with the premises of social insurance,” Mr. Marmor said. “Large numbers of upper-income people will eventually want to find alternatives to Part B of Medicare and will no longer be in the same pool with other people who are 65 and older or disabled. Congress will then have less reluctance to cut the program.”

It is very difficult to means-test a voluntary program. I think that problem is insurmountable here, as long as the means-testing is designed to affect only the top 5 percent or so. I am also not moved by the "fundamentally at odds" complaint. Enormous transfers from young to old under the guise of intragenerational redistribution from the healthy to the unhealthy are at odds with sensible fiscal policy.

When I got to CEA in July 2003, the Medicare bill was already in conference. I read the proposed rules for means-testing based on annual income of seniors and decided I had better get to work. I wrote a memo arguing that it was better to means-test based on lifetime income. I envisioned the tax base to be the average indexed monthly earnings of the individual (or couple), where earnings are defined as those on which the Medicare payroll tax was paid.

Since that memo stayed in DC, I outsource the commentary to Gene Steuerle (remembering him in my thoughts today), who made similar arguments in 1997:

An alternative way to apply the new fee in a progressive manner would be to base it not on annual income, but on the lifetime earnings of individuals, as reported to the Social Security Administration. Most of these lifetime earnings are currently applied to the calculation of something called average indexed monthly earnings, from which social security cash benefits are determined. The social security formula itself is progressive, and grants a higher rate of return to those with lower lifetime earnings.

There are three advantages to this approach. First, the Medicare beneficiary would easily perceive the charge as an additional fee for Medicare, not as something else. Second, the additional charge would be easily administered. Those with high lifetime earnings and higher social security checks simply would find that a higher fee was assessed against them for Medicare. They already pay the rest of their Medicare fee out of their monthly social security check, and the amount withheld is exact. No additional forms need to be filed, and no reconciliation is required at the end of a year. Next year, instead of all beneficiaries bearing an identical additional fee of say, $3, only those with lower lifetime earnings would see a $3 increase, but those with higher incomes would see a larger increase, say, up to $20.

A third advantage is that past lifetime earnings are not as easily manipulated as is annual income for those who are already retired. Like annual income, however, no one measure is perfect, and some adjustments would need to be made -- as they are in the case of social security -- for those who are measured as having low lifetime earnings because they worked in federal or other employment that was exempted from social security tax. While these adjustments would not be perfect, on average I would guess that they still would be more equitable than annual income as a base for assessing the fee.

The memo received a good hearing in the White House, and I even got to visit the conference committee and explain the ideas to the staffers. The ideas didn't prevail, though, largely because this method of means-testing does not include unearned income at any point during a person's lifetime in its defintion of the tax base. I thought that was a very minor point (particularly given the manipulability of unearned income in retirement) compared to the ease, transparency, and robustness of the alternative measure.

A comment on a recent post asks:

Do you think we should use the on-budget deficit to measure our nation's short-term fiscal health? I thought most people looked at the unified deficit, measuring how much the US government has to borrow from the markets.

Calculated Risk's graph seems to show the increase in "national debt", rather than in "debt held by the public." But the "national debt" includes accruals to the Social Security and Medicare trust funds, which are merely intergovernmental accounting transfers. Do you subscribe to this as an appropriate metric?

I'm being deliberate in endorsing the on-budget deficit for the "must average to zero" standard and national debt (as opposed to that held by the public) for the "no Debt/GDP trend" standard. The key adjustment to the off-budget deficit is demographic, not cyclical. We are in a period when Social Security surpluses are being run in the anticipation of deficits as the Baby Boom retires. Suppose, counterfactually, that the present value of those off-budget surpluses and deficits is zero.

If we are targeting the unified deficit, then the current off-budget surpluses enable larger on-budget deficits in the near term. That wouldn't be too problematic if I thought that the looming off-budget deficits would cause the government to run comparably smaller on-budget deficits in those years. (An analogous argument holds if we use debt held by the public rather than national debt when assessing the trend in Debt/GDP.)

I don't think that will happen. We cannot get the on-budget account out of deficit, much less into surplus. The government is not releasing (or even making) budgets with a long enough time horizon to capture the demographic impact on the General Fund. Government officials are not targeting the unified deficit because they deliberately intend to have that future path of on-budget surpluses. They are targeting it because it postpones tough fiscal decisions of cutting spending or raising taxes to someone else's watch. That postponement needs to stop.

If we continue to amble along on our current path, then I expect that in 10 - 15 years, politicians will opportunistically switch to targeting the on-budget deficit when the off-budget account turns from surplus to deficit. And given that expectation, I want them targeting the on-budget account today, as a means of imposing some fiscal discipline.

I might have expected to post this as a "view from the other side" at Angry Bear, but I don't disagree with Calculated Risk in his assessment of former Senator Kerrey's and Senator Rudman's admonition to form a commission on "Securing Future Fiscal Health." CR writes:

Everyone should agree that the most immediate fiscal problem is the structural General Fund deficit. Excluding future health care costs, the structural deficit is around 4% to 4.5% of GDP. This serious problem has been caused almost exclusively by Bush's policies. And imagine if the economy slows next year, as many people expect, adding a cyclical deficit on top of the huge Bush structural deficit.

So isn't it reasonable to suggest that Mr. Bush and the GOP fix the structural deficit first, before addressing other long-term issues? Of course.

CR is correct in his diagnosis of the immediacy and the size of the problems of the General Fund deficit. As I have discussed in earlier posts (here and here, for example), the appropriate target for the General Fund deficit is for it to average to zero over a business cycle. A corollary to that is that the General Fund should be in surplus during the non-recessionary parts of that business cycle. (A slightly weaker target that I would also accept is that the Debt/GDP ratio not trend upward over time.) This Administration seems to have no problem submitting budgets that don't conform to this target. Certainly the Congress doesn't aspire to a higher standard.

So as much as I would like to see the looming financial crises with entitlement programs averted, CR's requirement of the current leadership in the White House and the Capitol is a reasonable one to impose as a precondition for agreeing to a bipartisan effort to address what will be the most immediate budget issues in a decade or two. It is also a good test of whether there is any reason at all to return them to those positions after the November elections this year and in 2008.