Jacob J. Lew - February 23, 1999

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TESTIMONY OF
JACOB J. LEW
DIRECTOR
OFFICE OF MANAGEMENT AND BUDGET
BEFORE THE
HOUSE COMMITTEE ON WAYS & MEANS

FEBRUARY 23, 1999

One year ago, President Clinton set the course of the Nation's budget policy with his charge to "Save Social Security First." The President recognized that we were entering a new era as we left behind the decades of large budget deficits. He was building the foundation for budgeting in this new era of surpluses.

Fiscal Progress Has Produced a Strong Economy

The year 1998 was one of the most extraordinary in modern U.S. economic history. We enjoyed the first budget surplus in 29 years -- the largest ever in dollar terms, the largest as a percentage of the economy in more than 40 years. And this budget surplus was not the result of a temporary wartime policy, as was the last surplus in 1969. We will have a budget surplus again in the ongoing fiscal year -- at an estimated $79 billion, larger than last year's -- which will mark the first back-to-back surpluses in more than 40 years. The President's budget for fiscal year 2000 proposes a third consecutive surplus -- the first time that will have happened in half a century. And our 1998 budget surplus was the sixth consecutive year of improvement in the U.S. fiscal position -- the first time that has happened in American history.

The private sector is the key to economic progress, but we have clearly seen in the decade immediately past that the Federal Government can either hinder or promote economic progress. If the Federal budget deficit is high, so that the cost of capital is driven up and the financial future is uncertain, the private sector cannot yield the progress of which it is otherwise capable. But if, instead, the Federal Government declares its intentions of responsible fiscal behavior, and lives by those intentions -- and if the Federal Government supplies the public investments that America needs -- then the economy is free to prosper. This is the path that this Administration has taken.

In 1998 we reaped the fruits of five years of fiscal responsibility. After the best sustained growth of business investment since the 1960s, the U.S. economy fueled that decades-absent budget surplus. And the economy itself defied the pundits, staying on a pace of solid, above-trend expansion, in the face of an international financial disruption that broke the stride of most other economies around the world. Unemployment and inflation both hit three-decade lows, with the lowest unemployment rates for African Americans and Hispanics in the history of those statistics; real wages continued to grow after more than a decade of stagnation, and a record percentage of adult Americans worked in those higher-paying jobs; the percentage of Americans on welfare fell to a 30-year low; the 10-year Treasury bond rate reached its lowest level in 30 years; and a higher percentage of Americans attained home ownership than at any time in our history.

The President deserves a great deal of credit for the virtuous economic cycle that we now enjoy. The announcement of a firm intention of fiscal responsibility in 1993 was greeted by a continued reduction of interest rates, which helped to trigger the investment boom that has proved central to sustained strong, non-inflationary economic growth. The two other pillars of the President's policy -- investing in our people and our technology, and opening foreign markets to U.S. exports -- complete this winning economic strategy.

The 2000 Budget Is a Defining Moment

This extraordinary budget-and-economic performance -- with the budget setting historical standards and the resilience of the economy setting global standards -- tells us something. It tells us that we have developed a winning economic policy and that we must not turn back. We must not discard the economic philosophy that got us here, to this confluence of economic indicators that all sides now agree is the best in modern memory.

So in one sense, our budget policy now clearly should be built on continuity. We have achieved a sustained fiscal improvement, and we should continue to sustain that improvement. We have an economy that achieved a record sustained peacetime expansion, and we should continue to sustain that expansion.

But in another sense, we have stepped into a new world. Where our budget used to be written in red -- for so many years that people came to take it for granted -- now we are in the black. And this change has tempted some to throw away all of the policy principles that got us here.

For two decades now, there has been much discussion about fiscal discipline, restraint, and deficit reduction. Since 1993, we have taken action; and far beyond the expectations of even the most optimistic, we now have budget surpluses as far as the eye can see. But now, as the first surpluses appear, it is important that we not revert to the practice of cutting taxes and raising spending first, and thinking about the fiscal consequences later.

As the President suggested in his State of the Union address in January, this is a moment that will do much to determine the character of our country at the end of the next century. We can build and strengthen the fiscal foundation that first arose in these last few years. Or we can sweep it away, before it is firm and strong, and set our economy to foundering again. The choice is clear and the President is determined to pursue a balanced program of fiscal discipline and prudent investment for the future. This budget charts that course into an era of surplus.

Fiscal Policy since 1993 Was Pivotal to Our Current Good Fortune

To see why fiscal responsibility matters, consider where this Administration started six years ago. In 1992, the budget deficit was $290 billion, the largest in the Nation's history. Between 1980 and 1992, the debt held by the public, the sum of all past unified budget deficits, quadrupled; it doubled as a share of our Nation's production, or GDP -- from about 25 percent to about 50 percent.

These adverse trends showed every sign of accelerating. Both CBO and OMB projected that, without changes of budget policy, growing deficits would add to the Nation's debt, and growing debt service costs would add, in turn, to the Nation's deficits. OMB forecast the 1998 deficit, in the absence of policy change, at $390 billion, or 5.0 percent of GDP; by 2003, we expected the deficit to be $639 billion, or 6.6 percent of GDP. And there was nothing in the forecast to indicate that this exponential trend would stop.

This threat was not turned back by accident. It required tough policy choices, which the Administration and the Congress took in 1993 and 1997. The President's initial economic program cut spending and increased revenues in equal amounts. Since that time, deficit reduction (and ultimately surplus increase) has more than doubled the estimates for the President's plan -- instead of the projected cumulative $505 billion, deficits have fallen by $1.2 trillion. That is $1.2 trillion less in debt that the American taxpayer must service -- forever.

And this deficit reduction has come as much from lower spending as from higher revenues. Spending has declined to its smallest share of the GDP in a quarter of a century. And thanks to the strong economy, receipts have grown beyond expectations, even though the tax burden on individual families is lower than it has been for about a quarter century:

The typical family of four -- with the median family income of $54,900 -- will pay a lower share of its income in income and payroll taxes this year than at any time in 23 years. Its income tax payment considered alone will be the lowest share of income since 1966.

A family with an income at one-half of the median level, $27,450, will pay the lowest share of its income in income and payroll taxes since 1965. Its income tax bill will be negative; it will receive money back because of the earned income tax credit. That was never the case before 1998.

Even a family at twice the median income level, $109,800, will pay less in income tax as a percentage of income than at any time since 1973.

Receipts have risen as a percentage of GDP not because of a heavier tax burden on typical individual families, but rather because of the extraordinary growth of incomes of comparatively affluent Americans (including capital gains and stock options that are not included in measured GDP); and because of the rapid growth of corporate profits.

The historic bipartisan balanced budget agreement of 1997 has reinforced expectations of Federal fiscal responsibility. This has had a favorable effect on interest rates, and the economy at large.

In the last six years, we have enjoyed an extraordinary economic performance because our fiscal policy was responsible and sound. If we want to continue to enjoy such strong economic performance, we must continue our sound fiscal policy. As the experience of the last 20 years clearly shows, budget problems are very easy to begin, and very hard to end.

Reducing debt burden is as important to the Nation as it would be to a family. The Nation must service its debt. If we gratify ourselves today by collecting taxes insufficient to cover our spending, and accumulate debt, our children and our grandchildren will have to service that debt. If, instead, we reduce our debt, our children and our grandchildren will be freed of the obligation to tax themselves more heavily in the future just to pay the interest on the debt they inherited from us as our legacy.

The President's proposal will fully reverse the buildup of debt of the 1980s -- and then go further. By 2014, the end of the 15-year horizon of the President's program, the combined effects of the President's commitments to Social Security and Medicare will reduce the Nation's debt burden to an estimated seven percent of GDP. This will be the lowest ratio of debt to income that the Nation has enjoyed since before it entered World War I. And as most experts would tell us, this will be one of the greatest gifts that we could ever give our children, as we exercise our fiscal stewardship of these United States.

The President's policy would devote more than three-fourths of future budget surpluses to reducing the Nation's debt and accumulating assets through contributions to Social Security and Medicare; and would dedicate another 12 percent to household savings through Universal Savings Accounts. This is important to our economic performance for four basic reasons: First, it increases the Nation's savings rate, which is critical to productivity gains and economic growth. Second, it reduces the debt. Third, it improves the fiscal position of the country, and puts it on a stronger footing for whatever uncertainties might arise. And finally, it improves the retirement security of all Americans.

The Current Challenge Is to Use the Surplus Prudently

In 1993, we faced the challenge of eliminating projected budget deficits of $4.3 trillion over ten years. Today we face the enormous opportunity of projected surpluses of more than $4.8 trillion over the next 15 years. The challenge is to use this surplus prudently -- to maintain our strong economic and budgetary performance.

We must save Social Security first. A statement of good intentions is not good enough for the millions of Americans, retired and working today, who rely on Social Security for their retirement security -- and for protection for their families against disability and premature death. From the beginning, this Administration has kept its eyes on the future, and taken policies that would benefit the Nation for generations to come. It has paid off. Saving Social Security first is precisely such a future-oriented policy.

The President's FY 2000 budget -- symbolically, as well as financially, "in the black" -- continues firmly on that successful path. The budget maps a course for the Federal Government after Social Security is reformed -- and makes its own policy recommendations for the beginning of the bipartisan Social Security reform process that the President inaugurated last year. But the budget also draws a line that this Administration will not pass without Social Security reform.

Thus, the FY 2000 budget is fully paid for within the existing budget law. Just as in every previous year, the President has specified his own priority initiatives, but has paid for all of them -- line by line, dime by dime -- with savings from elsewhere in the budget. The budget proposes a framework for allocating the surplus to meet national objectives if Social Security is reformed.

The President's policy calls for a bipartisan Social Security reform, this year. The President has already committed 62 percent of our projected budget surpluses -- enough to extend Social Security's solvency almost an extra quarter century, to 2055. We hope that this will launch a bipartisan process to address long-term Social Security solvency. We are gratified that several leaders from the Congress have already accepted this principle and hope that both parties, the President and the Congress, can follow through on this commitment and achieve sufficient additional reforms to extend the solvency of the trust fund at least through the traditional 75-year actuarial horizon.

If we achieve that objective, the budget makes further commitments of the surplus to priority National objectives in the future. The President proposes to dedicate 15 percent of the surplus to extending the solvency of the Medicare trust fund. This is a key element of the President's program, because the financial security of Medicare will be threatened even sooner than that of Social Security. In 1997, the President and the Congress, acting together, made Medicare financially sound through 2010. The President's 2000 budget would extend that lifetime ten years further, to 2020. We see the commitment of the surplus as a vital step to facilitate an environment in which a bipartisan effort -- including the current Medicare Commission -- can go even farther; with the time horizon so short, even after the contribution of 15 percent of the surplus, we cannot delay Medicare reform. As the President stated, he wants to consider, as a part of this reform process, expanding Medicare coverage to include prescription drugs.

The President also proposes using 12 percent of the surplus to finance his new Universal Savings Accounts -- "USAs" -- a tax cut which would provide seed money plus matching contributions for individual accounts. The matching contributions will provide a substantial inducement for low- and moderate-wage workers. The goal is for all Americans to see the rewards of saving building up in these USAs -- and with this introduction to the power of compound interest, to begin to save further on their own. The President believes that this program, with its Government seed contribution, has the potential to reach even those who have failed to respond to the generous subsidies in the current-law Individual Retirement Accounts (IRAs).

The President wants a fiscally responsible tax cut. He believes that the USA is the right kind of tax cut -- targeted toward the future, and helping the many American families who have the most difficulty saving for their retirement. It strengthens perhaps the most neglected of the figurative three legs of the retirement stool -- personal saving, to stand alongside Social Security and employer pension plans -- and for the many who have no employer plan, this initiative may be crucial. Most importantly, it is part of a plan that fixes Social Security first.

Finally, the budget proposes that the remaining 11 percent of the surplus be dedicated to other important priorities -- including education, National security, and health care.

The President's Framework Will Extend Trust Fund Solvency

The President's contribution of the surplus to Social Security will use many of the existing financial management tools of the Federal Government. It will be in addition to the accumulation in the Social Security trust fund that would occur with no change in the current law.

After the trust fund is credited for all of its own receipts, exactly as in current law, the Treasury will be left with the unified budget surplus. Each dollar of that unified surplus can be used only once -- for cutting taxes, increasing spending, or buying down the debt. The President has brought the debate right to the point: What should we do with that surplus? Or to put it another way: If we were to look back fifteen years from now, or at the end of the next century -- what would we want to be able to say that we had accomplished with this opportunity? The President wants to leave a legacy of building for the future: saving Social Security and Medicare; encouraging Americans to save for their own futures, build wealth, and prepare for retirement; investing in education; ensuring our National security; and making other key investments.

So the President started by committing 62 percent of the surplus to save Social Security first. Most of the share committed by the President to Social Security will be used to buy down the publicly held Federal debt through the periodic debt refundings of the Treasury Department, in exactly the same way as debt was retired last year. That same amount will be credited to the Social Security Trust Fund, in the form of Treasury securities. This same procedure will be followed for the President's contribution to the Medicare trust fund.

This commitment will significantly extend Social Security solvency. At the end of 1999, the currently estimated combined balances of the OASDI trust funds is about $850 billion. Through 2014, we estimate that additional contributions to the trust funds under the current law, including interest, will total about $2.7 trillion, leaving a total balance of about $3.5 trillion. The President's program would contribute an additional $2.8 trillion to the trust funds over the next 15 years. Taking into account additional interest earnings, that would leave a balance in the trust funds of more than $7 trillion -- instead of the approximately $3.5 trillion under the current law. The President's program will more than double the balances in the trust funds over the next 15 years. (This does not account for the anticipated higher earnings on the portion of the surplus invested in corporate equities.)

Because the President's plan will reduce the public debt, the total obligations of the Federal Government will not increase. We are already committed to paying benefits beyond 2032, when the trust fund is now expected to be exhausted. The President's proposal would reduce the debt borrowed from the public, and deposit assets of an equal amount in the Social Security trust fund. Interest payments will go to the trust fund, to cover future Social Security benefits, rather than to banks, individuals and other investors in Government bonds.

A small portion of the President's commitment to Social Security (21 percent of the commitment) will take the form of holdings of corporate stock. Because the Federal Government will need that amount of the cash surplus to purchase the shares, this contribution will not reduce the public debt. However, it will improve the Federal Government's implicit balance sheet -- to the same degree, but in a different way. While the reduction of debt will reduce the Federal Government's liabilities, the corporate shares will increase the Federal Government's assets. The salutary effect on the Government's balance sheet will be the same, but it will appear on the other side of the balance sheet. Furthermore, this amount will add to national savings, just as it would if it were used to buy down debt.

Thus, the President's policy in no way increases the total obligations of the Federal Government. In fact, by retiring part of the public debt, it strengthens our economy in exactly the same way that reducing the budget deficit, and avoiding the accumulation of debt, has helped the economy over the last six years. The President's program does shift the Federal Government's commitments to Social Security, however, and in that way improves Social Security's solvency for the next century. This will give Social Security a first call on the economic benefits associated with long-term reductions in publicly held debt. In a recent report, Merrill Lynch noted:

Allocating a portion of budget surpluses to debt reduction, as the President proposes, is a conservative strategy that makes sense. Reduced debt will result in increased national savings, lower interest rates, and stronger long-term economic growth than would otherwise be the case. (Merrill Lynch, Assessing the Investment Climate: Focus on Washington, 10 February 1999.)

The President believes that budgeting in an era of surpluses requires a focus firmly on the future. We must put money aside against our current obligations before we incur any new obligations. The President's program does that, by retiring debt and accumulating assets against the Social Security commitments that we already have.

Accounting for Sound Policy

There are some further, highly technical questions that one might ask about the effect of the President's framework on budget accounting, and on the presentation in the budget documents in the coming years. These questions are issues of detail, and have no bearing on the substance of the President's proposals, and on their effect on the economy and the nation broadly. The President's proposals are new policies that are designed to address new circumstances and new public needs, but sound accounting principles can explain these policies.

The unified budget surplus provides the best and most meaningful standard for assessing the fiscal impact of general fund transfers to Social Security. The unified budget is a comprehensive measure of the fiscal activities of the Federal Government, and the surplus or deficit in the unified budget is the best indication of the Government's demands in the private credit market. As OMB, CBO, and others have long noted, the unified budget is a comprehensive measure of the fiscal activities of the Federal Government, and the surplus or deficit in the unified budget is the best indication of the Government's demands in the private credit market.

...most economists, policymakers, and participants in credit markets look at the total budget figures, including Social Security, when they seek to gauge the government's role in the economy and its drain on credit resources. (CBO, The Economic and Budget Outlook: Fiscal Years 2000-2009, January 1999, p. 34.)

The shortcomings of focusing on the on-budget results can be illustrated by contrasting the Administration's proposed transfers to Social Security with alternative proposals for tax cuts that would reduce receipts by the amount of the on-budget surplus. While a dollar of tax cuts and a dollar transferred to Social Security would seem numerically equivalent and equally fiscally responsible, the dollar of tax cuts would increase publicly held debt and reduce national saving, thereby hindering the nation's ability to meet the future fiscal challenges of Social Security and Medicare. In contrast, the dollar of transfers would allow the debt reduction to take place.

There is a similar, and analogous, comparison between discussions of the debt held by the public, on the one hand, and the nation's gross debt (or the closely related debt subject to limit), on the other. Gross debt, in the broadest terms, includes debt held by the public plus debt owned by Government agencies (such as the Treasury securities held by the Social Security trust fund). Such debt is owed by one part of the Government to another. It does not therefore in any way reduce the Federal Government's ability to meet its obligations to actors in the economy at large. Financial market analysts have long believed that the economy is not affected by the amounts of agency-held debt; such debt does not influence interest rates, and thus does not influence the cost of capital to American businesses. Therefore, future business investment, and hence future rates of economic growth, will be driven by changes in debt held by the public, rather than in gross debt. Policies that reduce debt held by the public are thus far more important than changes in gross debt.

Of course, a policy that increases debt held by the public will also, all else equal, increase gross debt dollar for dollar. Accordingly, changes in gross debt are not irrelevant, but it is essential to consider why gross debt changes. If gross debt increases because of policies that increase the nation's budget deficit and publicly held debt, then that change does signal an adverse impact on the economy. However, if, as under the President's Social Security framework, gross debt increases while debt held by the public declines, the effect on the economy will be favorable, not adverse. It may be worth noting that the President's framework, in buying down the publicly held debt and increasing the assets in the Social Security trust fund, would have exactly the same qualitative economic effects as the bipartisan and now universally hailed Social Security Act Amendments of 1983.

We have an historic opportunity for long-term prosperity if we rise to the moment

There is much to be proud of in America today. By balancing the budget, we have not just put our fiscal house in order; we have left behind an era in which the budget deficit, as the President said recently, "came to symbolize what was amiss with the way we were dealing with changes in the world." Today we have risen to the challenge of change -- by preparing our people through education and training to compete in the global economy, by funding the research that will lead to the technological tools of the next generation, by helping working parents balance the twin demands of work and family, and by providing investment to our distressed communities to bridge the opportunity gap.

If the deficit once loomed over us as a symbol of what was wrong, our balanced budget is proof that we can set things right. Not only do we have well-deserved confidence, we have hard-earned resources with which to enter the next century.

As the President said, what we do now -- after having balanced the budget -- will shape the character of the next century. We can build upon our newfound firm economic foundation; or we can squander it.

The President has brought the debate right to the point: What should we do with the surplus? Or to put it another way: If we were to look back fifteen years from now, or at the end of the next century -- what would we want to be able to say that we had accomplished with this opportunity?

The President wants to leave a legacy of building for the future: saving Social Security and Medicare; encouraging Americans to save for their own futures, build wealth, and prepare for retirement; investing in education; ensuring our National security; and making other key investments.

There is no more pressing issue facing us as a nation than the need to guarantee that Social Security will be there for generations to come. And there is no better time to act than now while the system is still strong. This is truly an exceptional moment in America -- the economy is prosperous, the budget is in balance, and the President's commitment to national dialogue has created conditions for constructive action. We must seize this moment.

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