LC 21-2». :8 if: m13~7<722;v1 ua.aul...n.l ' ' '- . CNGRESSIONAL RESEARCH S SERVICE THE LIBRARY OF CONGRESS 9 ¢‘a\ rj i2:\.<’f«;:;=3;°-*.=:éng:_j;i.-:‘:,=r?. ‘£_.§5’§i‘e'é=;i‘S3i”$‘3%’ Mini Brief sTo figs -ii '~’i' “iii? i " L? E A NOV 18 L989 . < H Universitfl éfimiiéiébiiiiii u u I mum in miii l 010-103940 30 lllfll L;}£b.§ nu nu THE BALANCED BUDGET PROPOSAL: SOME MACROECONOMIC IMPLICATIONS MINI BRIEF NUMBER MB79229 AUTHOR: John B. Henderson Senior Specialist, Price ECOI'1OII'liCS THE LIBRARY OF CONGRESS CONGRESSIONAL RESEARCH SERVICE MAJOR ISSUES SYSTEM’ DATE ORIGINATED O4/16/79 DATE UPDATED l2/Ol/82 FOR ADDITIONAL INFORMATION CALL 287-5700 1201 CRS- l MB79229 UPDATE-L2/Ol/82 ISSUE DEFINITION Several proposals have been made, on the basis of strong and persistent public sentiment, to prohibit the federal government from running a budget deficit in any fiscal year. Such a restriction on the fiscal activity of the federal government would profoundly alter the role of the federal government in the nation's economy, inasmuch as only two of the past twenty" fiscal years‘ budgets have recorded a surplus. Fory the most part, however, the proposals merely declare a criterion of performance —- usually to require that, on the unified budget basis, federal budget outlays shall not exceed receipts. They do not differentiate the role and structure of the federal budget from those of states and localities, corporations or households, and they do not address the questions of how the required budgetary outcome is to be achieved or what impact might be delivered to the economy by adherence to the requirement. This mini brief outlines some possible macroeconomic implications of adopting a statutory or constitutional commitment to balance the federal budget every year. BACKGROUND The federal budget is unlike other budgets The federal budget resembles other budgets only in that it is an economic prospectus, a declaration of intentions. It differs from state and local budgets in that most subordinate governments differentiate current account budgets from capital budgets, requiring in many instances balance in the current accounts, whereas the federal government makes no distinction between outlays for current expenses and outlays of the nature of investment in social capital. By standards of federal accounting, many states and municipalities, while adhering to the requirement of current-account balance, would be in budgetary deficit if they were to consolidate their budgets, since borrowing creates a deficit on capital account. For the same reason, vigorously growing corporations, in issuing new debt in excess of their net income, are practising what is called deficit spending in reference to the federal government. For most households, too, the first purchase of a home associated with a mortgage commitment is relatively a huge excess of outlays over receipts in the year of its acquisition and hence is also a cause of deficit spending. It is true that the creditworthiness of states, localities, corporations, and households places limits on the scale and terms on which they are able to borrow, and that no similar short-term constraint applies to the federal government. There'are long-term limits, however, and the ability of subordinate borrowers to service debt finds its counterpart in the willingness of the federal government to impose taxes to raise revenues. Federal revenues and expenditures cannot be precisely controlled The President's budget is presented to the Congress each January, more than eight months before the beginning of the fiscal year to which it applies. Its taxing and spending proposals determine the estimates of revenues and expenditures on the basis of explicit economic presumptions. CRS- 2 MB79229 UPDATE-l2/Ol/82 Whether the actual course of events will conform to these presumptions cannot be assured. If the President presents a budget in balance, and even if such changes as the Congress makes leave the budget in balance at the time of the Second Concurrent Budget Resolution, which is required before the beginning of the fiscal year, there is still no assurance that the budgetary outcome will result in a balance. This is due to such factors as the unpredictable timing of actual expenditures, particularly on long lead-time projects and multi—year programs; the existence of open-ended programs such as unemployment assistance; and the variability associated, with commitments, such as the payment of interest, at an unknown future rate, on the federal debt. Moreover, the actual federal outlays during the fiscal year will be affected by unspent authority enacted in earlier years. And the budget numbers are, in some programs, conditioned by past commitments to expenditures that are "relatively uncontrollable," i.e., require Congressional action for any change in that fiscal year.p Finally, the budget document reports certain activities that are by law "off—budget," most Of these outlays being excluded from the unified budget totals. MOSt Of all, the uncertainty Of the federal budget outcome iS due t0 the impact of the state of the economy on the budget. For example, personal and corporate income levels affect income tax receipts. The level of unemployment affects payments of assistance. And some grants and subsidies vary in response to economic conditions, state and local government expenditures and receipts, etc. The intent of many of the programs most affected by the state of the economy is not only that they incur certain expenditures or raise revenue from specified sources, but that they act a automatic stabilizers of the economy, causing federal outlays to rise and receipts to fall if economic activity is reduced, and vice versa. Consequently, the budget figures presented initially by the President are directly affected not only by the programmatic propoaals but also by the underlying assumptions about the future performance of the economy. The crucial importance of these assumptions is seldom emphasized, largely because every Administration has a political interest in projecting the success of its economic policies. The result is that relatively few allowances are made for adverse economic developments. The actual budgetary deficit tends in most cases to exceed, rather than fall short of, the initial expectations, even if no programmatic changes are made in the interim. Required budgetary balance may affect the stability of the economy A rigid adherence to budgetary balance could severely constrain the stabilizing influence of fiscal policy. For if lower general economic activity generated lower federal tax receipts and threatened to cause a budgetary deficit, the commitment to balance the budget would necessitate a reduction of expenditures or an increase in taxes, either of which would further reduce economic activity -- a destabilizing process. Equally, if there were the same obligation to avoid surpluses, higher income and higher tax receipts might require high expenditures at the very time when stabilization policy would call for less, or at least not more, federa spending. Alternatively, higher tax receipts could be considered as a reason for a cut in tax rates, a stimulative action at a time when restraint might be more appropriate. CRS- 3 MB79229 UPDATE-l2/Ol/82 Federal government expenditures on goods and services generate incomes, and federal government transfers to state and local governments and to private individuals provide purchasing power to be exercised usually within a short period of time. Federal receipts of all kinds withdraw purchasing power from the private sector. However, the important consideration is what all government activity, and not just the federal budget alone, is doing to the economy. From the viewpoint of the private sector of the economy, the effects of federal fiscal policy may be enhanced or countered by the fiscal activities of state and local governments. It is noteworthy that, on the basis of the national income and product accounts of calendar year 1981, the Federal Government deficit of $60.0 billion was partially offset by a State and local government surplus‘ of $31.7 billion. On balance, the whole government sector was stimulating economic activity to a moderate degree, largely because of a recession-induced increase in Federal payments and decrease in Federal receipts. Congressional action to balance the budget is subject to both limitations and political perceptions There is no way to estimate by what means the required federal budgetary balance would be achieved. But some account has to be given to the fact that "relatively uncontrollable" outlays (requiring Congressional action to change an on-going program) account for about three-quarters of total outlays and, among these, open-ended programs involving payments for individuals, such as Social Security, account for almost one—half of total outlays. Of the ‘relatively controllable" outlays, well over half are found in the defense budget. It is also noteworthy that the budgetary process sometimes takes longer to decide on major changes in outlays than changes in taxes -- a situation that might move the Congress to raise taxes rather than cut spending, the opposite reaction to the intent of many of those favoring a balanced budget. There is likely to be asymmetry in Congressional responses, for tax cuts and expenditure increases cause less difficulty than tax increases and expenditure cuts. It is possible, of "course, that the Congress could respond to the difficulty of reducing expenditures by altering the coverage of the budget. As mentioned earlier, there are off-budget federal entities, federally owned and controlled but with most of their outlays excluded from the unified budget totals, and.not subject to the ceilings set by the Congressional budget resolutions. Their status is created, and can be changed, by law. while most of them are involved in loan programs, Congress could choose to extend the concept of an off-budget entity. In addition, the regulatory activities of the federal government are capable of being conducted in such a fashion that, instead of incurring budgetary costs, they could impose costs on the private sector. An immense variety of options exists, ranging from preventing layoffs of employees (and avoiding payment of unemployment benefits) to mandating higher product prices instead of subsidizing production. ‘he change in budgetary procedures will not leave monetary policy unaffected There is a continuous relationship between budgetary and fiscal policy, federal debt management, and monetary policy. The likely consequences of a CRS- 4 MB79229 UPDATE-12/Ol/82 commitment t0 a balanced budget would be a diminution Of the power and SCOP of fiscal action, and a consequent increased reliance on monetary policy,- especially in the event that the loss of fiscal discretion has a destabilizing effect on the economy. It should not be forgotten, ‘however, that monetary policy cannot be a complete substitute for discretionary fiscal policy. Both budgetary expenditures and taxes are able to perform specific distributive and allocative functions, channelling resources to certain types of people, organizations, industries, or locations, and withdrawing resources from certain others. Monetary policy cannot .do this, and even such a proposal as credit allocation cannot attain anything like the purposefulness of budgetary action. Moreover, the budgetary process involves open political deliberation, whereas monetary policy is conducted by the independent Federal Reserve System under conditions of strict confidentiality, though Congress is entitled to oversee the general performance of the System. It is not necessary that this independence should continue. On the contrary, the balanced budget might endow the management of monetary policy» with such enhanced and critical power that political pressure would curb the independence of the Federal Reserve System. Ad hOC budgetary balance and surplus It must be emphasized that nothing in this analysis runs counter to the View that at some times the budget should be balanced or in surplus; the desirable budgetary outcome depends on the economic circumstances. However, a rigid requirement that the Federal budget should be balanced carries th' risk that this might be achieved by measures whose associated costs to th Nation, in terms of equity, efficiency, and economic stability, had not been‘ given adequate consideration. In December 1982, it appears that the budgetary outcome for fiscal 1983 Will be t0 a considerable degree affected by DOW much longer the eCOnOmiC. slackness experienced since mid-year 1982 persists, and also how strongly the economy will grow when eventually the recovery begins. There is, however, no chance that the FY83 deficit will be less dthan a massive one- In these circumstances, constraints applied by attempts to bring the budget quickly closer to balance would tend only to prolong the recession or to deepen it. Price inflation has moderated considerably under the influence of worldwide recession and a general weakness in world markets for primary products. This has been transmitted to consumer prices, especially through lower rates of price increase for energy, food, and housing costs. The annual rate of increase in the consumer price index is now below 6%, or even as low as 4% by other measures of prices. 1 The weakness in labor markets has been accompanied by a downward trend in annual wage settlements. The outlook for improved labor productivity in 1983 depends on the course of the economy, but in the absence of a further substantial decrease in real activity, the prospect exists that the upward movement in output per manhour recorded in the latter part of 1982 will continue. Thus, the underlying cost-related rate of inflation, heavily influenced by wages, may be 6% or even lower in 1983. The 1981-82 recession was accompanied by an extraordinary and sustained high level of interest rates, especially in the context of a decline in the rate of inflation. One influence contributing to these high rates was market concern about the prospect for large and growing Federal budget deficits. CRS- 5 MB79229 UPDATE-12/Ol/82 Yet, the recognition of the severity of the recession and the absence of signs of quick recovery prompted a fairly sharp decline in the real costs of borrowing, beginning in early July l982. In the course of the following three months, the 3-month Treasury bill rate fell by 5 percentage points to less than 7%, and high—quality corporate bond yields fell by 2 l/2 percentage points to less than 13%. This still leaves the real cost of borrowing at very high level for such a severe recession, but at least allows some scope for a cautious movement to increase the supply of credit. However, any sizable improvement in the Federal budget deficit remains dependent on a relatively strong recovery of which there is as yet no clear evidence. This situation leads to a further question about the realism of proposing a quick return to budgetary balance, however much that budgetary outcome might be desired as appropriate to the current needs of, and pressures on, the economy. Of course it is possible to forecast balance by using economic presumptions that are overly optimistic; but that would do nothing to assure the achievement of balance. As it is, the weakened economy is likely to reduce tax revenues and to bring about some increase in expenditures. on entitlement programs. And moderation of price increases in itself is likely to reduce revenues more, and more promptly, than expenditures. The reduction in Federal debt service that will result from lower short-term interest rates will provide onlyi a partial offset. On balance, a weak economy will inevitably tend to widen a budgetary deficit. An even more serious problem is the recognition that the deficit in the Federal budget is not merely a natural accompaniment of cyclical downturns, but the manifestation of a new tendency for Federal expenditures to grow at a faster rate than Federal revenues in both good years and bad. The :onsequence is that deficits are naturally inclined to increase rather than to shrink. This is partly due to the Government's commitment, at a time of inflation, to sharply higher expenditures because of indexation or the maintenance of a stable path of real purchases. Another basic reason is the lower rate of personal and corporate taxes, that has the additional effect of reducing somewhat the progressivity of the tax system at higher income levels. In combination, these changes appear to reduce the prospect of achieving any enduring movement to budgetary balance. Recent budgetary legislative action to increase tax collections and reduce some tax favors granted in l98l is in itself far from sufficient to reverse the tendency to widening budget deficits. The basic question is whether giving first priority to a balanced budget as a goal in itself would cause the economy to weaken and become less manageable. The real issues require decisions on whether proposals to reduce tax rates now or in future years are consistent with the lasting need for fiscal constraint. It is necessary also to ask whether plans for expenditures are compatible with prospective revenues, resource availability, and the financial environment. If not, the risk is that a commitment to tax reductions and insufficient constraints on total Federal spending will frustrate the desired reduction in the deficit. A widening deficit in future, when the economy attempts to resume more vigorous growth and private investment generates a greater demand for funds in the financial markets, would assuredly threaten to destroy the vigor of the recovery. LIBRARY OF WASHINGTON UNIVERSITY 937 FQE95 ' V'V'°-