CRS REPORTS ON OBRA'S TAX-EXEMPT BOND PROVISIONS.

                               SUMMARY

It is correct to say that no increase in resources will occur as long as the total deficit is targeted. The CHANGE to a zero unified budget balance, as envisioned in Gramm-Rudman-Hollings, if maintained over a long period of time, is, however, a significant shift in savings. Thus, by coincidence, the policy of balancing the total budget will accomplish a substantial accumulation of economic resources similar to what would occur had the deficit been set at historic levels but social security receipts and payments not been counted in the deficit totals.

The study also surveys some of the issues surrounding the question of optional deficit policy, and suggests that it is difficult to determine such an optional policy -- different theories could justify either deficits or surpluses.

The conclusions in this study do suggest that we might eschew the more ambitious goal of balancing the budget excluding the social security receipts and expenditures and nevertheless accomplish a significant accumulation of resources which will reduce the burden on workers of financing the baby boom generation's retirement.

CONTENTS

THE SOCIAL SECURITY SYSTEM, DEFICITS AND INTER-GENERATIONAL TRANSFERS

THE BUDGET DEFICITS IN HISTORICAL CONTEXT

OPTIONAL DEBT AND DEFIClT POLICIES

CONCLUSION

The author would like to thank Ron Boster, Bill Cox, Al Davis, Don Kiefer, David Koitz, Royal Shipp, and Tom Woodward for valuable comments and suggestions.

DEFICIT TARGETS, NATIONAL SAVINGS AND SOCIAL SECURITY

Concern about the large Federal budget deficits of the 1980s led eventually to legislation which requires a balanced budget. Under current law (subsequently referred to as Gramm-Rudman-Hollings, or GRH), this zero target is to be reached by 1993. The attaining of a zero deficit target will be a significant change from past policies, since the Federal government has run a deficit in nearly every year in the post war period, and deficits exceeding 2 percent of GNP in nearly all of the past eighteen years.

The GRH targets refer to a total budget concept, which includes receipts and expenditures from the trust funds, in particular the social security trust funds, as well as general receipts and expenditures. Because of legislation enacted in 1977 and 1983, the social security trust funds will run surpluses for about twenty five years and deficits thereafter. This pattern of surpluses and deficits corresponds to a buildup and then eventual reduction of the assets (or reserves) of the social security trust funds, with the fund exhausted, absent other changes in the law, around the year 2050.

Recently, questions have been raised about the appropriateness of this total budget deficit target in light of the projections for the social security trust funds. A total deficit target means that the annual surpluses in the social security trust funds can be used to attain the deficit reduction in the GRH legislation without cutting non social security expenditures or raising non social security taxes as much as would be the case if the social security trust funds reflected a more typical historical pattern of being roughly in balance.

One option is to set the deficit targets excluding the social security receipts and expenditures. This option would result in a total budget SURPLUS in the next twenty-five years or so, followed by a total budget deficit. Such a target would involve much more stringent spending cutbacks and/or higher taxes than envisioned today because the annual surplus in the social security trust funds is significant relative to the target deficit reductions, reaching a level of almost $100 billion by 1993.

To some extent, the validity of this notion depends on the objectives of the social security reserve buildup. This buildup is intended to provide resources to make benefit payments as the postwar baby boom retires, when the retired population will increase relative to the working population. Without such a buildup, either benefits to the baby boom generation would have to be cut substantially, or payroll taxes rise substantially, absent new financing of benefits outside of the trust funds.

There is a crucial difference in how this social security reserve buildup is related to the overall deficit/surplus stance of the government. Congressional intent is not completely clear. If the objective of the social security reserve buildup is to relieve the then working population of the economic burden of supporting an unusually large cohort of retirees and if government deficit policy is set on a total budget basis, there will be no real effects of the social security reserve buildup. If we wished to increase economic resources in the future, then the reserves in the social security trust funds should be invested in productive physical capital. In the future, the earnings and sale of the assets could then be used to pay the additional costs of benefits without raising taxes on workers.

If, on the other hand, we were to achieve the current policy, the annual surpluses in the social security trust funds would be used to offset spending reductions or tax increases elsewhere in the budget, and there would be no change in the asset position of the government. While the social security trust funds would show larger financial assets, the rest of the government would have correspondingly larger financial liabilities. There would be no real increase in productive physical capital and no additional economic resources available to pay benefits in the future. When the baby boom retires, and the trust funds fall into a deficit position, reductions in spending or increases in other taxes would be required. The only effect of the reserve buildup would be in the composition of spending and taxes. Workers would be relieved of higher payroll taxes, but they would have to pay higher taxes of other types or suffer cutbacks in government programs. While the retired population would bear some of the burden of these tax increases or benefit reductions, workers would nevertheless be substantially burdened by these changes.

What is really at issue here is the degree to which resources are to be transferred across generations. In other words, if government borrowing is assumed to more or less offset private investment, the only way to transfer resources across generations (inter-generational transfers) is for the government to increase its aggregate savings (which are in turn invested in real physical capital which increases productivity). This means that current generations give up resources in the form of foregone consumption and future generations will have a larger capital stock and higher productivity. The buildup of the social security reserves will only have an aggregate effect on increasing resources in the future if that buildup reduces aggregate government debt held by the public.

This study examines this issue of transfers across generations in light of the GRH deficit targets and the reserve buildup in the social security trust funds.

The following section explains the mechanism of inter- generational transfers and how such transfers relate to the social security system. Note is taken in that section of the effect of such transfers on the potential configuration of taxes and spending over time.

The next section takes a historical perspective. In particular, it stresses that the CHANGE to a zero unified budget balance, as envisioned in Gramm-Rudman-Hollings, if maintained over a long period of time, is in and of itself a significant generational shift, quite apart from the social security issue. Thus, balancing the total budget will accomplish some of the across generation distribution were the buildup in reserves in the social security trust funds intended to reflect a real resource transfer from the baby boom generation to following generations, at least for the next thirty years.

The final section addresses the general issue of the optimal distribution of resources across generations in light of economic theory, and some rules of thumb about optimal budget deficits. This section reviews some of the economic issues about the effects of social security and the deficit on aggregate capital formation.

The conclusions do suggest that we might eschew the more ambitious goal of balancing the budget excluding the social security surpluses and nevertheless accomplish a substantial increase in economic resources to finance the retirement of the baby boom generations. Another way of saying this is that had we continued our historic pattern of deficits excluding social security receipts and payments, but accumulated the social security reserves as real increases in the capital stock, we might have obtained results quite similar to the zero total budget balance (that is, GRH).

THE SOCIAL SECURITY SYSTEM, DEFICITS AND INTER-GENERATIONAL TRANSFERS

The social security system was enacted during the depression of the 1930s and has, for most of its history, been on a pay-as-you-go basis. There were two alternative ways of setting up the system. In a funded system, each generation would receive benefits only from the accumulation of its contribution (with interest). These investments would be made in private assets much as in the case of private pension plans and thus would reflect real physical capital assets. Real saving would occur as the system set aside reserves and invested them to support a growing population of recipients. Practically speaking, such a system might still involve holding of government assets by the trust funds, but aggregate outstanding government debt would be reduced (with corresponding increases in the private capital stock). Under the unfunded ("pay-as-you-go") approach, working individuals would pay taxes which would be concurrently be paid out as benefits to existing retirees. This unfunded system was essentially the one adopted.

There has been considerable debate in the economics literature as to whether our unfunded social security system has affected private savings and reduced capital formation. Nevertheless, either type of system is feasible in the long run, and the unfunded system can operate continuously with little problem as long as the population grows at a smooth rate. The two systems, however, have very different implications during the start-up period. If social security were enacted on a funded basis originally, it would have taken considerable time for full coverage of the retired population to be realized. And, a pay-as-you-go system can encounter difficulties when population growth suddenly increases and these larger cohorts reach retirement age.

It is in part due to the uneven growth of the population that the current planned buildup in social security reserves was undertaken. When the very large population cohort of the baby boom generation retires, a pay-as-you-go system would require social security taxes to be increased substantially to pay for benefits. The social security amendments in effect will require the baby boom generation to pay some of these taxes in their working years which would for the first time accumulate substantial reserves in the social security trust funds. These reserves would eventually be drawn down to help pay for benefits upon retirement.

As noted above, if the total budget deficit reflacted this pattern of social security surpluses and deficits, there would be a real transfer of resources between generations via forced savings. During the years of social security surpluses, total budget surpluses would also increase, government borrowing would decrease, and increased real capital investment would occur, while consumption would decline. This accumulated investment would then be drawn down to pay extra benefits for the baby boom generation rather than increasing payroll taxes on then current workers. In short, the baby boom generation would pay for more of its retirement than had the pay-as-you-go system been maintained.

If, in contrast, the increased social security net receipts are used not to reduce total deficits but to cut other taxes or increase spending, none of this real transfer would occur. In an accounting sense, the social security trust funds would have adequate reserves to pay out benefits and payroll taxes would not have to be increased. But there would be no actual savings. In the future, as the social security benefits eventually begin to exceed social security taxes and interest on the reserves, the social security system would produce deficits. These deficits would have to be offset by surpluses in the remainder of the budget, requiring higher taxes on current workers or reduced spending.

It is this reasoning which would argue that deficit targets be set without regard to the social security surpluses, i.e. by not including them in the budget deficit. Such reasoning also assumes that it is appropriate that the baby boom generation pay for additional benefits rather than future workers. One can state arguments which suggest that it should not. Being in a large population cohort tends to be costly to the individuals in that group. During working years it causes the capital/labor ratio to decline, with resultant lower wages. During retirement years, the reverse occurs, which causes a lower return to capital. For these reasons, as well as technological growth, the generation following the baby boom will likely enjoy a higher standard of living.

Of course, from the point of view of the baby boomers, the social security reserve buildup may be desirable, even if no increased savings occur, to reduce the possibility that strains on the system would cause major cutbacks in their benefits rather than increased taxes on workers. As long as the social security system is separate in an accounting sense, it will appear to have sufficient resources to pay benefits. The pressure might then fall on other government spending or other taxes. These observations suggest that the buildup in reserves in the accounting sense (even if no actual savings occurs) would nevertheless have real consequences for the configuration of spending and taxes.

THE BUDGET DEFICITS IN HISTORICAL CONTEXT

One of the difficulties confronting policy about deficits is that we never start from a "clean slate." Policy discussions necessarily take place in an environment with a history of deficits, surpluses, and debt. As table 1 demonstrates, the history of deficits and debt is to run deficits in most years -- in the years from 1940 to the present, surpluses occurred in only eight years, and most of those years of surplus were in the late forties and the fifties.

The ratio of debt to GNP, which reflects the government's relative claim on assets, has been very uneven. Large ratios of debt to GNP occurred as a result of World War II, although the economy had inherited a substantial debt which accrued during the contraction of the 1930s. The ratio declined through the mid seventies, when it stabilized, and then turned up during the large deficits of the 1980s. Over the entire period, the debt-to-GNP ratio measured as a simple average was 38 percent of GNP, with a high of 114 percent immediately after the World War II and a low of 24 percent in 1974.

While deficits during the fifties and sixties averaged less than one percent of GNP, deficits during the seventies were two percent of GNP. Before the era of relatively large deficits in the eighties, deficits were running over two percent of GNP and the debt to GNP ratio was about 27 percent. Over the entire period the deficit averaged three percent of GNP.

The upshot is that the budget has typically not been balanced in the post war period. Thus, setting aside the social security issue, achievement and maintenance of a balanced budget would represent a significant departure from recent history.

Some projections into the future will illustrate this point, and the implications of a unified balanced budget. Assume the zero total deficit targets are reached by 1993 as required by law and maintained thereafter. The nominal value of the debt will be approximately $2.4 trillion. It will, however, remain fixed at this point while GNP will continue to grow. Using social security projections of growth, this aggregate level of outstanding debt relative to GNP will be seven percent by the year 2022, the year when the peak in the accumulation of trust fund balances in the social security trust funds is to occur. These reserves are currently projected to be 29 percent of GNP. ¹

 TABLE 1. Ratio of Federal Debt Held by the Public and federal Budget

The estimated ratio of debt to GNP, seven percent, has not been seen in the U.S. economy since the start up of World War 1. In other words, setting the social security issue aside, the achievement and maintenance of a balanced budget would be a major departure from recent history. in and of itself, it involves an accumulation of capital by the current baby boom generation.

Another way of looking at this issue is to consider what would have happened if we were to maintain our historic average level of debt, but separate out the social security reserves and accumulate those as private capital investments. If we take the average ratio of debt to GNP of 38 percent,and subtract the accumulated social security surplus of 29 percent, we obtain a net debt of nine percent of GNP. In other words, adoption of the zero aggregate deficit targets is roughly similar to maintaining historic debt levels but separately accumulating social security reserves as private assets.

Alternatively, we might also consider what would have happened were we to run a consistent deficit of two percent of GNP, but separated out the social security reserves. Using a 6 percent nominal growth rate for GNP (consistent with the social security 2022 projections), debt excluding the reserves would be 34 percent of GNP. Assuming an accumulation of social security reserves equal to 29 percent of GNP, the total outstanding debt would be five percent of GNP.

All of these illustrations are making a common point. In the context of recent historical experience, the achievement of a zero budget deficit leads to growth in private capital whose earnings will provide benefits to aid in payment of the social security benefits. A fall in the debt from its average of 38 percent to seven percent would mean annual budgetary savings of 2.2 percent of GNP at a seven percent interest rate. In the year 2022, social security payments will exceed revenues by 1.1 percent of GNP, while in 1988 revenues exceed benefits by .8 percent of GNP. Thus the interest savings due to a lower debt would more than finance the differential between the two (1.1 +.8, or 1.9 percent) in that year.

Social security benefits relative to payments will increase after 2022. The excess of payments over taxes will grow to 2.5 percent of GNP (2030), reach a peak of 2.8 percent (2035), and then begin to decline. The debt and accompanying interest payments will also decline, although at a slower pace. By 2050, payments will exceed receipts by 2.6 percent of GNP, for a differential compared to today of 3.4 percent. By that time the debt will have declined to a negligible fraction (one percent ) of GNP, so that interest savings will be 2.6 percent of GNP. These interest savings will finance much of the change in the configuration of social security taxes to benefits. In other words, the reduction in the debt and attendant debt service will pay for most of the increase in burden on the taxpaying population due to the rise in social security benefits during that time.

To both balance the budget and accumulate the social security reserves would lead to a negative outstanding debt (i.e. assets) of 22 percent of GNP. from historic levels, this change would translate into annual budgetary savings of over four percent of GNP and to a level of negative debt never experienced in U.S. history.

OPTIMAL DEBT AND DEFICIT POLICIES

The foregoing analysis suggests that moving to a zero deficit over a long period of time in itself suggests an inter-generational shift of resources, but does not address the issue of what optimal policy should be. Ideally, one might wish to identify such an optimal target and then determine the best path of reaching it, assuming the economy is not on that target.

Unfortunately, there are no clear answers to either of these questions. Output produced by an economy can either be consumed or invested in capital. In the absence of government one would expect those choices to be made by individuals making their own decisions about savings (which would be to finance retirement, to provide funds in case of special need, or for bequests). One might argue that the government should let these private decisions determine the path of consumption over time. ² Such an approach suggests that while the government might provide social goods such as national defense, the pattern of total consumption of all goods over time should remain fixed.

Ignoring the effect of programs such as social security for the moment, this goal suggests a general rule of thumb -- that outstanding government debt should equal the value of government assets. Such a system would keep the total time path of consumption fixed. That is, when the government undertakes a spending program which involves investment, it is appropriate to borrow to finance that investment and tax to repay the interest and principal. (The notion of borrowing to finance capital expenditures is well established at the State and local level where it is common to issue bonds to construct roads, schools, etc.).

Such a rule of thumb would provide a rationale for a substantial amount of debt relative to GNP. Eisner estimates that for 1984 the value of government capital excluding mineral reserves is 28 percent of GNP; including mineral reserves raises the total to from 45 to 48 percent of GNP. By this rule of thumb, even the current level of debt, about 43 percent of GNP, is justified.

The deficit policy implied by this rule of thumb depends on the growth in the value of government assets. If government assets grow at the same rate as the economy as a whole, this would imply an optimal deficit equal to slightly under three percent of GNP if assets are slightly under half of GNP and the economy grows at a nominal rate of 6 percent. Of course, the deficit would vary every year depending on actual change in the nominal value of assets.

There are further complications in assessing debt and deficit policies. One of most controversial is the effect of social security on private saving. Because social security is unfunded, that is, pay- as-you-go, the argument is made that the social security system reduces aggregate savings; because individuals know that they will receive social security benefits in their old age, they are likely to save less. If such an effect occurs, it would be appropriate for the government to accumulate this savings on their behalf so as to maintain the time path of consumption which would occur in the absence of government programs. Gradison has estimated that this effect could justify a budget surplus of over three percent of GNP.

There are alternative views of social security which might lead to a different result. One such argument is that social security benefits have not so much substituted for savings as substituted s social transfer system for transfers between family members. If, prior to social security, children supported their parents in their old age, and social security allows children to reduce their support, the presence of a social security system would have little effect on private capital formation. In that case, an unfunded, pay-as-you-go system more closely replicates what the private economy would do in the absence of government. Such a view suggests, in fact, that we make no corrections to fund social security for the baby boom generation, since the future working population which will support the baby boom generation will pay higher taxes, but will nevertheless be relieved of a greater obligation to support their parents. Of course, this argument would not apply to individuals who do not have children.

There are many other possible economic effects of social security. Prior to the introduction of social security, individuals may have worked longer and the system may encourage earlier retirement. This effect could actually increase savings if social security benefits are smaller than earnings would have been. It is not clear whether a funded or an unfunded social security system is better in the context of the possible distort;on of work effort.

While social security raises questions about the optimal level of debt, there are also other problematic issues. One such issue is how to deal with accumulated war debt. One could argue that fighting a war is an expenditure that yields security and other benefits for all generations, present and future, and could therefore be treated as a non-depreciating investment. In that case, it would have been appropriate to maintain the value of the war debt (in real terms, that is, indexed for inflation) indefinitely. The value relative to GNP would decline slowly, because real GNP grows.

While considerable uncertainty surrounds the issue of the optimal level of debt, there also is the question of how to achieve that optimal target. For example, if we determined that it was actually desirable to achieve a funded social security system, the generations that make the transition from a pay-as-you-go system to a funded system would bear the burden of that change. It is not clear whether it would be considered socially equitable to so burden the transitional generation.

The observations in this section do not provide clear answers to either the desired level of debt or the issues associated with moving to a new level. They do suggest, however, that increasing capital formation by reducing and maintaining the deficit below historic levels involves a social judgment about income redistribution across generations. The desirability of that objective cannot be answered by application of economic analysis.

CONCLUSION

Several important observations arise from the preceding analysis.

First, the accumulation of reserves in the social security trust funds have no effect on the real accumulation of resources which future generations can draw on to finance the baby boom retirees. This observation does not suggest that there are no real effects on the configuration of taxes and spending both now and in the future; such effects appear plausible. Requiring the baby boom cohort to actually save can only be accomplished, however, through a change in the aggregate budget deficit.

Secondly, by coincidence, a separately developed policy to reduce the unified budget deficit to zero would accomplish much of this inter-generational transfer, at least judging by historical standards. Indeed, to adopt both a zero budget balance and restrict this balance to the budget excluding social security receipts and benefits would be an unprecedented departure from history as it would eventually place the government in a net asset position. Under these circumstances, the more limited goal of balancing the total budget might be considered adequate. Of course, a perceived need to accumulate assets in order to relieve the burden of supporting the baby boom generation may strengthen the case for a zero budget balance, at least over the next forty or fifty years. Moreover, to balance the budget over a long term might require targeting a surplus in order to allow deficits during economic contractions, in order that the zero average be maintained.

Thirdly, the question of the optimal debt and deficit policy is by no means clear. There are theories which would support substantial deficits even given the demographic bulge of the baby boom. Other theories would support a substantial surplus.

² Arguments might also be made, however, that the consumption path generated by private savings is not optimal. The private economy might save too little because of lack of foresight. Or, alternatively, it might be desirable to reduce the level of savings because future generations will be better off than current ones due to technological advance. In addition, some theories of economic behavior which combine rational expectations and concern for future generations suggest that private actions undo any government actions, and therefore, that government debt and deficit policy is irrelevant. This view is discussed in Robert J. Barro. "Are Government Bonds Net Wealth?" Journal of Political Economy, vol. 82 (1974), pp. 1095-1117.

³ Robert Eisner. How Real is the Federal Deficit? New York: The Free Press, 1986, p. 29.

⁴ Bill Gradison. "Is a Balanced Budget Enough?" The AEI Economist. July 1987.