Although most Americans assume that a federal budget surplus in any year is automatically used to reduce the national debt, or at least the debt held by the public, this actually is not the case. The U.S. Department of the Treasury must implement specific financial accounting procedures if it is to use a cash surplus to pay down the debt held by the public. If these procedures are not followed, or if they proceed slowly, then the surplus revenue just builds up in the Treasury's operating cash accounts.
This excess cash could be used in the future to further reduce the debt, but only if it is protected from other uses in the meantime. Until the excess cash is formally committed to debt repayment, Congress could appropriate it for other purposes. Consequently, the current surplus will not automatically reduce the publicly held national debt of $3.54 trillion unless Congress acts now to make sure these funds are automatically used for debt reduction and for no other purpose.
There is a parallel to this in household finance. When a family with a large mortgage, credit card debt, and several student loans receives an unexpected financial windfall, it usually deposits the funds in a checking account and takes a little time to consider how best to allocate the revenue--whether to refinance the mortgage, pay off credit cards, or establish a rainy day fund. Meanwhile, the family's debt remains, and will not be reduced until the family formally transfers funds to one or more of its creditors. If the family does not take some action in the interim to wall off the cash, it often ends up frittering away the money on new purchases, and the debt remains.
The federal government faces a similar situation. Surplus revenues are accumulating in the Treasury Department's operating cash accounts faster than the Bureau of the Public Debt can efficiently dedicate them to reducing the public debt. Consequently, surplus balances in these accounts have reached historic levels, and they are likely to accumulate even faster as the size of the surplus grows. Unless Congress takes formal action to protect these funds, they are available to be used or misused at any time in the appropriations process. Fortunately, the House soon will consider a bill (H.R. 4601) that would protect the budget surplus from being raided by appropriators until prudent decisions can be made about its use.
Thanks to unexpected budget surpluses, the U.S. Department of the Treasury issued less new debt than it redeemed each year. It conducted several "reverse" auctions to buy back old high-interest debt. And it successfully reduced the amount of federal debt held by the public in less than three years by $230 billion, from $3.77 trillion in October 1997 to $3.54 trillion in April 2000. Chart 1 clearly shows that its efforts have been successful and impressive.
Unfortunately, even this projection may be too conservative. Examination of month-to-month changes in the closing balances indicates that the rate of cash accumulation has started to accelerate, which will cause the closing balances to grow even faster. The trend line in Chart 3 shows that the amount of positive monthly change in closing cash balances has, after accounting for normal fluctuation, increased since October 1997, and cash balances could start to increase by an average of $20 billion per month within two years.
The Treasury Department faces extraordinary cash management challenges as it attempts to repay the debt held by the public steadily and without destabilizing financial markets that depend on federal debt instruments as a standard of measurement. By protecting accumulated cash balances from misuse, Congress could provide the Treasury Department with the flexibility it needs to do its job more effectively.
Issuing Less Debt. As old debt matures and is redeemed, the Treasury Department issues a slightly smaller amount of new debt in return, thereby reducing the total debt held by the public. This is the federal government's most cost-effective and preferred method of debt reduction. However, it is not a simple process to determine how much new debt should be issued. If the Treasury Department returns too much debt to the financial market, it misses an opportunity to retire additional debt. If it returns too little to the markets, the cost of federal debt instruments will rise, driving down their yields and disrupting many private-sector retirement plans.
Reverse Auctions. The Treasury Department periodically conducts reverse auctions in which it announces that it will buy a predetermined amount of specific types of debt instruments from whoever will sell them for the best price. This method quickly reduces debt held by the public, but it can be expensive. Investors holding a T-bill that will be worth $1,000 in 20 years may be willing to sell it for $995 if they need the money now and believe that is the best price they can get. However, if they know the Treasury Department has made a commitment to buy a large number of T-bills in a short period of time, investors may hold out for $997--a premium of $2 million on every $1 billion of debt the Treasury Department retires.
Purchasing Debt Instruments. The Treasury Department can use private-sector brokers to purchase federal debt instruments on the open market without having it revealed that the client is the federal government. This method is slow, but it allows the Treasury Department to take advantage of unpredictable fluctuations in financial markets to buy back federal debt instruments for the best possible price. This method must be used carefully and discreetly to avoid having investors, upon realizing that the true buyer is the federal government, hold out for higher prices.1
The Treasury Department needs time and flexibility to use debt management tools effectively. It often will need to allow large balances to accumulate in the operating cash accounts while it waits for the opportunity to buy back federal debt instruments at the best possible price. If these balances are unprotected, they may prove irresistible temptations for appropriators with special-interest constituencies.
A prudent Secretary of the Treasury would not risk disrupting financial markets by recklessly reducing the amount of new debt issued each year, but might increase the number and size of reverse auctions to ensure that surplus revenues are used for debt reduction rather than remain available to congressional appropriators. The taxpayers would, at best, pay more than necessary to retire the federal debt, and they might find that appropriators have spent the surplus before it could be used to pay down debt.
What Is the National Debt?
The national debt consists of Treasury notes, T-bills, and savings bonds that were sold to raise cash to pay the ongoing operational expenses of the federal government. National debt held by the public consists of debt instruments sold to anyone other than a federal trust fund, such as the Social Security trust fund. Most federal debt held by the public is owned by state and local governments, pension plans, mutual funds, and individual retirement portfolios.
Most investors consider federal debt instruments to be cash equivalents that pay interest, and they are strongly motivated to hold them until maturity-up to 30 years in the case of T-bills. Many institutional investors, particularly pension funds, are required to maintain a certain portion of their portfolio in cash equivalents, and they depend on the federal government to issue new debt when their old investments mature and are redeemed. In additional, many lenders, particularly mortgage companies, use the market price of federal debt instruments as a measurement device to determine appropriate rates of return on alternative investments. These lenders rely on the federal government to maintain enough federal debt in circulation to make this measurement valid.
Fortunately, Congress has the opportunity to ensure that the Treasury's large cash balances are not misused in the appropriations process. The U.S. House of Representatives will soon consider H.R. 4601, the Debt Reduction Reconciliation Act of 2000, recently approved by the House Ways and Means Committee. This legislation, sponsored by Representative Ernest Fletcher (R-KY), is designed to give the Treasury Department the time and flexibility it needs to use debt management tools most effectively. It would protect the on-budget surplus revenues collected during the remainder of fiscal year (FY) 2000 and appropriate them for debt reduction by depositing them in a designated "off budget" Public Debt Reduction Account.
Although the surplus revenues could still cause an increase in cash balances, the cash would be dedicated in the Debt Reduction Account rather than in the Treasury Department's operating cash account. Appropriators would be able to reallocate these funds only by first rescinding the appropriation for debt reduction in legislation that would have to pass both houses of Congress and gain presidential approval. Once surplus revenues are deposited in the Debt Reduction Account, appropriators would have very limited ability to increase spending without creating an on-budget deficit, which many taxpayers would perceive as a raid on the Social Security trust fund.
H.R. 4601 would effectively protect the surplus revenues that are collected during the remainder of FY 2000; moreover, it serves as model for how Congress should allocate unexpected windfalls in the future. It does not preclude tax reform because it is limited to the current fiscal year and therefore affects only revenues that have already been collected or that will be collected before any tax reform legislation takes effect. Nevertheless, once the Debt Reduction Account is established, Congress could continue to appropriate funds to the account at any time. Consequently, Congress would retain the option to reduce revenues through tax reform and still have a mechanism to prevent unexpected surplus revenues, once collected, from being used for any purpose other than debt reduction.
H.R. 4601 would give the Treasury flexibility to use its debt reduction tools in the most effective manner. Surplus revenues deposited in the Debt Reduction Account would remain available until expended, but only for debt reduction. The department would be able to schedule reverse auctions at the most advantageous times, make funds available to brokers buying back debt on the open markets, or decrease the size of new debt issues--depending on which mechanism, or combination of tools, proves most cost effective. There would no longer be pressure to "use it or lose it."
Although H.R. 4601 demonstrates a real commitment of members of the House to fiscal discipline, the legislation could be improved. Congress should consider requiring the Secretary of the Treasury also to deposit all revenue received from the sale of Special Issue Treasury Bills (which are sold only to the Social Security Administration) in the Debt Reduction Account. This would preclude the possibility of any future raids on the Social Security trust fund.
Congress should also consider adding language to H.R. 4601 to automatically appropriate future real (rather than projected) surplus revenues to the Debt Reduction Account. This would allow Congress the flexibility to implement tax reforms while also guaranteeing that surplus revenues, once collected, could be used only for debt reduction.
Many Americans assume that if surplus revenues are not used for spending or tax cuts, they automatically reduce the national debt. Indeed, this has become an unstated premise in discussions of fiscal policy, whether in the press, academia, or Congress. Unfortunately, the premise is incorrect.
To make the premise true, the Treasury Department should be able to make specific provisions for retiring debt. If it is not given the power and obligation to do so, the surplus revenues accumulating in its operating cash accounts will be subject to misuse by appropriators. Congress has an opportunity and obligation to give the Treasury Department the time and flexibility it needs to utilize its debt management tools effectively when it considers H.R. 4601. This bill offers an effective first step toward the goal of making sure that budget surpluses do not disappear in new spending programs.
Peter B. Sperry is a former Grover M. Hermann Fellow in Federal Budgetary Affairs at The Heritage Foundation.
1. There is no way to know whether this particular debt management tool is being used by the Treasury Department at this time. If such knowledge were available, it would demonstrate a lack of discretion that would make this tool ineffective.