April 10, 1979

April 10, 1979 | Backgrounder on Federal Budget

"Balanced Budgets, Spending Limitations and the Economy"


(Archived document, may contain errors)

80 April 10, 1979 BALANCED BUDGETS, SPENDING LlMlTA TIONS AND THE ECONOMY INTRODUCTION The proposal to amend the Constitution with a balanced budget requirement is no longer a notion appealing only to a philosophic al minority. The economic trends and political temper of recent. times have made it an issue with tremendous popular appeal. The pressure from the public, the states, and some of its own members will force Congress to confront this issue both proponents a nd the opposition have become more impassioned.

The balanced budget is for some a panacea, solving all of the econo mic ills of today. To others it is a prescription for economic disaster and social chaos. This study will examine some of the economic impli cations and also look at some congressional proposals As the momentum for a balanced budget amendment has increased MACROECONOMIC ISSUES Certainly one of the major points of debate is the effect of a balanced budget upon economic' performance. The argumen t encom passes not only such purely economic issues as inflation and growth but also philosophical or social questions such as the amendment's effect on the poor.

Excessive Spending A major factor in the move for a balanced budget has been the public's perception of government spending as excessive and politi cally motivated. The chronic deficits are often cited as evidence of the government's inability to restrain itself. For instance since 1961, the federal budget has been in deficit 19 times and 2 produced a surplus only once. During the past four years (1976-791 Congress has defied conventional economic theory and accumulated 193.4 billion in deficits during a r emarkably robust recovery.

The public often complains that since households must balance their budgets, it is only fair that the government also do so Critics dismiss this idea as both naive and erroneous. They ob serve that households engage in deficit sp ending when purchasing a home or car. Furthermore, consumer debt has, since 1950, grown at a rate faster than federal debt.

These criticisms miss the point. Households must balance their budgets over a segment of time. The federal government does not oper ate on the same principle. Unlike households, the govern ment can pass its debt on to future generations. Its debt horizon is seemingly infinite, while its budgeting horizon rarely extends beyond the next year I The knowledge that future Congresses must a b sorb the cost of this year's deficit makes the professionally myopic legislator less restrained in spending choices. Programs initiated in the present will be paid for in the future. The FY 1980 legacy of past Congressei is the 57 billion in interest paym ents on the national debt. This sum is nearly double the projected budget deficit and is more money than will be spent on education, training, employment, social ser vices, transportation, and energy combined.

The ability to incur a deficit presents Congre ss with a strong political temptation to do so. Theoretically, Congress should spend until the benefits of each additional expenditure are equal to the cost of financing that expenditure. Under a balanced budget amendment, the public's reluctance to be ta x ed would act as a natural brake on government spending. If, for example, the govern ment attempted to extend spending beyond the point where benefits equalled costs,'the public's dissatisfadtion with the additional taxes would exceed the benefits of the e x penditures beyond the benefit-cost equilibrium, when financed through a deficit appear costless. No additional taxes are levied and thus the re straining influence is lost. Congress is permitted to enjoy the benefits of deficit spending while ignoring the costs, inflation and slow economic growth Expenditures Inflation To Congress, the .budget deficit appears costless. In reality this is not the case. Over'thirty years ago, in the heyday of the Keynesian Revolution, Colin Clark theorized that when the publ ic refused to support additional expenditures through taxes, overn ments would finance additional spending through inflation. 9 Al though there is no statistical correlation between deficits and 1.

Economic Journal, 1945.

Colin Clark Public Finance and Ch anges in the Value of Money 2 3 inflation, there does exist a strong relationship between inflation and the money supply. The Federal Reserve accommodates federal deficits by expanding the money supply and thus creating inflation.

Clark also hypothesized the deficit-inspired inflation would become chronic. Recent shifts in consumer behavior suggest that the public now perceives inflation as a permanent state. In previous infla tionary episodes households reduced consumption, increased savings and waited o ut the inflation. Currently households are increasing consumption, reducing savings, and undertaking unprecedented levels of debt.

Economic Growth Another significant cost imposed by the deficits is slower The persistent deficits and the borrowing needs of the economic growth. In addition to inflationary increases in the money supply, deficits may be financed through borrowing from the public government "crowd out" the private sector in the financial market.

Funds which would have been used to finance capi tal investment are diverted in support of the deficit of economic ills, including an absence of private investment and a subsequent decline in productivity. The inflation-induced reduc tions in personal savings portend even greater difficulty for the priv a te sector in obtaining funds foreign exchange value of the dollar national debt is in foreign hands debt adds to the U.S. balance of payment deficit and ultimately leads to pressure against the dollar The result has been a range The federal deficit also c o ntributes to the decline of the Over twenty percent of the The interest payment on this Fiscal Policy A balanced budget requirement would effectively eliminate the government's ability to undertake discretionary countercyclical policy. In that event, crit ics foresee an economy careening reck lessly out 09 control, with a decided inclination toward recession.

This scenario is unrealistic for a variety of, occasionally exclu sive, reasons. First, it is based on benign assumptions about both the intent and ef fectiveness of fiscal policy. Secondly, it ignores the capacityofmonetary policy to perform in a countercyclical man ner. Finally, there is evidence which suggests that the private sector is inherently stable and that efforts to "fine tune" are in practic e, destabilizing.

Fiscal policy is based on the belief that the government can smooth out the business cycle the government promotes expansion by spending in excess of receipts.

Conversely, when demand threatens to burst into inflation, the government red uces demand by cutting expenditures and raising taxes and thereby producing a budget surplus In times of faltering. private demand, 4 The recent unsymmetrical application of fiscal policy indicates that elected officials find its political uses more compe lling than its economic application. Fiscal policy serves not only as a guise for excessive spending, but also as a tool in electoral politics.

William D. Nordhaus of Yale University has found that U.S. macro economic policy, under both political parties, has been mani ulated on a cycle corresponding to the four-year presidential term 5 The efficacy of fiscal policy, even when pursued with the purest of motives, has become increasingly suspect. There has developed in recent years a prominent school of econ o mic thought known as "rational expectations Adherents believe that stabilization policies fail because they are based on the proposition that the public can be repeatedly fooled. For example, policymakers. attempt to stimulate the economy through a tax cu t . The public, believing income has increased, will spend more. However, if government spending is not reduced in concert with the tax cut, the perceived rise in income will be illusory. The large deficits, interest co'sts, inflation and future tax rises w ill eliminate the benefits of the tax cut.

The "rational expectations" school believes that after a number of such tax cuts, the public will anticipate the longer term effects and not respond in.the expected manner. The intended effect of the tax cut will then be lost. Expansionary monetary policy and federal spending increases will meet the same fate.

The growing acceptance of the rational expectations school is indicative of a quiet revolution within the economics profession.

Fortune, in a random sample of economics professors in the southeast m id-west, and southwest, uncovered some startling changes within the profession. Over 80 percent of the respondents expressed "less confidence in the ability of the government to fine tune the economy."

Nearly all, in the past five years, have changed thei r approach in teaching economics. Perhaps the most telling point is the comment of'0tto Eckstein of Harvard University and Data Resources Inc Economists no longer believe that some blissful state can be achieved by demand management. Unfortunately that ha s n't penetrated to the Brookings Institution or the White House they're both ten years behind academic thought in fiscal policy I 2. William D. Nordhaus, "The Political Business Cycle," Review of Economic Studies Vol. 42 April) 1975 3. Fortune, December 31 , 1978, p. 77. 5 Yes Is there a sense of lost moorings in economics 66 Increasing doubt about the accuracy of macroeconomic models 75 Less confidence in the ability of the government to fine-tune the economy 82 Less confidence in government programs,as sol u tions to economic problems 87 Are you teaching economics differently than you did five years ago 98 Despite the loss of fiscal policy, a balanced budget would not preclude the use of countercyclical economic policy. Still remaining would be the government 's ability to manipulate the nation's money supply, known as monetary policy. In a landmark study, Leonall C.

Andersen and Jerry L. Jordan, both at that time with the Federal Reserve Bank of St. Louis, found that monetary policy was superio to fiscal policy in terms of strength, speed, and predictability.

Examination of the 1960s policy record offers confirmation. Only twice did the government engage in contradictory monetary and fiscal policies. In 1965 and again in 1968, the effects of monetary policy ov erwhelmed fiscal effects,muchto the surprise and anguish of the policymakers 5 Both fiscal and monetary policy are based on the depression inspired belief that the private sector is unstable. Proponents of stabilization policies have argued that the gover n ment must con tinually intervene to avert erratic and harmful economic cycles 4. Ibid p. 77 5. Leonall C. Andersen and Jerry L. Jordan, "Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization," Federal Reserve Bank of S t . Louis Review, November 1968. 6 i The reawakening of the economics profession to the importance of money has brought with it a recognition of the inherent stability of the private sector.6 Private demand, which is dependent upon the money supply, is rela t ively stable. Fluctuations are caused by changes in the money supply, under the control of the Federal Reserve, and erratic fiscal policy BALANCED BUDGETS AND THE POOR An implicit purpose of the balanced budget amendment is to reduce the growth in governm e nt spending A belief shared by both proponents and opponents is that Congress will slow the growth in government spending to match tax receipts, rather than increasing taxes to match the growth in spending. Opponents of the amendment charge that any restf i ckion on government outlays would be felt primarily by the poor and underprivileged. This view claims that a balanced budget requirement would represent an abdication of the social responsibility of the government and a reversal of Western tradition conce rning congressional responsibility. Proponents of the amend ment believe it necessary to curtail Congress' fiscal irresponsibility.

Opponents believe that because of Congress' irresponsibility the interests of the poor will be subservient to more political ly re munerative projects Ironically, both pro.'and con forces share a common outlook It is important to realize that nearly all balanced budget and spending limitation measures would not require a cut in existing services, but merely impose a limit on th e growth of expenditures.

The current services budget, a projection of revenues and outlays at existing levels, including those tied to inflation, will be in balance in 19

82. The possibility that any constitutional amendment could take effect before then is small. It would, however, behoove Congress to prepare will suffer under a balanced budget is the proposition that welfare and income security are low priority items. That proposition bears little resemblance to reality. Federal expenditures for income security, which includes programs such as social security, unemploy ment insurance, food stamps, and child nutrition, has risen from 21.9 percent of total budget outlays in 1970 to 33.7 percent in 19

80. Health outlays have risen from 6.6 percent in 1970 to 10 per cent in 1980 a strong case that welfare is a high priority expenditure difficult to accept the proposition that high priority expenditures will suffer under a balanced budget.

The charge that national security will absorb the brunt of the fiscal restraint appears more plausible creased from 40 percent of total outlays in 1970 to 23.7 percent in 1980 An implicit but essential element of the claim that the poor Both the size and growth of these functions present It is Defense outlays have de 6 197 8 1, p. 14 Thomas Mayer, The Structure of Monetarism (New York: W. W. Norton Company 7 BALANCED.BUDGET AMENDMENTS Balanced budget amendments possess a great popular appeal. The concept is simple and easily understood. Yet it is this simplicity whichcreatesm a ny p,ractical difficulties be judged on how well it confronts the following obstacles A proposed amendment might Reversibility A constitutional amendment mandating a balanced budget could, in the event of war or economic catas trophe, render the governmen t helpless. It is essential that any such amendment contain an escape clause.

Perhaps the most insistent criticism of the balanced budget concept is that it is undefinable. It is charged that the Congress will evade the intent of the amendment by removing spending programs from the budget.

Many state governments, bound by law to a balanced budget can in practice run a deficit through the separation of current and capital expenditures. If a balanced budget is instituted, some claim, Congress will follow the states' lead.

The problem of definition, while real, can be overestimated Definition Although most of the balanced budget amendments do not define what is meant by the terms "outlays" or "expenditures, informal def ini tions of these terms do exist. Furthermore, action s such as taking on-budget items off budget would be identifiable as attempts to evade the constitution. Skeptics must make a case for not only congressional defiance of the Constitution but also for judicial approval, a more difficult proposition Economic . Forecasts: Congress presents its budget on May 15, four and one-half months before the fiscal year, be gins. Projections of both revenues and expenditures are reliant upon economic forecasts, and thus are somewhat tenta tive. It is quite possible that a b udget balanced i-n May or even September, when the second resolution is adopted will become unbalanced during the course of the fiscal year.

Enforcement: The final consideration is enforcement.

Projecting revenues and outlays is an inexact science. Just as economic forecast accepted in good faith, can be in error it is possible that revenue projections will be incorrect.

If the budget is not in balance, should it be brought into balance? How, and by whom Lugar Amendment Senator Richard G. Lugar (R-Ind.) h as proposed a constitutional amendment (S.J. Res. 4) requiring that any concurrent resolution in which "total budget outlays" exceeds the "recommended level of federal revenues" must be approved by two-thirds vote in each House. 8 By definition this "supe rmajority" approach offers Congress sufficient flexibility to deal with any emergency. Total budget outlays,althoughnot defined in the amendment, is a term commonly used in the budget document.

The Lugar amendment, because it applies to the concurrent resolution, is dependent upon economic forecast. This difficulty is mitigated by the need for two-thirds approval in each House.

The vote will center about not only the budget but also economic assumptions. However, it is conceivable that'membe'rs will vote for a balanced budget with unrealistically favorable assumptions.

Perhaps the most attractive point about the Lugar amendment is that is does not require adjustment after the fiscal year. The proposal is not intended to pr0duce.a strictly balanced budget b ut to make it more difficult for Congress to produce a deficit focus of attention is not on the final line, but rather on how that number is arrived at The Stennis Amendment Senator John C. Stennis (D-Miss.) has offered a constitutional amendment S.J. Res . 6) which would require the president to deter mine and Congress to enact a tax surcharge to make up any deficit.

The amendment permits the surplus to be suspended through a three quarters vote of each House.

The Stennis amendment avoids the pitfalls of economic forecasts It balances the budget after the fact. There are, however, flaws.

It is quite possible that the timing of the surcharge might retard economic growth. If for instance a deficit was incurred during the low point of a business cycle, as is most*,likely, the tax surcharge assessed in the next calendar year might very well reduce aggregate demand and thus threaten the economy. Another consideration is that a series of small deficits which are quite possible even with the best of intentions m ight cause a more costly surcharge. The uncer tainty regarding taxes might impede the private sector.

Proxmire Bill Senator William Proxmire (D-Wis.) has introduced S. 331, a bill requiring the president to submit a budget balanced on the assumption of a 3 .percent real growth rate of real growth exceed 3 percent, there would be a surplus. If the economy grew at a ra'te of less than 3 percent, the budget would be in deficit Should the actual rate The advantage of such a proposal is that. the.budget is balan c ed over the business cycle. This concept has much'greater economic validity than the yearly balance. 'Proxmire chose 3 percent because it is close to the nation'% long-term average growth rate. The bud get would become an automatic stabilizing device, in d eficit when 9 growth is slow and in surplus when growth is rapid that if applied to the last 17 years, there would have been surpluses in 12 years, not just one budget proposals, the problem of economic forecasts. The forecast Of real economic growth is i r relevant. However, an important variable is the rate of inflation A budget balanced at the assumptions of 3 percent real growth and 4 percent inflation will differ from a budget based on assumptions of 3 percent real growth and 10 percent inflation is tha t it promises more than it can deliver that the president submit such a budget.

Congress will adopt it Heinz-Stone Amendment Undoubtedly, the most explicit and comprehensive amendment was developed by the National Tax Limitation Committee and offered by Se nators John H. Heinz I11 (R-Pa.) and Richard Stone (D-Fla The proposal is to link the growth rate of government expenditures with the growth rate in the nominal Gross National Product (G.N.P.) of 3 percent, government spending may grow at the same rate as had G.N.P.

If inflation exceeds 3 percent, the growth rate of government spending will be reduced by one-quarter of the difference between 3 percent and the actual rate of inflation. For example, nominal G.N.P. has in creased by 10 percent with an inflati on rate of 7 percent spending might then increase by 9 percent: 10 percent minus the 1 percent inflation penalty.

The amendment requires that any surplus be used to reduce the public debt to be changed by a three-quarters vote of each House specifying that for the first six years after ratification federal grants must be continued at the same proportion as existed th ree years before ratification will lower federal spending limits the federal government might have to gain at the expense of the states additional state spending without providing the necessary funds.

The amendment very adeptly avoids the-major pitfall of the balanced budget. Since outlays are based on the calendar year prior to the beginning of the fiscal year, the spending growth is based on Proxmire claims The bill also avoids one of the major deficiencies of balanced The Proxmire bill has much to recom m end it A serious drawback The bill requires only It offers no assurance that the previous calendar year. Should the inflation rate be at or below 7 Federal It also contains a clause permitting the outlays limit Finally, the amendment protects state and lo c al governments by Any reductions in grants after six years This would remove any incentive The federal government is also prevented from mandating any 7. For an interesting discussion of spending limitations, see Jeffrey T. Bergener Federal Spending Limit a tions An Idea Whose Time HasCome Policy Review Spring 1979. 10 actual data and not economic forecasts. The twenty-one month dif ference between the fiscal year and the calendar year on which it is based incorporates an automatic countercyclical element in federal spending. If, for instance, the economy peaks in 1979 outlay growth will be large in 1981 when the economy most likely will be slowing down. Conversely, slow G.N.P. growth will slow federal spending twenty-one months later when the economy is in a boom'and growth in government demand may invite inflation.

The amendment also presents the federal government with a strong incentive to reduce inflation A rate of inflation beyond three percent cuts into government spending. To maximize its spending the government would attempt to minimize inflation. The link between real economic growth and government spending would also promote greater federal interest in promoting economic growth.

The spending limitation is superior to a balanced budget con cept in al l regards save one. The balanced budget is more flexible a crucial difference. Under a spending limitation, federal expendi tures are either a stable or declining proportion of G.N.P. The deficiency is that there is no reason to believe that the public pr i vate sector mix, as desired by the taxpayers, will always be declining or stable. If, for example, the Soviet Union increased its military spending, the public might be very willing to surrender its resources to the public sector to bolster U.S. security. This could be easily achieved under a balanced budget by raising taxes.

With a spending limitation, it would require an act of war or a declaration of a national emergency. Limitations-on the declara tion of an emergency and the time duration of an emerge ncy might thwart a widely desired response. Military spending is merely one example of a possible change in the taxpayer's private-public pre f erence CONCLUSION The balanced budget concept possesses both political and economic virtues. The public's resis tance to taxes will act as a counterweight to the political impulse to spend. The restrictions against deficits will prevent the casual commitment of the future's resources.

Al- though a balanced budget does not guarantee an inflation-free society the elim ination of deficit spending would remove a major incentive for inflationary monetary policies. Finally, a balanced budget would free resources vitally needed by the private sector for investment.

This latter point, which is usually the least emphasized, i s perhaps the most important. It is the private sector which produces long term economic growth and raises the nation's standard of living A balanced budget, while restricting spending, does not remove the pressures to spend. It might be anticipated that t he government will attempt to satisfy these demands through other means. Guaranteed 'loans or mandating that state government or the private sector make the outlays are two such avenues. They are, however, by no means inevitable. The same public pressure which produced a bal anced budget amendment, can be brought against these instruments.

Despite the doomsayers, there is only one way to find out if it works: try it the balanced budget is the alternative policy The balanced budget offers tremendous benefits at little risk.

Perhaps the most compelling argument in favor of to continue our present I Eugene J. McAllister I Walker Fellow in Economics

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