FROM THE OFFICE OF PUBLIC AFFAIRS

Beyond Borrowing:
Meeting the Government’s Financial Challenges in the 21st Century

 The principal financial challenge for our federal government in the 21st century will be to fulfill the many promises made in the 20th century.  All the major industrial economies face this challenge.  But I will stick to my knitting and, as Under Secretary for Domestic Finance, focus on the particular challenge that we face in this country: to make the government’s finances sustainable, to make sure that we align the promises we make with those we can keep.

 The popular understanding of our national fiscal position revolves around two concepts, the annual budget deficit (or surplus) and total debt held by the public.  This past fiscal year, the federal government ran a deficit of $159 billion and our accumulated debt is now roughly $3 trillion.  Putting these numbers in perspective, we usually express them as shares of our gross domestic product.  To keep the numbers simple, I’ll round our GDP down to $10 trillion (in truth it’s closer to $11 trillion), which makes our deficit 1.6 percent of GDP and total debt 30 percent of GDP.

 As concerning as these figures are, they unfortunately understate the challenge because they point in the wrong direction: the past.  They reflect the government’s continued reliance on cash accounting, recording transactions only when cash changes hands.  They ignore the commitments we have yet to fund: our future obligations. 

 We need to develop a forward-looking understanding of all of the financial responsibilities of the federal government.  When we do, when we confront the trillions of dollars of promises that our government has made, we can begin to think more clearly about preparing to meet these obligations.  I am going to suggest three admittedly predictable policy imperatives.  First, we need to invest and to save more, much more, so that we can grow as fast as we can and maintain our standards of living during our collective retirements.  Second, we need to get a hold of our escalating health care costs.  Finally, the federal government needs a more forward-looking budget discipline.

A more complete measure of the government’s fiscal position than the deficit or debt would take account of all future obligations, calculating costs and revenues as they accrue regardless of when they must be paid, but denominated in today’s dollars.  A handy tool is net present value.  This is hardly a revolutionary idea in finance or accounting.  College students in introductory economics routinely make NPV calculations and corporate CFOs live by them.  Unfortunately, NPV hasn’t yet made its way to the fore of federal budgeting or the public lexicon.  

Not everyone has overlooked the importance of forward-looking public finance.  In September, in testimony before the House Budget Committee, Chairman Greenspan suggested that accrual-based accounting would be a sensible step for federal budget accounting.  Former Secretary of Commerce Peter Peterson has warned tirelessly of the consequences of a graying population with fewer and fewer workers per retiree.  Due to their and others’ efforts, we all have a dim sense of long-term fiscal strains involving Social Security and Medicare.  But we need to bring this forward-looking understanding out of the shadows.  We need to shine the same spotlight on it that the annual deficit and total debt receive in our government’s budget rituals.

 We do not yet have very good forward-looking measures of the government’s overall financial position.  The ones we do have present a daunting picture.

 The most recent Financial Report of the United States Government, published last March, provided an accrual-based assessment of the government’s net liability for Social Security, for Medicare, and for government worker and military retirement benefits.  The government has assumed these obligations, and designated taxes and revenues to pay for them.  The Report projects that Social Security and Medicare will begin falling short around the year 2016.  On a 75-year horizon, these programs collectively have a negative net present value of $26 trillion.  The figure is even higher if one wants to ensure a fully sustainable system beyond that point.

 That figure does not account for the other, general revenues that the government collects.  Treasury staff estimate that if we tap general government receipts, projected at the recent average of 19 percent of GDP, the figure falls to negative $23 trillion.  Again, that’s using a 75-year NPV calculation.

 A Congressional Budget Office study from this July took another tack.  It projected the government’s finances out to 2075, holding discretionary spending constant as a share of GDP.  The result?  The federal government would double its share of the economy, from 19 percent of GDP today to 40 percent in 2075.  Reverse engineering these CBO projections gives you a negative NPV of “only” $18 trillion.
 
 Both these estimates are fairly crude.  Making 75-year projections about anything is an inherently imprecise and risky business.  But making promises of future government payments without keeping track of the costs is even riskier. 

 On the backward-looking basis, our debt to GDP ratio is 30 percent.  On the forward-looking basis, our liabilities to GDP ratio is 200 percent or more.

 Think of the federal government as a gigantic insurance company (with a side line business in national defense and homeland security) which only does its accounting on a cash basis – only counting premiums and payouts as they go in and out the door.  An insurance company with cash accounting is not really an insurance company at all.  It is an accident waiting to happen.

This particular insurance company, it turns out, has made promises to its policy holders that have a current value $20 trillion or so (give or take a few trillion) in excess of the current value of the revenues that it expects to receive.  A real insurance company could try to grow its way out by raising its premiums and its earnings on investments faster than its liabilities.  The federal government, however, would have to raise taxes or borrow faster than it increases outlays.  

In my opinion, neither is likely nor desirable.

Consider borrowing.  The CBO projections assumed that the government would hold taxes constant at 19 percent of GDP and borrow the shortfall.  In these projections, by 2075 annual deficits would be greater than 20 percent of GDP, compared to 1.6 percent today.  This would result in total federal debt reaching 255 percent of GDP.  Just paying the interest on the national debt would consume 11 percent of GDP, half of today’s federal budget and more than what government spends today on everything other than Social Security, Medicare and Medicaid.

To judge the ramifications of raising taxes on this magnitude, it’s worth first going back over a little history.

 Over the last forty years we have had great debates in our country about taxes – about raising taxes and about cutting taxes.  However, throughout this time – from 1960 to 2001 – the federal government’s revenues as a share of GDP have varied within a range of less than 4 percent – from a low 17.0 percent in 1965 to a high of 20.8 percent in 2000.  The year 2000, in fact, was the first time federal revenues as a share of GDP exceeded 20 percent since 1944, when they were 20.9 percent.

 Some of us would rather see total federal taxes to be noticeably less than one-fifth of our economy and pushed back toward the middle of their recent range.  The tax cuts proposed by President Bush and approved by Congress last year, and which the President wants made permanent, aimed in that direction: to cap federal receipts at approximately 19 percent of GDP.  Others may feel differently and think it appropriate or desirable for taxes to be at the higher end of their recent range.  But whatever one’s opinion, we must recognize that even to finance the Second World War, taxes did not exceed 21 percent of GDP and that federal revenues have averaged 18.6 percent of GDP for the last forty years.

Looking forward, now, if we were to keep debt held by the public to no more than its post-war peak of 50 percent of GDP, federal tax receipts would have to rise to 31 percent of GDP in 2075.  That’s 64 percent higher than what taxpayers have borne for the last 40 years.

Some say that that we should raise taxes starting now to ease the challenge of meeting the government’s long-term liabilities.  Put aside that it is odd to argue that, as the economy weakened and tax collections waned, we could have, would have, or should have, kept pushing taxes up to maintain a given surplus.  That would have been folly.  Put aside the costs of waging war on terrorism and bolstering homeland security. 

 If we were to have paid off the entire $3 trillion of outstanding debt held by the public, we would have – in simple terms – reduced our $18-to-$23-trillion negative financial position by around $3 trillion.  To say that doing this would “make it easier” to meet our future liabilities is misleading.  It’s like telling a man that it would easier for him to jump across the Mississippi River if he took a running start.

 To secure our economic future, in the face of the government’s large, negative financial position, we will have to look beyond the government’s cash flows for the answers.  If we examine only the cash flows themselves we will be stuck inside a numbers game confined to zero-sum trade offs among the mix of benefits and taxes.

 At the risk of stating the obvious, let me briefly suggest the three things that I think we must do if we are to hope to get on a sustainable path.

 First, we need to invest and save more so that, as a society, we can grow as rapidly as possible on a non-inflationary basis.  One way or another we are going to pay for our collective retirements.  We can either pay by having lower collective standards of living than would otherwise be the case or we can save and invest more for the future and keep boosting productivity. 

 My children will be retired in 2077, the time horizon I have been talking about.  If we set our country on a path to grow 2 percent a year in real terms until then, our GDP would grow from $10 trillion to $44 trillion.  If we could boost the growth rate to 3 percent, however, GDP in 2077 will be over twice as big – $92 trillion.

It is true that faster growth and higher productivity alone will not solve the whole fiscal problem, because some expenditures will rise along with tax revenues.  Social Security costs, for instance, rise with wages and hence with GDP.   The wealthier we are, however, the more freedom we will have to re-allocate our resources for paying for our retirement and health care without sacrificing other private and social goals. 

 So to have any hope of catching up with our own promises to ourselves, we need to invest more and save more.  To do this, we need to take away barriers to both investment and savings.  Fundamental reform of our tax code comes to mind as a promising possibility.  Personal wealth accumulation accounts is another.

 Second, we need to get a grip on rising health care costs while still seeking a healthier population.  The Financial Report of the United States shows that the real budget-buster is health care.  Medicare and Medicaid account for two-thirds of that $26 trillion shortfall.  For many years, health care costs have been rising faster than economic growth, at one percent more than GDP annually for a decade.  For the past two years, partly due to the recession, the gap has been five percent.  This is not sustainable.

 I am not a medical expert, but I do know something about economics and incentives.  Our system of health care insurance – both private and government – reimburses for the provision of health care services.  The problem is that we reward the production of health care services without regard to whether anyone’s health has actually improved.

 If we want to provide health care to those who need it but cannot afford it, and at the same time constrain health care costs so they do not absorb an ever-increasing share of our society’s resources, we need to redirect our system for health care delivery and medical reimbursement.  It must reward those who can demonstrate a measurable improvement in health, not just those who have simply sold more health care services.

Finally, we need to consider a more forward-looking budget discipline for the federal government, one that recognizes the cost of promises made about the future.  We need to consider a new kind of budget discipline that would require us all to confront the actuarial exposures created by promises of future benefits and other off-budget and off-balance sheet liabilities.  While retirement and health care insurance are the biggest pieces of this problem, we must also confront the true costs of all government programs.

Federal budget decision-making needs to follow good business practice and move on from cash accounting to accrual accounting.  If we can do this, maybe the federal government can learn how to better align the promises that we make with those that we can keep.