Washington: Endless Spending

Proposals for cutting the deficit ignore its real cause—the growing costs of providing for the middle class

VOTERS WILL HEAR quite a bit this year, especially from Democrats, about the evils of large federal deficits. They will hear very little from either party about the more important economic development of which deficits are merely a sign.

At first glance, the deficit question looks like an open-and-shut political case, which favors the Democrats and works against President Reagan. Before the beginning of this Administration, deficit spending had never exceeded $67 billion in any one year. (It reached that level under Gerald Ford, in the recession year of 1976.) But in fiscal year 1984, which ends five weeks before this fall’s election, the deficit is expected to be $184 billion, and most forecasting services predict that it will remain in the vicinity of $200 to $300 billion a year for as many years in the future as their projections run.

Between the end of the Second World War and the beginning of the Reagan Administration, the deficit had never represented more than 4 percent of the gross national product, its level in 1976, and in only two other years had it been as high as 3 percent. But in 1983, the deficit was 6.1 percent of the GNP. Although predictions vary, most show that deficits will average 4 or even 5 percent of the GNP through late in this decade. For thirty-five years after the end of the Second World War, the total public debt fell almost continuously, year by year, when measured as a percentage of the GNP. In 1982, it began to rise again.

Perhaps most dramatic, the “structural” deficit—the amount that would be left even after a full economic recovery, with many people paying taxes and few drawing benefits—has reached a new plateau. Through the 1970s, the decade of America’s most fitful economic performance since the 1930s, the structural deficit averaged 1.9 percent a year of the GNP. During the late 1980s, if current policies are followed, it will remain stuck somewhere between 3 and 5 percent a year.

Seizing on this one obvious weakness in the President’s domestic performance, the Democrats have accused him of creating the deficits through a big military buildup and an unrealistically large reduction in tax rates. The architects of the tax cut have in turn blamed the Federal Reserve Board, the Congress, and even quislings within the Administration for delaying and diluting the original taxcut plan, thereby bringing on recession, deficits, and ruin.

In a sense, all of them are right. Any fair-minded etiology of today’s deficits reveals that only the combined impact of tax cuts, defense increases, and recession could have made the deficits as large as they are. But in another sense, all the political accusations miss the point. If there has been a significant fact about public finance during the Reagan Administration, it is not that taxes have been reduced. It is, instead, that government spending has continued to rise.

The “supply-side” principles of economic management, which were ratified by the tax-cut legislation of 1981, have, in fact, reduced taxes, but not to a dramatic degree. In fiscal year 1980, the federal government took in 20.1 percent of the gross national product through taxes and other levies. Four years later, in fiscal year 1984, federal revenues have fallen to 18.8 percent of the GNP.

But during the same four years, federal expenditures have risen at least as substantially as tax rates have fallen. In 1980, federal outlays were 22.4 percent of the GNP. In the first budget that the President’s economic advisers submitted after taking office, they predicted that by 1985 the economy would have expanded so rapidly and government spending would have shrunk so fast that federal outlays would be a mere 19 percent of the GNP, about what they were during Lyndon Johnson’s Administration. In reality, by the end of this fiscal year, federal spending, according to the Congressional Budget Office, will be not 19 percent of the gross national product, as it was supposed to be, nor 22.4 percent, as it was when the President took office, but 24 percent, the highest in postwar history. Under Ronald Reagan, the federal government’s claim on national output is larger than it has ever been in modern history except when federal dollars were needed to build Liberty ships and supply General Patton with tanks.

THAT GOVERNMENT expenditures should continue growing faster than the private economy, in the teeth of a conservative Administration with a reputation for slashing budgets, ought to give us something to talk about in an election year. One part of the growth might be said to reflect deliberate choice. Federal spending has risen to nearly one quarter of the GNP in part because the military budget has increased from 5.3 percent of the GNP to 6.6 percent from 1980 to 1984. But the military budget was not the only one that grew. Medicare and Social Security rose from 5.8 percent of the GNP in 1980 to 6.8 percent in 1984, and interest payments on the national debt rose from 2 percent to 2.9. All other categories of government spending shrank, but not by as much as these grew.

The absolute increase in military spending was larger than those in the other areas. But even if the share of the gross national product devoted to the military had not increased at all (remember that the Carter Administration proposed an increase about half as large as the one the Reagan Administration has achieved), government spending under Reagan would still claim a larger share of the GNP than ever before in peacetime.

Except for the military budget, the sources of increased government spending have been nowhere near center stage in this year’s political arguments. Instead, each contending group—the supply-siders, the more orthodox Republican conservatives, and the Democrats— has developed an alibi for the deficits that is consistent with its short-term political interests. The supply-siders say that deficits don’t matter, the other Republicans blame big spenders in Congress, and the Democrats say that both the President’s tax cut and his defense budget are too large.

The unspoken theme that runs through all the groups’ positions is that the growth in government spending cannot be contained. For each dollar the Democrats would take out of an MX or B-1 contract, they have already promised at least a dollar in new spending for education, job training, or other domestic programs. The Republican conservatives rail against spendthrift Democrats yet propose no significant reductions themselves. They argue by implication what the Democrats say quite plainly: that taxes must go up. The supply-siders, of course, disagree; their world is built on the idea that taxes must go down. Their options, then, were to try to reduce spending or to laugh away the deficits that resulted from higher spending and lower taxes. In undertaking the second task, they revealed their assessment that the first could not be done.

Through most of 1983, Donald Regan, the secretary of the treasury, his former assistant secretary for economic policy, Paul Craig Roberts, and Roberts’s successor, Manuel Johnson, traveled the country saying, essentially, If deficits are so bad, why does the economy look so good? Interest rates have declined since 1981, when the prime rate hit 21 percent, so how can the government be “crowding out” other borrowers to meet its credit demands? Inflation barely exists, so where is the hyperstimulation that deficit spending supposedly brings? Too many people are still out of work, so can it make sense to raise any individual’s—or business’s—taxes? On the other hand, the economic recovery is well under way, so can the deficits really be so serious a threat to economic growth?

Much of this argument, of course, was simply a rehabilitation of John Maynard Keynes. With the government injecting so much extra money into the economy through deficit spending, an orthodox Keynesian would expect a recovery that featured more consumer spending than business investment—which is exactly what we have seen. The Keynesian would go on to warn that since the deficit spending was projected to continue even if everyone was back at work (this is the “structural deficit”), it would inevitably lead to inflation or some other economic mishap. But the supply-siders, selective in their embrace of Keynes, brushed off this point.

They also disregarded the more immediate and provable consequences of deficit spending. Today’s interest rates are very high when measured in “real” terms—the difference between them and the rate of inflation. (Last year’s inflation rate was about 4 percent, and the prime interest rate was 11, for a real interest rate of 7 percent, versus a historic norm of less than 2 percent.) They are also high by international standards—almost twice as high as Japan’s, for example. Nearly everyone, except the supplysiders, concedes at least some connection between heavy federal borrowing and high interest rates. The rates would be even higher if it weren’t for foreign investors, who have been pouring their assets into the United States to take advantage of the higher return available here. This has made the dollar much stronger relative to the mark, the yen, and the pound, which has meant good news for American tourists but disaster for American export industries. In addition to the largest budget deficit in history, 1983 produced the largest foreigntrade deficit, $69 billion. The President’s U.S. trade representative, William Brock, has predicted that this year’s will reach $100 billion. American exports fell by nearly one sixth from 1981 to 1983; the Commerce Department has estimated that this decline eliminated 1.3 million American jobs.

Rudolph Penner, the director of the Congressional Budget Office, spent most of last fall and winter warning that budget deficits, like other sums subject to the workings of compound interest, can have surprisingly large cumulative effects. The ripples from this year’s near-$200 billion deficit will not cease in Ronald Reagan’s lifetime, nor in his baby granddaughter’s. The Administration projects that annual interest payments will be $47.4 billion higher in 1985 than when it took office. That increase more than wipes out all the reductions made in social-welfare programs when Ronald Reagan and David Stockman held Congress in meek submission in 1981. Because of this year’s deficit, next year’s interest burden will be roughly $20 billion greater than this year’s (or more, if interest rates rise). That is, the government will have $20 billion less to work with next year and every succeeding year than if there had been no deficit this year. With that money, it could have paid nearly all the costs of the Medicaid program, or more than tripled its annual grants for elementary, secondary, and vocational education, or more than doubled all benefits under the Aid to Families with Dependent Children and Food Stamps programs, or placed forty Border Patrol agents where each one stands now, or increased the Internal Revenue Service’s auditing staff by 600 percent, or increased foreign aid by 400 percent. To put it another way, in order to make up for the lost $20 billion, it could cancel orders for a thousand new fighter planes or for two complete nuclear-powered aircraft-carrier battle groups, or give up the entire MX missile system, or cancel construction of ten Trident submarines—and ten more the following year, when there will be another $20 billion loss to cover.

Secretary Regan has not seriously attempted to rebut the export argument or Penner’s analysis, because he and his supply-side associates are not really talking about the deficit at all. They are talking about taxes. Their creed is based on the belief that steadily higher tax rates accounted for much of the recent stagnation of the American economy; they are determined that the rates shall not go back up. They know that, because payroll taxes for Social Security and Medicare have steadily risen, many Americans are now subject to higher overall tax rates than they were before Ronald Reagan “cut” taxes. In 1960, a typical family earning the national median income paid 10.1 percent of its total income in federal income and Social Security taxes. Because of the bracket structure of the progressive income tax, the next dollar the family earned would be taxed at a “marginal” rate of 20 percent. In 1980, its overall federal taxes had risen to 17.5 percent of its income and the marginal rate was 30 percent. In 1984, taxes on a median-income family are still at about their 1980 level, the Social Security increases and income-tax decreases having canceled each other out. But tax rates for those who earn less than the median income are already higher than before Reagan took office, and rates for every income category are scheduled to rise in order to pay for Social Security.

When speaking for the record, the supply-siders often said that they preferred “to hold the line on taxes to force a confrontation with the Congress over spending cuts,” as Manuel Johnson put it in an interview late last year. But they said very little about where the cuts would be made; in fact, their arguments revealed their conclusion that it was futile even to think about controlling spending. They found themselves apologizing for deficits because the only alternative was the thing they most feared— a “revenue solution.”

For non-supply-siders and for nearly all the Democrats, the “revenue solution”—higher taxes—was the inevitable remedy. With varying degrees of honesty, the Democratic candidates have said they would attack big deficits with tax increases. John Glenn, the most forthright on this point, proposed an acrossthe-board 10 percent surcharge on taxes, so that a company or individual now in the 50 percent tax bracket would pay 55, while the rate for those in the bottom 11 percent bracket would rise only to 12.1. Most of the Democrats, including Glenn and Walter Mondale, said that they would eliminate or postpone the plan to index tax brackets to inflation; in addition, Mondale proposed a 10 percent surtax for people earning more than $100,000, a 15 percent minimum tax on corporate income, and other steps to raise taxes at the upper reaches of the income distribution. Together with a hazily defined program of reducing defense and medical spending, these taxes would, according to Mondale, cut the deficit in half within four years.

INSIDE THE ADMINISTRATION, a crucial and well-publicized battle was waged this winter over whether to include any “revenue solutions” in the 1985 budget, which was submitted in February, or to put the whole thing off until after the election. Through December and January, White House officials on both sides of the struggle hinted in interviews that a revenue solution might be at hand. Edwin Dale, David Stockman’s spokesman at the Office of Management and Budget, said, “If we don’t face this [the deficits] in 1984, I don’t know how we can deal with it in 1985.” An economic adviser in the White House ended a thirty-minute soliloquy about the dangers of chronic deficits by saying, “I think the President should announce a tax increase, run on it—and then get a mandate for doing something next year. ” Yet when the budget came out, it contained no “revenue solution,” nor any but trivial reductions in spending.

If he is re-elected, presumably the President will be less coy. His assistants say they cannot be sure whether the means will be an overt tax increase or a retreat from indexing or a new excise tax or some sweeping plan for tax reform, but in one way or another, they say, a second Reagan Administration will be forced to bring more money into the Treasury. Manuel Johnson said, “Against my wishes, it looks like we’re moving toward a big tax increase.” It will probably not be quite as big an increase as if the Democrats win, which means that the economic choice to be made in this election is one of degree. If Ronald Reagan is re-elected, deficit spending will be relatively more important as a way of meeting federal obligations. If the Democrats win, they will rely more on taxes. The obligations themselves will differ in composition— more military spending from the Republicans, more domestic initiatives from the Democrats—but not much in size.

“History will record that the first Reagan Administration stopped the juggernaut of federal spending,” an official of the OMB said last winter. “It will also record that he demonstrated the floor beneath which government spending as a share of GNP cannot be driven.” Manuel Johnson said, “Some people feel that this is the level of service that the public wants, and we’ve got to find a way to pay for it.”

Indeed, the behavior of both parties indicates that we have come to an historic accord on the dimensions of the modern welfare/national-security state. Through AFDC, Food Stamps, and Medicaid—which together cost roughly $40 billion, or less than one fourth as much as Social Security—it will make modest provisions for a dependent class. Through Social Security and Medicare, it will provide a cushion for the retired. Above all, it will continue to grow.

It will grow because all of its most important components contain built-in expansive pressures. Military spending, interest payments, and Social Security and Medicare together account for more than two thirds of all federal outlays, and each of them is increasing. When the other entitlement programs, the largest of which are military and civil-service pensions, are included, these categories account for more than four fifths of the federal budget—or more money than the government collects in taxes. If we awoke to find that the federal government had abandoned every function except paying pensions and medical bills, fielding a military, and meeting the interest on its debt, we would still find that the budget was in deficit, and that the deficit was on its way up.

Most of the Democratic candidates say that they would start wrestling with the deficit by canceling the B-1 bomber or the MX missile, but their proposed reductions in defense spending are merely reductions in the rate of increase. Even if he wanted to, the next President would find it difficult to brake military spending before the end of his term. The major purchases—the aircraft carriers, the bomber fleets—are already locked in by votes taken in 1982. A Democratic President might push the military onto a much lower “growth path” in the long run, but for the next few years defense spending seems certain to grow, no matter which party is in office.

So do Social Security, Medicare, and the other public pension programs, all subject to the demands of an aging population. Medicare, moreover, is affected not only by a growing number of clients but also by the sharply rising costs of medical procedures. According to Medicare trustees, the most expensive part of the system, Hospital Insurance, which covers hospital bills for aged patients, will run out of money sometime between 1988 and 1990. Hospital Insurance is legally forbidden to run a deficit, so the program will have to be “saved”; but unless the incentives in the medical system are changed, the rescue will boil down to raising taxes.

Hospital Insurance is now financed by a payroll tax of 2.7 percent. (It is part of the payroll deduction that most people think of as Social Security. The deduction totals 14.1 percent of a company’s payroll costs, divided between employee and employer.) Under the trustees’ optimistic set of economic assumptions, the tax necessary to pay for Hospital Insurance will nearly double, to 4.9 percent of the payroll, by the year 2005. If medical costs rise more quickly than expected, or if the taxable payroll rises more slowly, the trustees say the tax may reach 8 percent. The rest of the payroll tax will be rising too, because of steps taken to “save” Social Security in 1977 and again five years later. Technically speaking, Social Security and Hospital Insurance cannot add to the federal deficit, since they are required to cover their own costs through payroll taxes. But from the employee’s point of view, there is not a lot of difference between the deduction listed in the FICA tax column and that under Federal Tax Withheld. Whatever the category, the money is still missing from the paycheck. So, as payroll taxes go up, it becomes harder to raise the income tax to pay for other federal obligations.

The costs of other pension programs are headed the same way. Civil-service retirement now costs roughly $22 billion a year, compared with $8 billion eight years ago. Military pensions have similarly increased. Every actuary will say privately what the Grace Commission reported publicly last January: that the federal pension programs are more generous than any others ever devised. Under the typical private system, the retirement age is sixty-three or sixty-four, the pension is some percentage of the highest five years’ pay, and benefits are not indexed for inflation. The federal plans typically offer retirement at age fifty-five (civil service) or forty (military), base their benefits on the highest three years’ pay, and are fully indexed for inflation. No national-security argument can be made for granting pensions after twenty years’ military service. Indeed, many scholars of the military say that longer careers, typical of European armies, would improve the character of military leadership, by reducing the pressures of today’s up-or-out promotion system.

Yet, in the chorus of reaction to the Grace Commission’s report, neither Democrat nor Republican was heard supporting changes in public pension plans. (The exception was Ernest Hollings, who proposed a freeze on federal pensions as part of a freeze on most government spending. His lowly standing in the presidential race, however, proves the larger point.) In the briefings that accompanied its 1985 budget, the Reagan Administration hinted that it would wrestle with pensions and medical programs—but not until next year, after the election. Its failure to face them so far is more impressive than its assurances about the future.

And, of course, interest payments must grow; their meteoric increase is a measure of the inability to square accounts elsewhere in the budget. Since the Second World War, they have averaged between 8 and 10 percent of all federal spending. The House Budget Committee has extrapolated from current policies to predict that by the end of this decade they will account for 16 percent of the budget, or $200 billion per year. As “an ever-increasing share of taxes is devoted to paying the interest on past borrowing, the pressures will be great to repudiate the debt in some way,” the committee said in its report. “Historically, this has taken the form, in many countries, of rapidly printing money to reduce the real value of the burdensome public debt through high inflation. ... In this sense, our own deficits are truly mortgaging our grandchildren’s futures to allow us to enjoy higher consumption today.”

HAVE WE REACHED the historic consensus? Has our politics evolved to a point where Democrats and Republicans will fight over raising taxes versus tolerating deficits, but have little to say about an entitlement system that confers benefits on more and more of us regardless of need? So it seems; and if that appearance is correct, each party will have to accept a consequence that it claims to abhor.

Republicans must accept that, year after year, a larger share of national income will be claimed by taxes. If they believe anything their President and his economic theorists have been saying about the connection between individual incentive and economic growth, they must view such a future with dread. If they are resigned to the dimensions of the modern welfare/national-security state, they must scrap their deepest convictions about the ways a nation generates its wealth.

For Democrats, the intellectual and spiritual cost may be even higher. The more they foster a government that sluices benefits to everyone, the less room they will have for visions of a redistributive state. Social Security and Medicare protect vulnerable people from catastrophe, which is one important kind of redistribution. But they are not redistributive in the normal sense. They are financed by a payroll tax, which weighs especially heavily on small businesses and those in low income brackets, and they generally provide the largest benefits to those who were most comfortable to begin with. Despite Social Security’s growth, many of its beneficiaries need more. The only real redistribution Social Security effects is from one generation to another: those now under the age of forty or forty-five are transferring resources to their elders. Perhaps this is justified. The generation that won the Second World War and built the postwar prosperity is receiving tribute from its children. But this is not the kind of goal Democrats usually pledge themselves to, and it is so expensive that it precludes redistribution of any other kind.

The tax system, too, bears the marks of both parties’ desire to provide benefits for everyone. “Tax expenditures” is the government’s term for revenue that is lost because certain kinds of income— say, interest on municipal bonds—is declared nontaxable. Tax expenditures have risen even faster than direct federal expenditures have. In 1983, they cost the government almost three times as much money as in 1967, after adjusting for inflation. Democrats like to point out that many of the provisions shelter business income. Ernest Hollings, with the honesty that often betokens a floundering campaign, listed four of them that he would eliminate (tax-free status for interest on life-insurance reserves, which he said would bring in $30.8 billion in additional taxes over five years; allowances for intangible drilling costs for oil and gas, $19.3 billion; the famous oil-depletion allowance, $8.7 billion; excess-bad-debt allowances for banks, $4.2 billion). Hollings pointed out that Texaco had earned $2 billion in profits worldwide in 1982, yet had received an $88 million refund from the federal government. Corporations, he said, should also face a minimum 4 percent income tax.

But not even Hollings, of all the candidates the most honorably explicit on budgetary questions, dared talk about another kind of tax-free haven. Perhaps the candidates recalled Jimmy Carter’s experience in the 1976 campaign, when he briefly mentioned limiting the tax deduction for mortgage-interest payments and was pummeled from all sides for having made an unpardonable gaffe. The mortgage-interest deduction is sacred to the middle class, yet of the $28 billion in taxes that it diverts from the Treasury this year, half would have been paid by the wealthiest 10 percent of households. (One quarter of the total savings go to the wealthiest 2 percent of households.) The property-tax deduction, the tax-free status of medical-insurance benefits, and other “middle-class” tax breaks vary in detail, but their overall effect is the same. Only about a third of all households, the most affluent ones, itemize deductions at all, which means that the other two thirds get absolutely no benefits from most of these deductions. If both parties refuse to confront the exemptions—even a change as modest as limiting mortgage deductions to one house per family or to a certain amount of interest paid per year—where will they find the money for the next increase in benefits?

This is not merely a matter of patches of red ink in a ledger book: if we cannot control the budget, we must face unpleasant questions about the central purpose of our government. Only nine years ago, although it must seem like prehistory to him, David Stockman prophesied eloquently about the government’s failure to confine its generosity to the intended recipients. If transfer spending were ever to be contained, he said, it would have to serve some explicit purpose—whether that purpose was the limited one of saving “the truly needy” from starvation or a more ambitious one of income redistribution. Yet neither party, he said, seemed able to discipline benefits. For example, educational loans, meant to offer opportunity to those who would otherwise be denied it, were soon extended to everyone, including future doctors, whose rise to the top of the income distribution scale was thus subsidized by their fellow citizens.

Viewed cynically, the growth of federal spending is no mystery at all: the more the government evolves into a benefit program for the middle and upper-middle classes, the larger it must become. Every Democratic politician has pointed out that the supply-side tax cuts conferred the greatest reward on the richest people. But at least supply-siders had a rationale, however dubious, for distributing benefits as they did. By returning money to the wealthy, they believed, they could revitalize the economy. What is the rationale for pensioning off soldiers at age forty, or subsidizing the purchase of very expensive homes, or raising payroll taxes so as to guarantee Social Security benefits to everyone, including those who could not conceivably be called needy? Why should the government subsidize the small number of people who can afford private jet planes? (The tax levied on jet fuel does not come close to paying for the runways, control towers, and other equipment and services that the government provides either free or at a discount.) There is everything to be said for private jets and comfortable retirements and costly homes. But why should the government underwrite the cost?

Most politicians obviously feel that it is impossible even to raise such questions. By evading them, our elected leaders make the entire financial structure dangerously brittle. What if all those foreign investors whose capital now covers our budget deficits suddenly take their money back home? What if another recession begins, and we confront a deficit not of $200 billion but of $400 billion? What if the government decides that it can escape its mounting debts only by starting up the printing presses? Are the potential wounds less grievous because they would be self-inflicted?

—James Fallows