Governing Principles

The President's budget plan is shaped around a clearly defined goal—the conviction that Government should play a role that is both activist and limited. The Government has an important role to play in fostering an environment in which all Americans have the opportunity to better themselves and their families. This is done by providing good educational opportunities for all youths; allowing families to keep more of their incomes and thus easing their way up the income ladder; keeping our commitments to the elderly and future generations; keeping the peace; and ensuring that communities have the ability to minister to their local needs.

However, Government must be careful not to overstep and to ensure that it keeps the commitments it makes. It must also take lessons from the private sector, finding ways to increase efficiency and customer satisfaction. Government has had difficulty doing this in the past. It is the Administration's objective to change this track record, by making the Government more accountable and ultimately raising citizens' confidence in the ability of Government to work in partnership with the private sector to raise standards of living for every American.

Allocating the Taxpayers' Dollars

Over the next 10 years, the Federal Government is projected to collect $28 trillion in revenues from American taxpayers. The President's Budget devotes roughly $22.4 trillion to extend the Government we have today, including the President's new initiatives.

This leaves a $5.6 trillion surplus. The President's Budget takes a cautious approach to allocating this staggering sum, starting by saving the entire Social Security surplus—nearly 50 percent of the total surplus—for Social Security and debt retirement. None of the Social Security surplus will be used to fund other spending initiatives or tax relief.

By devoting these revenues to debt retirement, the Nation will be able to pay off all the debt that can be redeemed—an historic $2 trillion reduction in debt over the next 10 years. The only remaining debt will be those securities with maturity dates beyond 2011. In all likelihood, American taxpayers would have to spend an additional $50 to $150 billion in bonus payments to bond holders to accelerate the repayment of those notes, a wasteful and senseless transaction. It makes more sense to allow the securities to mature naturally, leaving the Nation on a glide path to zero debt post 2011. (See Chart III–3.)

By 2011, Federal debt will have fallen to only seven percent of GDP—its lowest level in more than 80 years. Net interest payments on this debt will be less than 0.5 percent of GDP, less than one quarter of today's share and only three percent of the budget. This represents a great national achievement.

Even after setting aside Social Security and paying off the debt at these unprecedented rates, $3.0 trillion of the expected surplus remains. The President's Budget devotes these funds to the following priorities:

• Any additional debt reduction that proves financially practical.

• The Administration proposes to return $1.6 trillion of tax dollars to the taxpayers—or about six cents out of every dollar that will be collected between 2002 and 2011.

• After achieving these goals, roughly $1.4 trillion in projected surpluses will remain. The President proposes to use some of these funds—$153 billion over 10 years—for Medicare reform, $0.4 trillion for debt service, and the rest to establish a reserve for future priorities and unexpected contingencies.

The Additional Needs and Contingency Reserve is ultimately an insurance policy. For example, budget surpluses may not be as large as currently projected, farm conditions could require additional resources for agriculture, and more money may be needed for national security requirements.

Of course, there are very large opportunities and contingencies that could expand the surpluses over these 10 years. These include Government reforms that would reduce future costs and, largest of all, the potential that revenue continues to outpace estimates as it has for the last several years.

If not left with taxpayers through lower taxes or committed to important new priorities, such as national defense or Social Security reform, remaining funds beyond those usable for debt retirement would have to be invested in private assets. The Administration believes that Government acquisition of the private economy is utterly unacceptable as a matter of principle. Further, the Administration agrees with Federal Reserve Board Chairman Alan Greenspan that Government investment of these uncommitted funds in private companies and securities would harm the economy's long run growth prospects.

In sum, there is ample room in the Administration's budget to pay off debt as far as possible, to reduce taxes for American families, to fund program priorities, and still leave roughly $1.0 trillion for Medicare modernization and to meet other programmatic and contingency needs as they arise.

In fact, more than 60 percent of the projected surplus is allocated to debt reduction or held in reserve for future needs. This is more than double the share allocated to tax relief. This is a farsighted and moderate budget, which uses today's good fiscal news as a means for shoring up the economic and fiscal environment that our children and grandchildren will inherit.

The President's Budget and the Medicare Trust Funds

The President's Budget reserves all Medicare funds for Medicare.

Recently, there has been much discussion about the relationship of the budget to Medicare's trust funds. Some would like to set aside the "surpluses" accruing in the Medicare Hospital Insurance (HI) trust fund from the rest of the budget and permanently require budget surpluses equal to these trust fund "surpluses."

In a sense this argument is moot, in that the President's proposed Additional Needs and Contingency Reserve far exceeds the "surpluses" in the HI trust fund over the period 2002 to 2011. Nonetheless, viewing Medicare HI's activities in isolation is flawed for several critical reasons.

First, the assertion that Medicare is running a "surplus" is misleading. Medicare actually has two trust funds, not one: the HI, or part A, trust fund, and the Supplementary Medical Insurance (SMI), or part B, trust fund.

A simple examination of both of these trust funds reveals there is no Medicare "surplus". The SMI trust fund receives substantial transfers annually from the general fund. From the perspective of the overall Federal budget, the SMI program is running a large deficit as premiums collected from beneficiaries cover only about 25 percent of program costs. The SMI deficit is projected to total $86 billion in 2002 and $1.171 trillion over the period 2002 to 2011. This deficit in SMI, combined with the HI "surpluses", reveals a Medicare shortfall of $52 billion in 2002 and $645 billion over the period 2002 to 2011. (See Table III–1.)

Second, the amount of debt retirement that is feasible is already far exceeded by projected Social Security surpluses. Adding a new requirement to run larger surpluses would only put us on a clearer path toward investing excess balances in the private economy, something that the Administration, Chairman Greenspan and most Americans oppose on both philosophical and economic grounds.

Third, the HI "surplus" itself is due in large part to a gimmick. In 1997, the HI trust fund was projected to be depleted by 2001. The imminent bankruptcy of the HI trust fund forced the Administration and Congress to make adjustments in Medicare to avoid catastrophe. Many of the changes made in the 1997 Balanced Budget Act were positive changes for Medicare.

But the previous Administration and Congress—in a transparent effort to further improve HI solvency—also shifted a large portion of home health spending out of the HI trust fund to the SMI trust fund. This shift had no economic consequence, nor did it change total Medicare spending. But it did have the intended effect of making the HI trust fund appear more "solvent."  Approximately one-third of the projected HI "surplus" over the next 10 years is due to this gimmick.

Fourth, the President is committed to true Medicare modernization. A 21st Century Medicare program will catch up to rest of health care by recognizing that all modes of treatment—hospitalization, outpatient care, home care, and prescription medications—must be integrated if patients are to be well cared for. Medicare's current artificial division between hospital care and all other care is an antiquated relic reflecting the health system of the 1960s and before.

Finally, perpetuating the illusion that Medicare takes in more than it spends increases the risk that we will postpone urgently needed reform. The time for action is now, and we should not allow an arbitrary and misleading accounting concept to delude us into procrastination, as the political process is all too inclined to do.

Sources of Variability in Budget Estimates

The President's Budget recognizes that there are inherent uncertainties in making 10 year budget projections. In deference to this, it sets aside a large $1.0 trillion reserve, which can be tapped to cover priority and contingency needs starting with Medicare modernization. It is important to note, however, that the presence of this reserve does not mean that all the risks to surplus projections are to the downside. Indeed, if the past is any guide, this reserve fund could well increase in size as successive baseline estimates are made during the course of the year.

Baseline Issues

Budget projections are naturally subject to uncertainty, which increases as the projection period is lengthened. Policymakers need to be aware of this and plan accordingly. It is important to remember that there is uncertainty on both sides. Ultimately, the proper baseline assumptions used for constructing a budget plan are those that fairly balance upside and downside risks.

There has been considerable public discussion of the potential downside risks to the surplus projections. However, the greatest "risk" to accurate forecasting in recent years has been on the upside as a result of stronger than expected revenue growth and weaker than expected outlay growth. Revenues have contributed most to surplus underestimates, which can be seen in a comparison of revenue projections made by the Administration and the Congressional Budget Office (CBO) in January 1995 with actual receipts. (See Chart III–4.)

Over the 1996–2000 period, revenues came in roughly $850 billion higher than originally forecast in January 1995. When combined with associated debt service savings, revenue underestimates contributed to roughly a $1 trillion underestimate of the five-year cumulative surplus.

This gusher of unexpected revenue was not principally a result of stronger economic growth. The real driver of the revenue surprise is a current tax code that continues to extract an unexpectedly high percentage in taxes from each dollar that Americans earn. Annual revenue growth outran GDP growth by more than two percentage points in each of the last eight years, due to increased capital gains receipts, real bracket creep, growth in high-income taxes paid, and stronger receipts from retirement account conversions.

Some argue that while revenue growth consistently outstripped GDP growth in the past, this trend may not continue. It is important to realize that the Administration and CBO baseline revenue assumptions have just such caution built into them already. Both assume that revenue growth will lag GDP growth going forward for a protracted period. This is an extremely conservative view since annual revenue growth has historically exceeded GDP growth by 0.7 percent on average, over the last several decades through good and bad economies. (See Chart III–5.)

Realistically, one would expect revenues to grow at least slightly faster than the economy, absent tax changes, due to real bracket creep over time. (Major parts of the individual income tax code are indexed for inflation, not nominal wage growth. Thus, as taxpayers' real incomes rise, their effective tax rate rises due to a dilution of the impact of the standard deduction, exemption and credits and as some are forced into higher tax brackets.)

On this key variable, the Administration is even more cautious than CBO, expecting revenue growth to lag GDP growth throughout a multi-year period to a degree generally experienced only during recession. Capital gains are a main factor behind the deceleration in both the Administration's and CBO's revenue growth. Both expect capital gains realizations to post effectively no growth in nominal terms over the next 10 years and thus shrink markedly as a share of GDP—a very rare historical occurrence. This compares with nearly 30 percent average annual growth in realizations between 1995–1999.

Furthermore, the Administration assumes that the individual effective tax rate will edge lower, as the share of taxes paid by high income taxpayers shrinks in coming years. In addition, the Administration is assuming economic forecasts that are generally more cautious than the Blue Chip consensus. Thus, there are convincing reasons to assume that higher revenues are more likely than lower revenues and a larger, not smaller, surplus lies ahead.

In economic parliance, there are significant "upside risks" to the surplus projections, in addition to the downside risks that tend to dominate public discourse.

Policy Issues

The Administration has crafted the policies in this budget blueprint to meet the President's key budget goals: achieving maximum debt retirement, preserving the Social Security surplus for Social Security, funding program priorities, and providing tax relief that is fair and sustains short- and long-term economic growth.

However, no budget can fully anticipate fiscal requirements a decade into the future. Unanticipated events here and abroad may require new commitments of resources that will challenge our commitment to live within the Administration's budget parameters.

That is why the Administration has taken the cautious approach of setting aside a roughly one trillion dollar reserve for priority needs, beginning with Medicare modernization and contingency purposes. While it believes that, in general, additional funding demands above inflation can be largely accommodated through offsetting program savings, it recognizes that this may not always be the case.

Examples of areas that could require the commitment of new resources in the future include the following:

• The President's strategic review of post-Cold War requirements for national defense may require the restructuring of current forces, the development of more versatile weapons systems including a Ballistic Missile Defense, and pruning the strategic weapons arsenal. New resources required to fund these changes could be offset in part by savings from commercialization and more efficient use of current base infrastructure, but a net increase in defense spending is certainly possible.

• Poor weather, floods, or other disasters may require assistance to farmers above the levels in existing farm assistance programs, such as the Loan Deficiency Payment program.

• Efforts to buy back non-matured debt in the latter part of this decade seem very unlikely to be cost effective. However, if modest further buy-backs do prove affordable, the Federal Government might want to extend its Treasury buy-back program.

However, the existence of the priority and contingency reserve is not meant to be an open invitation to spend money. As the title suggests, these funds should be held in reserve for truly unforeseen needs or for programmatic reforms that are needed to shore up the long-term economic and fiscal outlook. As such, the Administration will emphasize the need to examine existing programs, looking for ways to redirect resources to their most productive end. Such examination is necessary, lest the size of Government increase without limit. Among the areas that offer the potential of freeing resources to address emerging needs are the following:

• Flattening the Federal hierarchy, reducing the number of managerial layers in the upper echelons of Government, in order to make Government more citizen-centered.

• Moving the Government toward performance-based contracting—focusing on results achieved, rather than reimbursing for costs—will increase the efficiency of the Federal contract dollar, potentially yielding savings for use elsewhere. It holds the potential of generating upwards of $70 billion in savings over 10 years.

• Making full use of the Federal Activities Inventory Reform Act to open Government functions to competition will encourage market-based pricing and innovation, freeing up more funds in agency budgets. This could generate more than $50 billion in savings over 10 years.

• Reducing erroneous payments by Federal agencies will ensure that taxpayer dollars are being used for their intended purpose and free up savings for other needs. A General Accounting Office study found $21 billion of improper payments alone in 1999 alone, more than half of which were in Medicare fee-for-service payments.

• Expanding electronic Government, including e-procurement, has the potential for savings from reduced transaction costs and greater competition. Private business has already reaped substantial savings from shifting procurement to the Internet. This should allow greater productivity gains in the public sector—indeed, if Government productivity grew only one tenth as fast as recent three percent gains in the private sector, the discretionary spending savings could exceed $100 billion over 10 years.

This budget, like any long-term plan, is subject to alteration due to unanticipated needs. By using cautious estimating assumptions, reserving the Social Security surplus for debt retirement and Social Security reform, and preserving an additional large reserve beyond the Social Security surplus, the Administration has made it easier to adjust the budget in the future to meet new requirements as they arise. And, of course, whatever portion of the reserve does not prove necessary for net new spending should never be collected at all, but should be left with American workers through lower taxes in the future.