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TESTIMONY OF FRANKLIN D. RAINES
DIRECTOR
OFFICE OF MANAGEMENT AND BUDGET
BEFORE THE
JOINT ECONOMIC COMMITTEE
UNITED STATES CONGRESS
February 26, 1997

     Mr. Chairman, Members of the Committee, I am pleased to be here this morning to discuss the President's 1998 budget and the Administration's views on the health and direction of the economy.

     I will begin by making five basic points about our budget. I will then discuss the budget and the economy, focusing on the competing visions of fiscal policy that have dominated the last two decades -- the budget policies of the 1980s and the budget policies that President Clinton has pursued.

     I will then be happy to take your questions.

     We have already done much of the hard work

     My first point is that, over the last four years, we have already done much of the hard work of achieving balance.

     Before the President took office, the deficit reached a record $290 billion in 1992 and was headed up. In 1993, he worked with Congress to enact his economic program of lower deficits and more investment. Since then, the deficit has fallen by 63 percent -- from that $290 billion to $107 billion in 1996. We have the smallest deficit since 1981 and, as a share of Gross Domestic Product (GDP), the smallest since 1974.

     The President's plan has exceeded all expectations. It was designed to reduce the accumulated deficits over five years, 1994 to 1998, by $505 billion. In just its first three years, 1994 to 1996, it has already reduced the deficits by $485 billion. We now project that over the same five years, the plan will reduce the deficits by $925 billion.

     More than that, we now estimate that the plan will reduce the deficits through 2002 by $2.5 trillion -- the difference between where our original baseline said the deficits would be from 1994 to 2002, and where we now project them over those nine years. Our new projections are based on the steps we have already enacted into law. The 1998 budget calls for a net $252 billion in additional savings to reach balance in 2002 -- just 10 percent of the savings that we put in place in the 1993 plan. Having done much of the work, we surely can finish the job.

We are enjoying the fruits of our labor

     My second point is that, we are clearly reaping the benefits of our success to date in cutting the deficit.

     We inherited an economy that, in the previous four years, had barely grown and had created few jobs. As I previously said, the deficit had hit record levels. Savings and investment were down, interest rates were up, and incomes remained stagnant, making it harder for families to pay their bills.

     Since then, the economy has performed well across the board. Business investment has grown at double-digit rates. The private sector has grown faster than under either of the previous two Administrations, while the Federal Government component of GDP has shrunk at an annual rate of almost three percent.

     We have over 11 million new jobs, 93 percent of them in the private sector. Wages are beginning to rise. Inflation has remained remarkably low -- below three percent by most measures. Interest rates are under control. And unemployment, which measured 5.4 percent in January, is nearly two percentage points lower than when President Clinton took office.

     Also, partly due to a strong economy (and partly to the Administration's policies), poverty, welfare, and crime are down substantially all across America. For instance, poverty has fallen from 15.1 percent in 1993 to 13.8 percent in 1995, the last year for which we have data. And violent and serious crime has fallen five years in a row, marking the longest period of decline in 25 years.

     With strong growth, low interest rates, low inflation, millions more jobs, record exports, more savings and investment, and higher incomes, it's no wonder that such experts as Alan Greenspan, the chairman of the Federal Reserve, have described this economy as the healthiest in a generation.

     Later in my oral remarks, I will provide more details on how our budget policy has strengthened the economy.

     We are proposing a credible budget to finish the job

     My third point is that, the President is proposing a credible budget with real savings, based on conservative assumptions.

     It wasn't too many years ago that Presidents would routinely send to Congress budgets that had little relation to reality. They were based on what became known as "rosy scenarios" about how the economy was likely to perform, with unreasonable assumptions about growth and interest rates. They pretended that the deficit would come down. Not surprisingly, it never fell in a sustainable way. Of the 12 budgets submitted by the last two Administrations, the economy performed worse than the forecast 10 times.

     President Clinton has broken the pattern. For four years, he has submitted budgets that were based on reasonable assumptions about the economy and the deficit. How do we know? Look at the record. The economy has consistently performed better than the Administration had projected, bringing in more revenues and enabling the Government to spend less on unemployment compensation and other social benefits. As a result, the deficit has fallen more than we estimated, and by an average of $50 billion a year.

     Like its predecessors in this Administration, this budget is grounded in conservative economic and technical assumptions. With pleasant surprises such as the recent fourth quarter GDP figures, we expect that, if anything, the economy will continue to outperform our projections.

     In addition, the President is proposing significant savings -- including $137 billion by cutting discretionary spending, $121 billion by cutting mandatory spending, $34 billion by eliminating unwarranted corporate tax subsidies, $16 billion in net interest costs, and $42 billion by extending tax provisions that have expired.

     The budget savings total $350 billion over five years, shrinking Federal spending from 22.5 percent of GDP in 1992 to an estimated 19 percent in 2002. At the same time, the President proposes to cut taxes by $98 billion, providing tax relief to tens of millions of middle-income Americans and small businesses. Thus, the budget calls for net savings of $252 billion.

     This budget does more than reach balance in 2002. It would keep the budget basically in balance until 2020. After that, demographic changes -- specifically, the retirement of the baby boom generation -- will present significant challenges in ensuring the continued viability of Social Security and Medicare. The President has called for bipartisan processes to address those challenges.

     This budget invests in the Nation's priorities

     My fourth point is that, the budget invests in the Nation's priorities.

     Balancing the budget is not an end in itself. Rather, it helps fulfill the Administration's central economic goal -- to raise the standard of living for average Americans. So, too, do the spending priorities of this budget.

     Let me take a moment to walk you through the highlights:

     Strengthening Health Care. The budget preserves and improves Medicare, extending the solvency of the Part A Hospital Insurance Trust Fund into 2007. It gives older Americans and people with disabilities more choices among private health plans, and it proposes new preventive health care benefits to improve the health of senior citizens and reduce the incidence of disease. For Medicaid, the budget preserves the guarantee of high-quality health care for millions of children, pregnant women, people with disabilities, and the elderly. It reforms Medicaid to give States much more flexibility to manage their programs. It helps an estimated 3.2 million families, including 700,000 children, keep their health care coverage for up to six months until their breadwinners find new jobs. And it provides coverage for up to five million of the 10 million children who do not now have it.

     Making Welfare Reform Work. To help welfare recipients move from welfare to work, the budget proposes a Welfare-to-Work Jobs Challenge to help States and cities create job opportunities for the hardest-to-employ recipients; and a greatly- enhanced and targeted Work Opportunity Tax Credit (WOTC) to provide powerful new, private-sector financial incentives to create jobs for long-term welfare recipients. The budget also proposes several steps to address the overly deep cuts affecting single people, legal immigrants, and children that Congress attached to last year's welfare reform law.

     Investing in Education and Training. The budget expands the President's investments in Head Start, in Goals 2000, in the Technology Literacy Challenge Fund, in Pell Grants, and in other key education programs. It also proposes a $1,500-a-year HOPE scholarship tax credit to make two years of college universal; a tax deduction of up to $10,000 to help middle-income families pay for postsecondary education and training; the America Reads Challenge to help ensure that all children can read well and independently by the end of third grade; and a new school construction fund to leverage new construction or renovation projects.

     Protecting the Environment. The budget increases funding for the Environmental Protection Agency's (EPA) operating fund and funds the Kalamazoo Initiative, a new national commitment to protect communities from toxic pollution by the year 2000. It funds start-up activities at the Grand Staircase-Escalante National Monument; increases funds for the National Park System to help improve park facilities and further protect our natural and cultural treasures; and re-proposes the President's "Everglades Restoration Fund" to provide a steady source of funds mainly for land acquisition to maintain the South Florida Ecosystem.

     Promoting Science and Technology (S&T). The budget maintains the President's commitment to biomedical and behavioral research, which promotes the health and well-being of all Americans. For the National Institutes of Health, in particular, the budget includes increases for HIV/AIDS-related research; research into breast cancer and other health concerns of women; minority health initiatives; high performance computing; prevention research; spinal cord injury; and developmental and reproductive biology.

Enforcing the Law. The budget puts 17,000 more police on the street, continuing the progress toward the President's goal of 100,000 by the year 2000. To fight drug abuse, it increases funds for the Drug Courts initiative, for drug testing, for the Safe and Drug-Free Schools and Communities program, for interdiction efforts along the Southern border, and for disrupting the drug industry and its leadership overseas. To strengthen efforts to control illegal immigration, it increases the number of Border Patrol agents, continues Port Courts to expedite removals, and expands efforts to verify employment eligibility of newly hired non-citizens.

Providing Tax Relief. The budget provides a $500 tax credit for dependent children under 13; expanded individual retirement accounts, and the HOPE scholarship tax credit and tax deduction for postsecondary education and training that I just mentioned. It also exempts 99 percent of all home sales from capital gains taxes by excluding up to $500,000 in gains for married taxpayers. At the same time, the budget cuts unwarranted corporate tax subsidies, closes tax loopholes, improves tax compliance, and extends various excise and other taxes that were allowed to expire.

     Projecting American Leadership. The budget continues support for democratic reform and free markets in Russia and the New Independent States (NIS) of the former Soviet Union, ensures that the United States continues to play a vital role in crafting a lasting Middle East peace, and proposes a mechanism to liquidate our arrears to the United Nations and its affiliated organizations -- presuming these organizations undertake the management, budget, and assessment changes that we and others have urged. The budget continues the President's policy of sustaining and modernizing the world's strongest and most ready military force, capable of prevailing with our regional allies in two nearly simultaneous regional conflicts. It continues our commitment to maintaining high levels of training and readiness for that force and to equipping it with technology second to none.

     We need bipartisan cooperation to achieve a five-year agreement

     And my fifth and final point is that, we need bipartisan cooperation to achieve a five-year balanced budget plan.

     We obviously think that the President's budget is the best plan for reaching balance by 2002. And, we think his budget is the right starting point for our discussions. But we understand that the executive and legislative branches share responsibility for enacting a budget.

     The time to balance the budget is now. Our economy is strong, so it can absorb the spending cuts that we would have to put in place. And the political stars seem to be lining up in the right orbit. Everyone learned the lesson of the last two years -- that conflict over the budget is not a path to success. Both the President and Congress have voiced their commitment to reach an agreement this year.

     So I am cautiously optimistic. But I am realistic as well. Mr. Chairman, as you know, we have been down this road before. You know that agreements that seemed inevitable have eluded our grasp. If we are to avoid that fate, we have to work together, in good faith. I want to assure you this afternoon that, from the President on down, this Administration is prepared to do that.* * *

     Mr. Chairman, I would now like to shift gears a bit. I will discuss President Clinton's fiscal policy, compare it to the fiscal policy that dominated the 1980s, and highlight the achievements of each.

     The 1980s-era fiscal policy held that tax cuts would generate greater saving, investment, and work effort, strengthening the economy and leading to more growth. The deficit, then, would take care of itself.

     President Clinton's policy held that reducing the deficit would strengthen the economy, leading to more saving, investment, and work effort. His program was designed to reverse the unsustainable rise in our deficit and debt that began in the 1980s, end uncertainty in the financial and investment markets, and show the world that this Nation had the will to address its problems.

     Now that we have tried the two policies, we can compare the results. And, as the record shows, President Clinton's policy worked. In fact, the program accomplished more of the explicit goals of the 1980s-era fiscal policy -- more saving and investment, higher growth, and lower deficits -- than that policy itself.

     Saving. Economists agree that capital formation, a major goal of the 1980s-era budget policy, requires more saving -- putting aside some of what we produce to invest in the capital needed to raise future production. Advocates of the tax cuts of the early 1980s argued that when people paid less in taxes, they would save more.

     The reasoning had a logical flaw, however; government, as well as households, can add to, or subtract from, the savings pool. If tax cuts raised the Federal budget deficit dollar for dollar, thus reducing the Nation's saving, then taxpayers would have to save every penny of their tax cuts just to hold national saving constant.

     In contrast, the President proposed to increase national saving by decreasing Federal dis- savings -- that is, by reducing the budget deficit that was subtracting funds from the savings pool. His 1993 program relied on both spending cuts as well as tax increases, the latter geared largely to the most well-off Americans.

     The result is clear, as seen in the chart on national saving. Net national saving averaged 9.3 percent of GDP from 1960 through 1980. It fell to 5.4 percent from 1981 to 1984, mainly because Federal saving fell from -0.8 percent of GDP in the 1960-to- 1980 period to -3.7 percent in the 1981-to-1984 period.

     Rather than rising, private saving actually fell after the 1981 tax cuts -- from 8.1 percent of GDP from 1960-to-1980, to 7.3 percent from 1981-to-1984. Americans chose to consume, rather than save. From 1984 to 1992, national saving continued to fall. By 1992, net national saving was only 2.4 percent of GDP; private saving was only 5.5 percent, and Federal dissaving was -4.5 percent.

     National saving has risen in the last four years (though it has not yet regained its pre- 1980s form). From 1992 to the third quarter of 1996, net national saving rose from 2.4 percent of GDP to 5.4 percent. Federal dissaving fell from -4.5 percent to -1.8 percent, accounting for most of the improvement. And, although high-income taxpayers faced an increase in their marginal tax rate, private saving also rose a bit -- from 5.5 percent of GDP in 1992 to 5.9 percent in the first three quarters of 1996 -- surely aided by the big increase in corporate profits under this Administration.

     With greater saving, we have greater potential capital formation, greater future productive capacity and productivity, and faster potential economic growth. In this important respect, the President was clearly successful.

     Investment. The second essential for capital formation is strong business investment. Economists generally agree that a larger and newer capital stock will raise our productivity and our productive capacity in the coming years, boosting prosperity and growth. The tax policies of the 1980s were designed to increase business investment; tax incentives for business, such as more generous depreciation allowances and an investment tax credit, were expected to induce greater investment spending.

     The Clinton philosophy was very different; while the President proposed more investment expensing allowances for small business, he relied mostly on a lower deficit and, thus, lower Federal credit demands and lower interest rates.

     Again, the record is clear. The 1980s witnessed a typical fall in investment with the 1981- 82 recession, and then a typical recovery of investment. But historical patterns changed little. By the end of 1992, the ratio of our equipment investment to our GDP was little more than when the 1980s began. As a share of real GDP, real equipment spending rose from 5.7 percent in 1977-to- 1980 to 5.9 percent in 1981-to-1984, and then to 6.3 percent in 1985- to-1988. But by the last year of the previous Administration, real spending on producers durables was still only 6.2 percent of real GDP.

     The Clinton years, though, have broken the mold. Real business investment in equipment has grown 2-1/2 times faster than in 1981-to-1988, and five times faster than in 1989-to-1992. Real equipment spending has risen from 6.2 percent of GDP in 1992 to 8.4 percent in 1996 -- a record level for this measure of investment spending. The four-year increase in investment spending of over 2 percentage points of GDP is the largest rise in equipment investment in the post-World War II period, and it will pay dividends in the form of greater future productive capacity, productivity, and prosperity.

     Work. Another fundamental of economic growth is work effort; labor must complement the greater capital that results from saving and investment in order to produce growth. Over much of our recent economic history, labor force participation has followed a steadily rising path, apparently impervious to policy. Much of the change has come from increased participation by married women, and experts have anticipated that, at some point, that trend would have to reach its limit.

     Starting in the mid-1960s, labor force participation in the United States began to rise sharply, mainly due to the rising participation rate of women. The average annual rise in the labor force participation rate over this period was 0.3 percentage point, and the cumulative increase sent labor force participation from 58.6 percent of the working age population in January 1965 to 63.8 percent in August 1981. At that point, the large tax cut was designed to increase the after- tax reward to work effort, thus increasing the supply of labor.

     Labor force participation continued to rise after the 1981 tax cut -- but no faster than during the previous 15 years. From 1981 to the end of 1988, the increase averaged the same 0.3 percentage point a year. From 1989 to 1992, labor force participation dropped even though marginal tax rates remained low for most workers, probably due to the recession and the poor prospects for finding a job.

     But, under this Administration, the stall has ended. As the chart shows, labor force participation has resumed its increase in the last four years, and the ratio of employment to the adult population has reached a record level. In other words, the President's policies of the last four years have worked even better to achieve the goals advocated by those who pursued the policies of the 1980s.

     In the last four years, employment has grown by over 11.5 million jobs -- over 93 percent of them in the private sector. The Council of Economic Advisers recently reported that two- thirds of them are in employment and occupation categories that pay greater than the average wage.

      Growth. Higher economic growth was the ultimate goal of the 1980s-era policies, but private-sector growth in Clinton years has exceeded growth in the 1980s. And growth under this Administration has followed the fundamentals of saving, investment, and work effort. More saving has led to more investment, concentrated in high-productivity private business equipment. This increased investment has facilitated the higher employment levels I just mentioned.

     As the chart shows, private-sector GDP -- the portion originating outside of government -- has grown more rapidly under this Administration than under either of its predecessors. The Federal Government component of GDP has actually shrunk at an annual rate of 2.6 percent; Federal employment has shrunk by 263,500 full-time equivalent positions, or 12 percent, since this Administration took office. Also noteworthy, business investment in equipment has been the leading growth sector in the economy by a wide margin under this Administration.

     Other economic indicators. Several noted, non-partisan economic experts have observed that this economy is the best of any in decades. Their comments reflect both the phenomena that I have discussed above, as well as other phenomena. Generally speaking, the major economic indicators today suggest that this expansion is extraordinarily solid, and can continue for some time.

     As a corollary to higher national saving, interest rates remain low. What has been remarkable about the economy under this Administration is the combination of high employment and low interest rates, as the next chart highlights. At times in the 1980s, the unemployment rate has been as low as under this Administration; at other times, interest rates have been as low. This Administration is unique for having low interest rates and low unemployment at the same time. In fact, the last time unemployment was as low as now, the 30-year Treasury bond rate was about 1.5 percentage points higher.

     Another indicator of long-term macroeconomic health is the modest rate of inflation. Since the start of this Administration, and despite low unemployment and solid growth, the core rate of inflation has fallen to its lowest rate since the mid-1960s. The following chart shows this trend. Because of this low and stable inflation, many economic forecasters believe that our steady, solid growth can continue into the foreseeable future.

     Thus, our economy is remarkably sound. Though we have not abolished the business cycle, no problem on the horizon threatens the current expansion. The President's fiscal policies would build on these accomplishments -- with continued deficit reduction to further facilitate business investment.

     The deficit. With low interest rates and a strong economy, the budget deficit fell swiftly and more than we forecast. As I have said, the deficit now is at its lowest level since 1981 and, as a share of GDP, its lowest since 1974. Four straight years of lower deficits have brought debt service costs under control. The ratio of our debt to our GDP, which virtually doubled in the previous 12 years, has begun to decline. We have put the worst of the fiscal excesses of the 1980s behind us.

     Some would argue that the President's program did not reduce the deficit; the economy did. To be sure, our brighter fiscal outlook is largely a product of the economy. But a key lesson of the last 16 years is that the economy cannot do its work when the Federal Government erects a barrier of fiscal uncertainty. The economy can work even better than we might have thought when the Federal Government gets its fiscal house in order.

     The last four years have shown what a responsible fiscal policy can do for our economy. And our progress to date gives us a second chance to reach agreement now on a plan to finally balance the budget. Such an agreement would enable us to reap the rewards of further economic progress.

* * *

     Mr. Chairman, that concludes my remarks. I would be happy to take any questions that you have.