The Nonissue

George W. Bush and John Kerry have paid little attention to the budget deficit as a campaign Issue. Come next year, the winner may not have that luxury.

Author: Julie Kosterlitz

Published: July 17, 2004

Economist Bruce Bartlett walks the supply side, where budget deficits are rarely cause for worry and tax cuts never go out of style. So it came as something of a surprise when Bartlett, a former aide to Jack Kemp and to President Reagan, stepped up to the podium at a recent forum at the center-left Brookings Institution and delivered a dire prediction of what will happen if President Bush wins re-election.

"We've gotten into a fiscal situation that is going to demand some action, sometime fairly soon," said Bartlett, a senior fellow at the Dallas-based National Center for Policy Analysis. He foresees a scenario in which over the next year or so, as the Federal Reserve continues to raise interest rates, the nation gets "a huge wake-up call" -- one as loud as the 1987 stock market crash, although probably sounded in a different financial arena, such as the secondary-mortgage market-makers, Fannie Mae and Freddie Mac.

Bartlett doesn't necessarily think that deficits will be the root cause of the wake-up call. Indeed, he has generally endorsed supply-side orthodoxy, which says deficits are a trivial contributor to rising interest rates. What worries Bartlett is Congress: Panicked by a financial-sector tempest, it will feel compelled to attack the deficit by raising taxes and cutting spending. "You're going to have to have a budget deal that is large enough to get the attention of the bond markets," he said -- big enough to close a budget gap that is currently running at around 2 percent of gross domestic product. That, he reckons, would mean a tax hike of well over 1 percent of GDP.

Many Wall Street economists and forecasters differ with Bartlett's supply-side views and tend not to subscribe to disaster scenarios, but many agree that financial markets could soon put "deficits" back into Washington's political vocabulary. "When the economy is concerned about deflation, concerns about deficits don't have much weight" in the bond markets, said Laurence Meyer, a former Federal Reserve Board governor. "But as [monetary policy] begins to tighten and we get back to a more neutral rate by the end of 2005," deficits will begin to "weigh more heavily on the bond markets over time," says Meyer, now a distinguished scholar at the Center for Strategic and International Studies and a senior adviser to Macroeconomic Advisers, the St. Louis forecasting firm he co-founded.

If so, the 2004 election will be crowned by an abiding irony: Fiscal restraint -- which has scarcely been a feature of either the Bush or Kerry campaigns -- may become the domestic policy issue that trumps all others. Thus far, the deficit has been perhaps the biggest-ticket nonissue of the presidential campaign. In a span of less than four years, the projections for the budget's health have gone from a $5.6 trillion surplus in 10 years to a $4.4 trillion deficit (including $2.4 trillion in borrowing from Social Security) under current law, according to Congressional Budget Office estimates. And even if, as some analysts expect, the next economic and budget forecasts due out from the government show a somewhat improved deficit picture as the economic recovery boosts revenues, the overall picture remains unchanged.

Yet, despite the different thrusts of Bush's and John Kerry's domestic policies, the budget impact of their proposals is surprisingly similar, deficit hawks say. Both espouse domestic policies that would add about $1.2 trillion to the deficit over the next decade, says Leonard Burman, who was a Clinton administration Treasury official and is now a senior fellow at the Urban Institute. "The two plans, in terms of their overall effect on the budget, are not that much different," Burman warned at the Brookings event.

Each candidate disputes this interpretation (while accusing the other of budget-busting). Both have promised to cut the deficit in half over the next four years, and to restore discipline to the budget process. Bush touts his economic plan as one that creates economic growth, thus helping to reduce the budget deficit. And his supporters say that he has already proposed ways to tackle the approaching costs of entitlements for the elderly. Kerry cites his early support of the 1985 Gramm-Rudman-Hollings budget controls as evidence that he will do what it takes to get deficits under control.

But deficit hawks say that the rosy short-term promises mask the big trouble looming ahead for America's fiscal Titanic -- Social Security and Medicare -- when Baby Boomers begin booking retirement cruises starting in 2008. Neither candidate, they complain, has a feasible plan to handle these problems.

The More Things Change

Rewind the tape to Campaign 2000, and two things stand out: how much the world has changed, and how little the candidates' fiscal policies have changed in response.

Back in 2000, as the Urban Institute's Burman reminded the Brookings crowd, "government forecasters were predicting a 10-year surplus of $5.6 trillion, we were at peace. And both candidates for the presidency were promising tax cuts -- Bush's bigger than [Al] Gore's." Now, he notes, "the 10-year forecast is for about $2 trillion in deficits, not counting the $2.4 trillion that we plan to borrow from Social Security... We're at war, ... and both candidates for the presidency are promising tax cuts -- Bush's bigger than Kerry's." (Any talk about "saving" the Social Security surplus for Social Security has all but disappeared, Burman also points out.)

While there are substantive differences between the candidates' domestic policies, what's striking, from a budget standpoint, is their similarities.

Both Bush and Kerry want to make permanent most of the tax cuts that Bush got Congress to pass in 2001 and 2003. As it is, most of the cuts are slated to expire in 2010, when the taxes and rates in place in 2001 would be restored. If that seems like a helluva way to run tax policy, it was, nevertheless, the arrangement agreed upon by the administration and Congress to avoid owning up to the cuts' burgeoning costs in the out-years, when the cuts have been fully phased in.

Bush would preserve the lower marginal tax rates and the correction of the "marriage penalty." He would repeal the estate and gift taxes -- now gradually being phased out -- after 2009, and preserve lower rates on dividends and capital gains. All of this would cost about $1.2 trillion over the next decade, with most occurring in the last four years of the decade, says Burman.

Kerry would extend Bush's tax cuts, with two important differences: Those families with incomes of more than $200,000 a year would face the higher income-tax and capital-gains tax rates that existed before Bush's cuts. And Kerry would maintain, rather than repeal, the estate and gift taxes, but with higher exemptions and lower tax rates. All of this would cost just over $388 billion over the next decade.

Although Kerry's broad tax cuts would cost less than one-third of what Bush's would cost, Kerry also proposes another $952 billion over 10 years in tax credits and new spending for his signature health care plan. That makes the overall cost of his proposals similar to that of his Republican rival's.

Both candidates also have additional initiatives that would cost around $200 billion over the next 10 years. Bush proposes new tax breaks for health insurance, savings, and charitable giving. Kerry proposes a national education trust fund to pay for a variety of elementary and secondary school programs, and he wants a "College Opportunity" tax credit.

The candidates, not surprisingly, would prefer to talk about the short run: that golden grace period when the economic recovery guarantees higher tax receipts, but before the full costs of the tax cuts and new initiatives have hit. It's no accident that Bush and Kerry promise to halve the deficit within four years -- but neither says much about what happens after that.

Bush calls for holding domestic spending -- outside of defense, homeland security, and entitlements -- to an annual increase of less than 1 percent. He says he'd impose a pay-as-you-go rule requiring all new entitlement spending (but not tax cuts) to be offset with spending cuts (but not tax increases).

Budget hawks complain about the blinding optimism and glaring omissions in Bush's plan, which is outlined in his fiscal 2005 budget. On his pledges to rein in other discretionary spending, they note that the president doesn't have a good track record: Bush has never followed through on his earlier proposals to restrain spending and institute budget controls.

They also consider his budget assumptions suspect. Already, in late June, for example, the Congressional Budget Office came out with a new estimate of the likely cost of military operations in Iraq and Afghanistan for fiscal 2005 -- and concluded it was likely to be more than double the $25 billion requested by the Bush administration.

Then there's the matter of fixing the infamous alternative minimum tax. Created to keep high rollers from unduly reducing their tax bill through creative use of deductions, the AMT is fast on its way to becoming the Tax That Ate the Middle Class. Bush and Kerry, however, propose just a short-term fix -- at a cost of $23 billion between 2005 and 2009. But that would allow the number of victims to grow from 3.6 million to 30 million -- something no president or Congress is likely to permit. The Tax Policy Center, a joint project of the Urban Institute and the Brookings Institution, estimates that a modest fix -- under which the number of victims would merely double -- would cost the Treasury about $196 billion over the next five years, and a whopping $769 billion over 10 years, in combination with Bush's tax cuts (and somewhat less with Kerry's).

As a candidate without access to the government's fleet of budget aides, Kerry doesn't yet have a budget proposal that allows scrutiny of his assumptions, as Bush's budget reveals his. The Democrat says that, in a world in which most of the Bush tax cuts would otherwise be extended, his proposed tax hike on upper-income Americans will pay for his health and education initiatives -- once offsetting savings from his health plan are factored in. But there is yet to be an official government scoring of Kerry's initiatives. Kerry gives no hint that he is prepared to spend less on defense or homeland security. He has pledged to hold other discretionary spending increases to the rate of inflation and has proposed reinstating the 1990s' pay-as-you-go budget rules, which were allowed to expire, on both new entitlement spending and tax cuts.

Even if Kerry's accounting for his initiatives is correct, his budget plan seems to suffer from the same optimism and omissions as Bush's. His major proposal to cut the deficit consists of creating a commission to identify and list "unnecessary corporate welfare" to eliminate. Congress would face a simple up-or-down vote on the list. Kerry cites estimates from Sen. John McCain, R-Ariz. -- an ally on this topic, as well as a friend -- that attacking corporate welfare could save taxpayers "tens of billions of dollars each year."

The Republicans say that Kerry's plans don't add up, and that his proposals would leave a $1 trillion shortfall. Kerry's pay-as-you-go rules seem to kick in only after his middle-class tax cuts are made, argued James Capretta, a Bush campaign aide, at the Brookings forum. And, Capretta continued, the Kerry campaign's vow to scale back promises in line with budget realities can prove politically difficult. "I can tell you from experience at OMB, the constituencies that were promised something before will remember," he said.

Bush and Kerry having been telegraphing to select constituencies, if not to the general public, that they will tackle deficits. Bush aides have been telling conservatives that they will scale back spending, while Kerry has been telling deficit hawks that regardless of his campaign initiatives, he, like Clinton, will do what it takes to deal with deficits once in office. Kerry is "willing to sacrifice his own priorities if he can't figure out a way to fit them in the context of a responsible, reliable budget," said Jason Furman, a former economic aide to President Clinton who is now director of economic policy for the Kerry campaign. Indeed, Kerry has already scaled back his early campaign wish list in light of the worsening deficit situation, Furman said.

Deficit hawks aren't reassured.

"What bothers me the most about the plans is what the two camps agree on" -- large middle-class tax cuts, and no serious fix for the alternative minimum tax, said the Urban Institute's Burman. Such agreement often becomes the basis for congressional action, he said.

And it's what happens after four years that really troubles deficit hawks. That's because the true cost of the tax cuts will really come home to roost then, and because the Baby Boomers will be starting to retire then. In a recent paper, Urban Institute senior fellow Rudy Penner, a former Congressional Budget Office director, took a look at three government-produced long-term budget scenarios that he deemed pessimistic but not unreasonable. The gloomiest, from the Government Accountability Office, assumed a continuation of the Bush tax cuts; projected discretionary spending being held to its current 20 percent of GDP; and took the midrange estimates of entitlements for the elderly from the Social Security actuaries. The result, he said, was "truly frightening," with national debt exceeding 100 percent of GDP in 2022, and 150 percent of GDP by 2028. The best of the three scenarios, from the CBO, still had deficits exceeding 10 percent of GDP in 2027 and interest payments on the national debt consuming nearly 20 percent of total spending.

Thus far, neither Bush nor Kerry has proposed any comprehensive plan to trim the growth of entitlements, let alone one that can pass true bipartisan muster.

Bush has yet to deliver on his 2000 campaign promise to address Social Security's problems with a plan allowing individuals to divert some share of their payroll taxes into private investment accounts. With the return of deficits, such a plan would likely face very tough resistance. Opponents are already bandying about such a plan's likely $1 trillion-plus in costs over the next decade. And as a chart in the 2004 Economic Report of the President shows, such a plan would probably cause the deficit to balloon over nearly four decades, adding at its peak nearly 1.6 percent of GDP before producing savings. The plan's addition to the national debt looks something like a parabola spanning nearly 60 years -- peaking at more than 23 percent of GDP in 2036.

Bush's original idea for overhauling Medicare -- by far the larger challenge -- was to use the promise of prescription drug benefits to entice (some said coerce) the elderly to join competing private health plans. Whether this approach would save money remains unclear. But in any event, Bush couldn't sell the idea to Congress, despite a Republican majority. Instead, Congress passed the drug benefit and whittled the proposed private-plan competition down to a demonstration project that will begin in 2010.

When it comes to entitlement reform, Kerry has said more about what he won't do than what he will do. Although he has promised to keep Social Security "viable," he has ruled out even partial privatization or any raising of the retirement age. He has hinted he might be open to raising the income cap on payroll taxes for those with the highest incomes.

On Medicare, Kerry has opposed Bush's goal of steering seniors into HMO-like plans, but hasn't suggested how he would rein in costs.

No More Perots

If the 1992 campaign season was the high-water mark for the deficit as a political issue, the 2004 campaign season may turn out to be the low-water mark.

Up until the Reagan era, the deficit was typically a weapon that Republicans used to oppose Democrats' expansive philosophy of government. Under Reagan, Republicans discovered that simply cutting taxes was a more popular means to the same end.

But by the end of the 1980s, the moral high ground went to centrists of both parties, who argued that deficits would hurt both the economy and future generations. First, George H.W. Bush was persuaded to reverse a campaign promise and raise taxes, and later Bill Clinton was persuaded to do the same.

Since the late 1990s, however, bountiful surpluses, followed by recession and the fallout from 9/11, have eclipsed deficits as a political issue with the public. Conservatives dismissed clamor on the deficit as the sour grapes of Democrats angry that the tax cuts would go to the wealthy and would force -- or so they feared -- cuts in the size of government.

But even free-marketeers who have raised warnings about the administration's fiscal policies have been rebuffed. One of these, the ill-fated former Treasury Secretary Paul O'Neill, captures the culture clash in an indelible, and perhaps apocryphal, exchange in his tell-all book. "Reagan proved deficits don't matter," he quotes his longtime friend and onetime ally, Vice President Cheney, as telling him, when O'Neill -- not long before being fired -- raised concerns about a second round of tax cuts.

What's glossed over in this summary is that Reagan himself approved a series of tax hikes. The tax increase the president approved just one year after his historic 1981 tax cut was the largest peacetime tax increase ever, Bartlett notes.

Still, evidence of the relationship between deficits and interest rates has been cloudy, with different academic studies producing widely varying conclusions. Now, in an election year, even while the return of deficits has not registered as much of a campaign issue, it has become a fiercely fought ideological matter among Washington intellectuals.

Former Clinton Treasury Secretary Robert Rubin, in a speech at the American Economic Association in San Diego in January, criticized the Bush administration's budget policies and warned that the full damage wrought by the return of deficits had yet to be felt.

That salvo was followed by a paper by another Clinton administration economic adviser, Peter Orszag, who is now a senior fellow at the Brookings Institution, and his Brookings colleague William Gale. They searched the academic literature for a consensus on deficits' impact on interest rates. Their conclusion: Although studies vary widely, those that looked at the effect of expected future deficits overwhelmingly found a corresponding rise in long-term interest rates. The size of the impact: A projected rise in budget deficits of 1 percent of GDP raises long-term interest rates by 0.3 to 0.6 percentage points.

In early July, conservatives struck back with a study by two of their own leading intellectuals: R. Glenn Hubbard, who spent two years as chairman of President George W. Bush's Council of Economic Advisers and is now dean of the Columbia Business School, and American Enterprise Institute resident scholar Eric M. Engen. Using their own economic model, they concluded that an increase in government debt equivalent to 1 percent of GDP would increase real interest rates by only 0.02 or 0.03 percent.

It might look as though the two sides had temporarily fought to a draw. Orszag, however, argues that the Engen-Hubbard study reinforces, rather than refutes, his own analysis. The appearance of disagreement comes from the fact that the two studies measured different things: One study looks at an increase in the deficit; the other looks at an increase in the federal debt, which represents many accumulated deficits. Orszag argues that when the Engen-Hubbard study looks at a 1-percent-of-GDP addition to deficits over 10 years, it shows interest rates rising by 0.3 percent. Such a finding is not too different from his own.

Looking Ahead

Both the politics and the economics of deficits are likely to be driven at least as much by perceptions as by data.

In the political arena, for example, some supply-siders are beginning to worry about the fiscal gap created on Bush's watch. They're particularly incensed by the cost of Bush's new Medicare prescription drug benefit. "Conservatives can always rationalize tax cuts, but our side isn't supposed to create new entitlement programs," Bartlett told the Brookings audience.

And although Wall Street has seemed to shrug off both near-term and long-term deficit forecasts, that may begin to change next year. "At the moment, the deficit is easy to finance," says Ethan Harris, chief economist for Lehman Brothers. "Corporations are reaping profits at a rapid rate, and they have modest borrowing requirements, so there's not much competition between the federal government and the corporate sector."

Also, businesses are still reaping huge benefits from the 2003 tax-cut legislation, which allows faster write-off of equipment purchases. "These are enormous tax breaks that will put $100 billion in corporate coffers in '04," says Mark Zandi of Economy.com, an economic consulting and research firm.

But borrowing may soon increase as businesses expand with the economy, and as the tax cuts that gave them extra cash expire (and not even Bush has plans to extend them). Extra demand needn't necessarily drive up interest rates, because in the global economy, foreign investors often meet the demand for more money. "We've grown accustomed to the kindness of strangers," says Harris -- especially the kindness of Asian central banks, which have been loading up on U.S. Treasuries in a bid to keep their currencies cheap and thereby continue boosting exports.

Last year, Harris says, Asian central banks bought enough U.S. Treasury debt to effectively finance half the federal deficit -- something he calls "unprecedented."

Different economists see different risks to all the foreign lending. Some, like Morgan Stanley's Stephen Roach, say the indebtedness to foreign banks makes the United States more vulnerable to swings in the value of the dollar and in interest rates, and such swings could put the current recovery at risk.

Harris warns that overreliance on foreign lenders is "a chronic vulnerability; it lulls American policy makers to sleep and creates the illusion of free budget deficits, with no impact on interest rates and no trouble for Treasury auctions."

Similarly, he says, deficits are rarely a driving consideration for the bond markets on any given day. Their impact is "more subtle and long-term" and is likely to show up in several years as "an embedded premium" on interest rates.

Greg Valliere, the chief strategist of the Washington Research Group of Charles Schwab, thinks that the deficits' impact on the bond markets is "overplayed." But he also argues, "As we go into next year, with interest rates going higher, there will be an inclination to look for scapegoats" -- and these will include budget deficits.

Anthony Crescenzi, chief bond market strategist at Miller Tabak, says that the bond markets are suspending judgment on deficits now, waiting to see the next president's budget. The bond markets, he says, will look to see the trajectory of the deficit. "If it looks like it's getting a lot worse, then the deficit would have an effect."

But Crescenzi adds, "The trajectory never seems to get worse and worse. There seems to be a self-correcting process, where government seems to rein itself in."

It's a revealing comment, one that may suggest yet another reason why markets haven't thus far reacted to dire budget forecasts. Two decades of deficit-reducing budget deals, in every administration from Reagan's to Clinton's seem to have persuaded Wall Street, if not Washington's budget hawks, that no president, and no Congress, could ever really allow deficits to get out of control.