787 September 4,1990 1 RxFORTHEFEDERALDEFICIT THE FOUR PERCENT SOLUTION INTRODUCTION George Bush has lost the first round of the budget sum mit negotiations with congressional leaders. After five months of negotiations and even his offer to renege on his no-new-tax pledge, the President has expressed his frustration at the failure of Democrats to offer a serious plan and says he will veto bud g et-busting spending bills returns from its summer recess. At the summit table Bush should offer con gressional negotiators a choice: accept a Four Percent Solution budget plan that would lead to a balanced budget by 1997 by limiting spending increases to f our percent per year, or face the sequester cuts imposed by the Gramm Rudman-Hollings budget law to bring the deficit down to next years re quired $74 billion target. Bush must let Congress and the American people spenders use scare stories about the dang er of such an action as an excuse for higher taxes Calling Congresss Bluff. With the crisis in the Persian Gulf and with con gressional elections only a few months away, Bush holds all the trump cards.

If he is willing to play them and to call Congresss bluff, he can win a budget deficit reduction agreement and still keep his pledge not to raise taxes.

As negotiations to reduce the budget deficit failed to produce an agree ment during the spring, the Wh ite House attempted a three-part strategy to break the stalemate. First, Bush accepted the advice of Budget Director Bush need not lose the second round of budget talks when Congress know that the country can survive with a budget sequester and not let bi g Richard Darman and Trsasury Secretmy Nicholas Brady to reverse his cam paign pledge of "no new The result: No budget deal, and a succession of spending bills passed by the House of Representatives that will send fiscal 1991 spending levels more than 11 p ercent over fiscal 1990 levels.

Second, the Bush team crafted a package to increase excise taxes on beer and other items.The result: No budget deal, and no comparable budget proposal from the liiral congressional negotiators. Instead, Bush was criticized b y the mres of groups that would be hit by the new taxes.

Third, in his mid-session review of the budget, Darman turned to scare tac tics. He warned that a $100 billion sequester would cut off essential services to the American people.The result: Still no budget deal, nervous tremors rip pled through financial markets, and many people began to talk seriously of an impending recession.

Return to Basics. To gain the upper hand in the second round of negotia tions, Bush must recognize that the Darman/Brady st rategy has failed. In place of it, Bush should return to the conservative basics: reducing the tax burden on Americans and limiting the growth ofgovernment.

He should tell the American people that for the past decade members of Congress have been talking about "solving" the deficit problem while, at the same time, going on a spending spree which has consumed the hundreds of billion of dollars in new tax revenues which were being collected.

He should tell the American people that now is the time to slow th is spend He should propose that starting in -1991, which begins this October 1 ing binge Congress be dowed to increase total federal spending by only four percent over the previouS year's levels. He should explain that by limiting congres sional spending increases to a generous four percent a year for the next six years, the budget will be balanced by fiscal 1997.

Essential Services Secure. He should announe that if Congress does not accept this Four Percent Solution, then he will allow the budgetatting ax of the Gramm-Rud~nan-Hollings sequester to fall on all spending, cutting $100 billion from the budget. He should assure Americans that this will not cut es sential services such as Social Security. But it will fall hard on government e Cannot hold-spendh g increaseis to foir percent per y-.

Bush's message to America, as the budget summit reconvenes, should be unambiguous: The time for budget games is over, the time for the federal government to live with a four percent annual spending increase has come and if the time comes for Bush to invoke the automatic cuts of a sequester, he will not flinch. workers and big-spendhg liirals who will have to explain to the voters why 2 SPENDING IS OUT OF CONTROL Advocates of higher taxes maintain that only new revenues c an reduce the budget deficit. Experience teaches, however, that new revenues do not reduce deficits. From fiscal 1982 to fiscal 1991, for example, aggregate federal tax revenues grew annually by roughly 3.3 percent above the rate of in flation Over this p e riod, this brought in an extra $254 billion in revenues a Spending and Tax Collections Fiscal 1982 to Fiscal 1991 1989 Dollrrr billiond 82 '83 '84 '86 '88 '87 '88 '89 '90 '81 1990-1981 doer not includ. S6L Bailout HerltagrDatrChrrt 1982 1983 1984 1985" 19 8 6 1987 1988 1989 1990 1991 939.35 I 976.18 36.83 992.77 16.59 1070.17 77.40 1093.48 23.31 1080.79 -12.69 1107.94 27.15 1142.60 34.66 1159.50 16.90 1194.06 34.56 Total $254.71 778.24 725.34 776.80 830.19 849.24 91 9.60 946.50 990.70 1002.03 1031.96 Total 1 6 1.11 51.46 215.97 53.39. 239.98 19.05 244.24 70.36 161.19 26.94 161.40 44.16 151.90 11.33 157.47 29.93 162.10 52.90 250.84 253.72 Fiscal 1983: Recession Lowers GNP Fiscal 1984 and 1985: The tax cuts of 1981-1984 boost th economy Fiscal 1990 and 1991 Does not Include the S&L Bailout. after adjusting .for inflation. Whathap pened to this quarter-trillion dollars?

Congress did not use it to reduce the deficit; Congress spent it dollar-for dollar. During fiscal years 1982 to 1991, aggregate federal spending grew annually by roughly 2.7 percent over the inflation rate, or an inflation adjusted total of $255 billion.

Some critics charge that the budget deficit is the result of Ronald Reagan's rebuilding of the American arsenal, a policy now vindicated by the spe ed with which the U.S. is deploying massive forces to the Per sian Gulf. Yet, defense spending ac counts for only 18 percent, or $45 bil lion, of the ten-year 255 billion real increase in spending. Since 1988 moreover, defense spending actually has gone d own in real terms by 7.7 percent, a reduction of $23 billion.

These savings were more than offset by real increases in non-defense spending. (See chart on page 4 Ex cluding interest payments on the na tional debt, non-defense spending has risen in inflatio n-adjusted terms by 106 billion since 1988, an increase of The budget deficit thus has not been due to lack of revenue nor to high defense spending. New revenues have been rolling in for a decade.The problem has been that Congress spends every new dollar, And most of this is on wasteful pork barrel programs nearly 17 percent 3 I MISSED OPPORTUNITIES With the economy deep in a recession, the federal deficit jumped to $127 billion in fis cal 19

82. Thiswas 4.1 percent of gross national product GNP the greate st post World War II share except for the 4.8 percent in 1948 and the 4.3 percent in 1976 Worse yet, total federal spending in fiscal 1982 was at 23.8 percent of GNP, the highest level since 1944, and federal taxes were at 19.7 per cent of GNP, the third h ighest level since 1945 could have lived with the 1982 level of spending. If Congress had controlled its As bad as that was, the U.S Defense vs. Non-Defense Spending Fiscal 1982 to Fiscal 1991 1080 Dollorr (billionr 800 000 400 200 0 '80 *el '82 '83 '84 ' 8 6 '811 '87 '88 '89 '90 '91 war Non-defenae rpnding excluding intonat payment8 1890-1001 doe8 not includ. 86L Bailout HerltrgeDitrChart spending habits that year, and simply kept annual growth of federal spending to the rate of inflation, the subsequent gr owth in tax revenues would have eliminated the deficit by fiscal 1988 and created a $92 billion surplus by fiscal 19

91. Obviously, the deficit was not erased by 19

88. Instead, the deficit was 161 billion the same inflation-adjusted deficit level it was in 1982.

Second Chance Wasted. Though Congress missed the opportunity in 1982 to cap spending at the rate of inflation, it had a second chance in fiscal 1988.

Increased tax revenues since then would have reduced the deficit to $75 bil lion by fiscal 1991 only $1 billion above the Gram-Rudman-Hollings deficit reduction target. And this would have created a $13 billion surplus by fiscal 19

94. Instead, the inflation-a djusted fiscal 1991 deficit is expected to be about $162 billion again, roughly the same as the 1982 deficit and the 1988 deficit. me hundreds of hours that budget negotiators have been spending in their summit" deliberations this year could have been avo i ded hiid-Congress not spent every new dollar of tax revenues generated by economic expansion resulting from the Reagan tax cuts of 1981 through 1984.The only check on this ten-year spending spree has been the Gram-Rudman-Hollings budget law, which sets de f icit targets each year and mandates automatic cuts if the 4 targets are not met. According to Heritage Foundation Economist Daniel J Mitchell, federal spending today would be $300 billion greater than it is had Gramm-Rudman-Hollings not slowed the nominal 9.9 percent increase of congressional spending from 1980 to 1985 The annual pace of spending in creases slowed to 4.8 percent after Gramm-Rudman-HoKngs went into ef fect in 1986 THE FOUR PERCENTSOLUTION The past ten years demonstrate that raising taxes do es not eliminate the federal budget deficit. Raising taxes merely prompts Congress to raise government spending. What is required to eliminate the federal deficit is to hold the growth in overall federal spending at, or near, the rate of inflation.

Bush sh ould offer just such a plan at the budget summit as the most effective and reasonable way to reduce the deficit To be sure, it is difficult to predict future inflation rates. But since inflation in recent years has been averaging roughly four percent, it is reasonable to as sume that aggregate federal spending would keep up with inflation if the spending grew annually at four percent.

Among other things, this would create an incentive for the federal govern ment to hold down inflation. If inflation goes a bove four percent but spending is held at that level, the government will find that its revenue buys less and Rx For Chronic Deficits The Four Percent Solution Enacted in 1991 Current Dollare billionr 50 1 I Surplua SA will be forced to cut programs from Deficit to Surplus. If a "Four Percent Solution" is prescribed for fis cal 1991 and beyond, this medicine will eliminate the deficit by the end of fis cal 1996, and create an $11 billion surplus at the beginning of fiscal 1997 This does not include the c o st of paying for the S L cleanup nor does it account for changes in tax policies I I PO '81 '92 '93 '94 '86 '96 '81 bar Her1 trgeDataChrrt quires more time than envisioned by the original Gramm-Rudman-Hollings timetable.Thus the timetable will have to be revised as follows 1 April 3,1990.

Daniel J. Mitchell Save the Gramm-Rudman Sequester Heritage Foundation Backgrounder No. 763 5 The Four P ercenl Solution Timetable 1991 1992 1993 1994 1995 1996 1 997 Current Dollars billions Deficit $134 $1 12 480 so 28 8 11 2.25% 1.7% 1.16% 0.68% 0.36% 0.09 GNP Constant 1989 Dollars billions Deficit GNP 1 24 468 a1 423 s 28 1.7% 1.16% 0.68% 0.36% 0.09 2.25 Because the economy generates increased tax revenues just about all the time, the Four Percent Solution allows abou t $50 billion in new spending each year. Lawmakers can distribute this pool of money throughout the budget as they wish to offset inflation, to fund new programs, or increase spending for different programs.This would have the healthy effect of forcing mem b ers of Congress to set budget priorities present method of baseline budgeting. Under this approach, introduced in the 1974 Budget Act, spending for each program automatically increases by a projected rate of inflation and projected program growth. This au t o matic increase creates the new baseline for the program. So doing, it enormously distorts budget calcula This approach would require the federal government to abandon its The Four Percent Solution Compared to Baseline Spending tions and confuses the pub l ic discus- Curront Dollara (billionr sion of spending. Example: a pro gram that costs $100 million in one SIB00 1700 year might be projected by the baseline budgeting method to receive 110 billion the following year. If Congress appropriates $105 million f or the program, this is recorded as a 5 million cut by the baseline method. In fact, of course, this is a $5 The baseline budgeting charade is 5,600 1500 million dollar increase l2O0 the reason why federal spending soared in the 1980s despite all the clai m s of spending cuts. Congress Management and Budget, uses baseline budgeting to disguise their failure to cut spending.The baseline budgeting method should be and latefy the Presidents Office of 80 81 92 83 84 86 96 87 88 War HrritagaDataChart 6 dropped. A commonsense method should replace it. The word cut should be used only if a program costs less than it did in the previous year. The word increase should be used any time a program costs more than it did in the previous year This is the method and vocabul ary used by Americans to run their household budgets and by corporations to run their business budgets.

Like the Average Taxpayer. While an absolute freeze in federal spending would eliminate the deficit very rapidly, it probably is politically unpalatable and too inflexible.-A Four Percent Solution has the virtue of allowing the federal government to have about the same rate of spending growth as that enjoyed by the average taxpayer.

To the average taxpayer, a four percent annual growth in spending, which matches the increases in general cost of living, probably seems very reasonable. Anyone advocating higher levels of federal spending should be seen for what he or she is: a big spender HOW TO LIVE WITH A SEQUESTER To win congressional approval for the Fo ur Percent Solution on govern ment spending, Bush will need substantial bargaining leverage with Congress.

If the President believes that the government cannot function with a Gram Rudman-Hollings sequester for even a short time his bargaining position wit h Congress is greatly weakened. Bush therefore must understand and make clear to budget summit participants and to the American people that it is possible for the federal government to cope with sequestration for even several months without disrupting maj or services and without significant in conveniences to the public. Even a full-year sequester, though painful and re quiring creative solutions, would be manageable for domestic programs.

According to the current baseline budget projections, federal spendi ng in fiscal 1991 will grow by 7.46 percent, or $90 billion over this years spending level.Thus, a $100 billion sequester for fiscal 1991 actually is no more painful than living with all of fiscal 1990s $1.2 trillion in federal spending less $10 bil lion. Moreover, a full sequester for fiscal 1991 merely would bring federal spending back to fiscal 1988 inflation-adjusted levels.

Summit Scare Stories. Budget summiteers who favor higher taxes and higher spending are using scare stories about the effects of a sequester. They want Bush to bow to their pressure and accept their policies.They claim that a sequester would shut essential federal services and cause severe economic hardship for the American people. They are wrong. The fact is, a sequester need not d o anything of the sort. Bush already has said that if a sequester comes, he will manage it as best he can.To this he should add that he finds that he could manage a sequester quite well percent cap on spending increases or 2) face a sequester.

Then Bush should give the budget negotiators a choice: 1) accept the four 7 In telling Congress that he can manage a sequester, Bush should make two First, major federal programs are exempt fkom the sequester. Most government services that directly and im m ediately affect the public are exempt from sequestration. Continuing as usual would be Social Security, Medicaid, Food Stamps, and the Women, Infants, and Children (WIC) program.The sequester only affects $125.3 billion of the roughly $900 billion in non defense spending.

Second, staffing reductions and cutbacks in work hours in most cases will be adequate to meet sequester targets. In most agen cies and departments affected by a two- or three-month se questration, the major cuts would be in personnel payr oll. Most non-defense agencies and departments could meet sequestra tion targets for several months merely by putting their work force on a three day schedule. Key staff could be kept on a full work week while workers in non-essential staff positions were furloughed for the entire period points especially clear HOW TO MANAGE A TEMPORARY SEQUESTER If a stalemate develops in the budget negotiations, Bush can and should ac cept a sequester. In the budget negotiations, while a sequester is in effect, he will h ave the upper hand. There are four steps to managing a sequester.

Step #1: On the day that the sequester goes into effect, the President should request that personnel in key defense and non-defense positions listed below, volunteer to continue operations f ull-time even though their pay officially is reduced to part-time levels. The President would promise full retroactive compensation for their volunteer services as soon as emergency appropriations legislation is passed.

Step #2: The President should require Congress to remain in emergency session until it passes legislation to exempt a few vital domestic functions from sequester for the approximately three months until Congress recon venes in January 19

91. While the public would not feel any pain from a se quester for most of the affected programs, such as the American Battle Monuments Commission and the Christopher Columbus Quincentenary Jubilee Commission, it would from several vital domestic government opera tions like 1) Meat and Poultry Inspection 2 ) Quarantine and Inspection Functions 3) Some FBI functions 8 I 4) Many Federal Prison System functions 5) Some Postal Service functions 6) Air Traffic Control functions.

To fund these continuing operations, deeper cuts could be made in the remaining progr ams subject to the Gramm-Rudman-Hollings targets In the case of the Postal Service, it is possible that the effects of a temporary se quester could be entirely offset by suspending delivery of all non-solicited third class mail, or junk mail. Otherwise, t h ree days-per-week mail delivery would accomplish the same goal.The President might ask Congress to allow private carriers to deliver First Class mail to help take up the slack in the sys tem Step #3: The President should ask Congress to exempt from seques t er Per sian Gulf military operations and other Pentagon and State Department func tions directly related to Persian Gulf operations. In essence, the President would be daring Congress to leave American forces in the Gulf stranded without adequate supplies and support.

Step #4: As for other Pentagon operations, the Gramm-Rudman-Hollings law allows the White House to exempt salaries and benefits to military per sonnel. For the rest of its functions, the Pentagon would manage by cutting training and practice time for forces not involved in the Persian Gulf deploy ment, delaying maintenance of facilities, and furloughing civilian personnel.

There are very many non-vital military functions that could manage through a sequester. For example, the Pentagon could: furlough civilian Defense Department workers involved in facilities maintenance, procurement, and re search and development activities; halt research, development and produc tion of submarines and other expensive projects that will not come on line for ma n y months or even years; and close many non-essential military facilities such as commissaries and the War College MAKING THE MOST OF THE SEQUESTER Once the emergency legislation is passed to exempt vital functions, the President can release members of Con gress to go back to their districts.

There they will have to explain: 1) why they reject the Presidents Four Per spending habits; and, 3) why they refuse to reach a negotiated budget with the President and, thus, force the government into an sequester duri ng the midst of an international military crisis. In such as situation, pressure will mount on Congress to approve the Four Percent Solution. In reality, there fore, the sequester probably would last no more than a month or two cent-Solution; 2) why they w ant a tax increase rather than control their 9 CONCLUSION For ten years Congress has pushed federal spending to record levels, all the while crying that the White House was slashing spending to the bone. Now Washington faces what it calls a deficit crisis . Perhaps the crisis is only an in side-Washington political game designed to fool the public into thinking that something is being done about the deficit If so, George Bush should not be part of this game.

Taking the Lead. Perhaps, however, Washington this time -really wants to reduce the federal deficit. If so, then new taxes are not the answer; they will lead only to new spending. Drastic spending cuts also are not the answer.

They will be too distasteful politically. What may be an answer is a Four Per cent Solution. This prescription raises no taxes. It need cut no programs. It gives the federal government an increase in allowance every year an in crease that is about the same as that received by American households. It tells Congress that it must liv e with this increase. And if it does, the federal budget will balance by the end of fiscal 1996 and show an $11 billion dollar surplus the following fiscal year.

Congress, throughout the budget summit process, has been demonstrating that it will not take t he lead in solving the budget crisis. George Bush thus must lead. He must be willing to confront Congress by giving lawmakers a choice: the Four Percent Solution or a sequester. Congress has everything to lose if it forces a sequester. All the cards are i n the Presidents hands Scott A. Hodge Grover M. Hermann Fellow in Federal Budgetary Affairs I I Heritage Foundation Policy Analyst Robert Rector contributed recommendations on managing federal programs during a sequester 10