How The Surplus Was Lost


It's still amazing how quickly we went from visions of endless surplus to the reality of permanent deficits. How did that happen?

The official line from the administration and its ever-willing apologists is clear: it's all because of runaway spending. That case will be made through whatever debating tricks they can think of. Mickey Kaus's non sequitur about me and Robert Reischauer - see, Reischauer says spending affects the deficit, so Krugman is wrong! - is nothing compared to what will be coming soon.

By the way, Reischauer and I don't have any major points of disagreement I can detect. Reischauer is, understandably, unwilling to get dragged into this; he has given me permission to post this statement, which is absolutely consistent with what I've been saying. In fact, he adds another point: the true costs of the tax cut will be much larger than the headline number, both because of the nonsense about the last year ("the extension of EGGTRA") and because of the looming collision of the tax cut with the alternative minimum tax ("the unavoidable costs of fixing the AMT").

But what's the real story? Let's go back to the budget situation on the eve of the 2000 election.

It's startling, now that we look back, to realize how short-lived the actual era of surpluses was. The federal budget first moved into overall surplus in fiscal 1998; but there was still an "on-budget" (non-Social-Security) deficit. We achieved an on-budget surplus in fiscal 1999, but a tiny one ($1.8 billion). We achieved a significant on-budget surplus in only one year: $87 billion in fiscal 2000, corresponding to an overall surplus of $236 billion.

What we should have realized even at the time was that revenues that year were swollen by temporary factors. The economy was running very hot, with growing inflationary pressure; my back-of-the-envelope calculation says that this swelled revenues around $40 billion compared with their sustainable level. The bull market contributed even more, probably more than $100 billion in a temporary revenue windfall. The "structural" budget surplus - the surplus you could have expected from the same tax and spending policies under more normal economic conditions - was probably less than $100 billion, all of it accounted for by Social Security.

There's an obvious conclusion from this, but one that I haven't seen stated explicitly: a candidate who promised not to tap the Social Security surplus, and to expand, not cut, domestic programs - and let's not forget that Bush very explicitly made both promises - had no business proposing any permanent tax cut whatsoever. The money simply wasn't there.

So where did all that stuff about $5.6 trillion surpluses come from? From two misconceptions. First, budget projections were made as if the hot economy and soaring stock market would go on forever. Second, those budget projections made the absurd assumption that unchanged policy means zero real growth in discretionary spending. This almost guarantees that at the end of a 10-year projection there will be big surpluses; but as I explained in my last post, zero real growth in a growing economy is in effect severe austerity rather than unchanged policy.

In short, we got snookered. There was never a case for a long-term tax cut.

But how did things get so bad, so quickly? This year's deficit will be around $165 billion - a non-Social-Security deficit of more than $320 billion. So we're $400 billion down from the surplus just two years ago. What happened?

Here's a very rough guess at how the accounting works:

- about $30 billion is due to Sept. 11-related spending

- about $60 billion is due to tax cuts that have already taken effect

- about $160 billion is due to the economy's depressed state

- about $150 billion represents the disappearance of one-time factors that swelled the 2000 surplus.

That's very rough, and I am happy to have my estimates improved. But it's good enough to make the main points.

The key point for the future is that even a full recovery won't bring back surpluses. We're now back in an era of deficits; it's almost as if, well, George Bush were president.

Defenders of the tax cut seize on the fact that so far tax cuts account for only about 15 percent of the budget deterioration. But using that to argue that the tax cuts did no harm is disingenuous in two ways.

First, that share will rise sharply over time: most of the tax cuts haven't phased in yet. If the whole tax cut were already in place, the deficit would be around $90 billion larger; if you take into account the inevitable AMT fix, it would go another $20 or $30 billion higher. In other words, any hope that economic recovery will bring us back into the black is eliminated by the tax cuts that haven't happened yet but are in the pipeline.

Second, saying that the tax cut is OK because it isn't a big share of the current deficit is like saying that I've gained weight mainly because I've stopped exercising, so it's OK to have another couple of donuts. Put another way: the original argument for tax cuts rested on the premise that there were big surpluses to be given back. Now the surplus turns out to have been a figment of our imagination; that means that tax cuts come at the expense either of bigger deficits or of cuts in discretionary spending. And we've now had an object lesson in what cutting discretionary spending means in practice.

Given the new budget realities, the administration's determination to proceed with the rest of the tax cut is a clear, stark demonstration of priorities: in order to ensure that heirs to $15 million estates get every last dollar, veterans won't be told that they are entitled to health care, firefighters will be denied adequate equipment, and - yes - poor children will go hungry. Sorry, guys, but it really is that raw.


"Budget projections that incorporate the effects of likely future tax and spending policy indicate that the nation is in for a period of growing deficits. This contrasts sharply with the picture painted by the government's official baseline projections which show shrinking deficits followed by ever growing surpluses. While a less robust economy and spending for defense, homeland security, other discretionary items, and prescription drugs that is well above baseline levels explain a not insignificant portion of the deterioration in the budget outlook a decade hence, the primary culprit is tax policy. The extension of EGTRRA and other expiring provisions of the tax code combined with the unavoidable costs of fixing the AMT will be the difference between a sensible fiscal stance and a recurrence of the budget mess of the 1980s and early 1990s."

Originally published on the Official Paul Krugman Site, 8.26.02