This paper was researched and written by Gary S. Olson, Director of the Senate Fiscal Agency. Karen Hendrick, Executive Secretary, prepared the final version of the paper.

Introduction

On July 28, 1997, United States Congressional leaders and President Clinton announced that an agreement had been reached to bring the Federal budget into balance by fiscal year (FY) 2002. This five-year plan to balance the Federal budget included recommended changes in Federal revenues and expenditures.

The initial phases of this agreement were implemented when the United States Congress approved the Balanced Budget Act of 1997 and the Taxpayers Relief Act of 1997 during August 1997. The Balanced Budget Act of 1997 established general policy changes over the FY 1998 through FY 2002 period that would be necessary to move toward a balanced Federal budget. The Taxpayers Relief Act of 1997 put in place tax policy changes that were an important piece of the overall budget agreement. The United States Congress is currently in the process of approving specific FY 1998 Federal appropriation bills that will begin to implement the budget agreement.

This Senate Fiscal Agency (SFA) Issue Paper will review the Federal balanced budget agreement and provide some general discussion as to the potential impact of the budget agreement on State government finances. The paper also will review some of the potential risks that could lead to an unraveling of the agreement over the next five years.

Recent Federal Budget History

Over the past 28 fiscal years, Federal outlays¹⁾ have exceeded Federal receipts²⁾, resulting in year-end budget deficits. These annual Federal budget deficits have been financed by Federal borrowing which has led to an increase in the level of Federal debt outstanding. Table 1 provides a summary of Federal receipts, outlays and year-end balances for the period FY 1965 through the projections for FY 1997.

During FY 1969 Federal receipts exceeded outlays by $3.2 billion. Over the next 28 fiscal years, Federal budget deficits have ranged from a low of $2.8 billion in FY 1970 to a high of $290.4 billion in FY 1992. The latest projections of the United States Congressional Budget Office predict a $34.0 billion Federal budget deficit at the close of FY 1997.³⁾

As illustrated in Table 1, the size of the Federal budget deficit has decreased substantially over the past five fiscal years. The Federal budget deficit, which peaked at $290.4 billion in FY 1992, will decline to $34.0 billion in FY 1997. This recent decrease in the Federal budget deficit can be attributed to three primary factors.

The first is that the end of the Cold War has resulted in Defense spending falling from $298.4 billion in FY 1992 to $265.0 billion in FY 1997. The second item involves provisions of the Omnibus Budget Reconciliation Act of 1993 that provided for Federal revenue increases coupled with modest restraint in Federal expenditures. The final item that has contributed to the recent reduction in the Federal budget deficit is an unanticipated surge in Federal individual income tax receipts during FY 1997. Federal individual income tax receipts were $46.0 billion above the anticipated level in FY 1997.³⁾ This unanticipated revenue windfall probably resulted from the strong growth in the stock market and large income increases for upper income taxpayers.

These three factors combined to drive down the Federal budget deficit before the 1997 Federal balanced budget agreement was reached. Since FY 1992, the annual growth in Federal receipts has exceeded the growth in Federal outlays, which has had a major impact on reducing the level of the Federal budget deficit. Figure A provides a graph of the annual growth in Federal receipts and outlays for the FY 1993 through FY 1997 period.

1997 Balanced Budget Act

The 1997 Federal Balanced Budget Act currently being implemented by the United States Congress provides many policy changes from the current laws regarding Federal receipts and outlays. Taken together, these changes are projected to lead to a small Federal budget surplus at the close of FY 2002. Over the next five fiscal years, Federal tax changes and changes in the pattern of projected Federal outlays will be implemented to eliminate the Federal budget deficit.

Table 2 provides a summary of the projected levels of Federal receipts, outlays and the year-end balance based on the criteria outlined in the 1997 Balanced Budget Act. Beginning in FY 1998 the Federal budget deficit will increase slightly to a level of $57 billion before gradually declining and reaching a projected $32 billion surplus in FY 2002.

The path to a balanced budget by FY 2002 results from the projected annual growth in outlays for the next five years. Figure B provides a summary of the projected annual percentage changes in Federal receipts and outlays under the Balanced Budget Act. With the exception of FY 1998, the annual projected percentage growth in receipts will exceed the projected growth in outlays, leading to a budget surplus at the close of FY 2002.

A basic question that might be raised in regard to the Federal Balanced Budget Act of 1997 is: Was it really necessary for Congress to enact a balanced budget plan when the projected year-end deficit will fall to $34 billion at the close of FY 1997? Table 3 attempts to answer this question. Table 3 provides a summary of the recent Congressional Budget Office (CBO) estimates of the Federal budget year-end balances for the period FY 1997 through FY 2002. The first column of the table provides the CBO estimate of the projected Federal budget year-end balance assuming the policy changes contained in the 1997 Balanced Budget Act had not been approved. In this case, the projected Federal budget deficit would have climbed to a level of $68 billion in FY 2000 before declining to a projected $62 billion deficit in FY 2002.

The impact of the 1997 Balanced Budget Act on the budget deficit is shown in the middle columns of Table 3. The Balanced Budget Act has the overall impact of reducing Federal receipts. This translates into increases in the size of the projected budget deficit. With the exception of some spending increases in the FY 1998 budget, the Balanced Budget Act calls for reductions in Federal outlays from the previous budget laws; thus resulting in a reduction in the size of the Federal deficit. Therefore, it is clear that the provisions of the 1997 Balanced Budget Act were necessary to reach a balanced Federal budget by FY 2002.

Federal Tax Changes

The 1997 Federal Balanced Budget Act contains several changes that will affect the level of future Federal tax collections. Table 4 provides a summary of the projected revenue impact of these changes over the five-year period FY 1998 through FY 2002. Over this five-year period tax reductions will total $141 billion while tax increases will total $60 billion, resulting in a cumulative net five-year tax reduction of $81 billion. This equates to an aggregate 0.9% reduction in Federal receipts as a result of the 1997 Balanced Budget Act.

The following information provides a brief description of the major tax reductions that were included in the Taxpayers Relief Act of 1997.

Child Tax Credit: The child credit will result in a $73 billion reduction in Federal revenues over the next five years. The credit is $400 per child for 1998 and $500 per child as of 1999 for each child under the age of 17. The credit is phased out for couples with an adjusted gross income (AGI) over $110,000 and for single taxpayers with an AGI above $75,000.

Education Tax Credits: Tax credits designed to reduce the cost of postsecondary education will result in a $39 billion reduction in Federal revenue over the next five years. The first education tax credit is referred to as the HOPE credit. The HOPE credit provides for a credit equal to the first $1,000 and 50% of the next $1,000 of tuition and fees paid for the first two years of postsecondary education. The Lifetime Learning credit provides for a credit equal to 20% of the first $5,000 of postsecondary education costs after the first two years of study. These credits phase out for couples with an AGI above $80,000 and single taxpayers with an AGI above $40,000.

Estate and Gift Tax Provisions: Reductions in Federal Estate and Gift taxes will result in a $6 billion Federal revenue reduction over the next five years. The legislation increases the exemption from estate taxes from the current level of $600,000 to $1 million by 2006.

Capital Gains Tax Changes: Reductions in Federal capital gains taxes under the individual income tax will reduce Federal revenues by $2 billion over the next five years. The law provides for lower tax rates for capital gains realized after May 6, 1997. The new capital gains marginal tax rates are 10% for people otherwise in the 15% tax bracket and 20% for taxpayers in higher tax brackets. These lower rates apply to gains on capital assets held longer than 18 months. The capital gains tax rates will be further reduced to 8% and 18% beginning in 2001. The legislation also provides homeowners with a $500,000 exemption from the sale of a home provided they have lived in the home for at least two years.

Other Tax Reduction Changes: The Taxpayers Relief Act of 1997 contained several other tax changes that will reduce Federal revenues by $21 billion over the next five years. These include expansions of Individual Retirement Accounts (IRAs), numerous tax reductions for small businesses, the extension of a research and experimentation credit for business, and changes that will result in a reduction of taxes for self-employed business people.

The Taxpayer Relief Act of 1997 provides for tax increases that will total $60 billion over the next five years. The following information provides a brief summary of these tax increases.

Airport and Airways Taxes: Federal receipts will increase by $33 billion over the next five years as a result of the extension of Federal excise taxes on airline passengers, airports and airline companies. These excise taxes, which were scheduled to expire on September 30, 1997, include a 10% tax on airline tickets, an increase in the international airline departure fee, and new taxes on credit card companies that award airline tickets to their frequent customers.

Cigarette Tax: The Federal cigarette excise tax will increase from its current level of 24 cents per pack to 34 cents per pack effective January 1, 2000. The tax will further increase to 39 cents per pack on January 1, 2002. These cigarette tax increases will result in $5 billion of increased Federal receipts over the next five years.

Federal Unemployment Tax: The Federal Unemployment Tax Act imposes a 0.8% tax on the first $7,000 of wages paid to employees. Included in this 0.8% tax rate is a 0.2% surtax that was scheduled to expire on January 1, 1999. This surtax was extended, resulting in $6 billion of increased Federal receipts over the next five years.

All Other Tax Increases: The Taxpayers Relief Act of 1997 provides for a variety of other tax changes that will increase Federal receipts by $16 billion over the next five years. These tax changes include limitations on the deductibility by business of certain life insurance policies, restrictions in the tax treatment resulting from the sale of corporate assets, changes in the capital gains treatment of business assets, and changes in the carry-forward treatment of business losses.

Federal Outlay Changes

The 1997 Balanced Budget Act does provide for several statutory adjustments that will have the impact of changing the future level of Federal outlays. Table 5 provides a summary of the projected change in the level of future outlays for the five-year period FY 1998 through FY 2002. Over this five-year period Federal outlays will decrease by a total of $198 billion as a result of provisions contained in the balanced budget plan.

The following information provides a brief description of the future outlay changes that are included in the Balanced Budget Act.

Discretionary Spending: The Balanced Budget Act contains new limits on Federal discretionary spending that will have the cumulative impact of reducing discretionary spending by $89 billion over the next five years. Federal discretionary spending includes the funding of the general operations of the Federal government and grants to state and local governments. The $89 billion reduction in discretionary spending is unspecified. The Balanced Budget Act applies caps to the future level of discretionary spending and it will be up to the President and the Congress to develop appropriations that fit within the spending caps.

Medicare: Spending on the Medicare program will be reduced by $112 billion over the next six years. Most of the savings will result from reductions in the level of payments provided to Medicare service providers. Rates of payments for Medicare services will still increase but at a slower level than current law provides.

Medicaid: Spending on Federal Medicaid payments to the states will be reduced by $7 billion over the next five years. The largest savings will result from instituting limits on the level of payments to hospitals that service a disproportionate share of clients under the poverty level. In spite of these Medicaid reductions, Federal payments to the Medicaid program will continue to grow at a substantial rate over the next five years.

Sale of Electromagnetic Spectrum: The balanced budget plan authorizes the Federal Communications System to conduct more auctions of the right to use portions of the electromagnetic spectrum for commercial purposes. This will allow expansion of a multitude of information technology communications equipment. These sales are anticipated to raise $21 billion over the next five years.

Veterans' Programs: Spending on Federally financed veterans' programs will be reduced by $4 billion over the next five years. Most of these savings will result from higher reimbursements from veterans for services delivered.

Children's Health Insurance: The 1997 Balanced Budget Act included $20 billion of increased Federal spending over the next five years on a program designed to provide expanded health insurance coverage for low-income children. States will administer these programs following guidelines developed by the Secretary of Health and Human Services.

Supplemental Security Income: Spending on the supplemental security income (SSI) program will increase by $10 billion over the next five years. This spending increase will reverse provisions of the 1996 Welfare Reform Act that denied SSI benefits to legal immigrants.

Earned Income Credit: Federal spending on the earned income tax credit will increase by $12 billion over five years. The new child tax credit will reduce the tax liabilities of families receiving the earned income tax credit, which will have the effect of increasing the level of earned income tax credits these families receive.

Potential Impact of the 1997 Balanced Budget Act on States

Federal funds appropriated to state governments are an important component of state budgets. Federal funds account for approximately 25% of the total Michigan State budget. Therefore, states should be particularly concerned as to how changes in Federal budget policy might affect state budgets.

In attempting to analyze the impact of the 1997 Balanced Budget Act on states it is necessary to review the major functional areas of Federal outlays. States should be concerned about the extent to which functional areas of Federal outlays that typically benefit states could be affected proportionately greater than other functional budget areas.

Table 6 provides a summary of projected Federal outlays by major functional areas for the period FY 1997 through FY 2002. This analysis provides a base fiscal year, FY 1997, before the impact of the Balanced Budget Act is factored in and the impact by the fifth year of the Act, FY 2002. State government tends to rely primarily on two of the functional areas of Federal outlays contained in Table 6. These are Medicaid outlays and the functional area referred to as nondefense discretionary outlays. Included in the category of nondefense discretionary outlays are the Federal funds the states receive for such programs as welfare, education, economic development, job training, and environmental protection.

As evidenced in Table 6, Federal grants to the states for the Medicaid program will continue to increase over the next five years. In spite of modest adjustments in the program previously discussed, Medicaid outlays will increase by $41 billion or 42.7% over the next five years. Therefore, the states' Medicaid programs should see fairly stable levels of funding in the future.

The category of functional Federal outlays that will see the sharpest impact from the Balanced Budget Act is the area of nondefense discretionary spending. The Act provides for caps on this area of outlays. The FY 2002 spending cap of $260 billion is $19 billion or 6.8% below the projected FY 1997 level. The exact impact of this substantial reduction in outlays is indeterminate at this time. Nondefense discretionary outlays will actually increase in FY 1998 to $285 billion and remain fairly stable through FY 2001. The big impact under the budget spending caps occurs in FY 2002 when this category of outlays must be reduced by $17 billion or 6.1% in one fiscal year.

The President and the Congress will determine how this proposed reduction in nondefense discretionary outlays will be distributed. This decision will occur in future Federal appropriation bills. Whatever is the outcome of these discussions, it is clear that when FY 2002 arrives, states should be prepared for a substantial reduction in Federal funds.

The other direct impact on the states from the 1997 Balanced Budget Act involves changes in Federal tax policy that will affect state tax collections. Changes such as the treatment of capital gains for individuals and the expansion of IRAs for individuals will have an impact on taxpayers' future levels of AGI reported on their Federal income tax returns. The Michigan State individual income tax is based on the Federal definition of AGI. Therefore, Federal tax policy changes that affect the reported level of AGI will have an impact on Michigan income tax collections. The SFA is currently analyzing this potential impact and will provide a detailed report to the Senate on this issue in October.

A final area of potential impact on state tax collections from the Federal tax policy changes involves changes in the Federal excise tax on cigarettes. The 10-cent per pack increase in the Federal cigarette excise tax on January 1, 2000, will have the indirect impact of marginally reducing cigarette consumption. Therefore, this reduced level of cigarette consumption will result in lower tax collections from Michigan's existing 75 cents per pack cigarette excise tax.

Risks Along the Road to a Balanced Federal Budget

The fact that the President and the Congress have agreed on the outlines of a plan to bring the Federal budget into balance during FY 2002 is viewed as favorable news to a vast majority of the American public. However, a word of caution is probably in order. The 1997 Balanced Budget Act is far from the first time in recent years that the President and the Congress have developed plans that were designed to lead to a balanced Federal budget at a future date. Of course, in spite of these previous agreements, the Federal budget is currently in deficit.

In 1985 the Congress approved the Balanced Budget and Emergency Deficit Control Act (known as Graham, Rudman, Hollings). This Act through a series of strict caps on Federal outlays, was designed to bring the Federal budget in balance during FY 1991. For a variety of reasons this goal was not achieved and the FY 1991 Federal budget closed in deficit by $269 billion.

In 1990 the Congress and the President amended the 1985 Act to institute new procedures for deficit control. The Budget Enforcement Act of 1990 enacted a five-year plan to bring the Federal budget into balance. Again this plan failed to achieve its desired goals and the FY 1995 Federal budget closed with a deficit of $164 billion.

These previous balanced budget plans failed to achieve the goal of a balanced Federal budget for many reasons. Some of these reasons, which could also apply to the 1997 Balanced Budget Act, are outlined below.

Economic Conditions: Any plan that aims to balance the Federal budget over a long period of time is based on a complex set of economic assumptions which in turn trigger assumptions on the current law level of Federal receipts and outlays. If the United States economy fails to perform at the level assumed in the Balanced Budget Act, actual receipts may fall below the estimated level and projected outlays may exceed the estimated level. This type of scenario caused major problems for the 1990 balanced budget plan.

Emergency Outlay Needs: Any plan to a balanced budget is built on assumptions concerning future Federal outlays. If the United States enters a situation where unanticipated expenditures are required, these expenditures could result in budget deficits. A prime example of this type of scenario is if the United States were forced to enter into an unanticipated military conflict that would drive defense spending above the levels assumed in the Balanced Budget Act.

Independent Nature of Congress: Any plan that proposes to balance the Federal budget over time assumes that the United States Congress, through its appropriation process, follows the agreements laid out in the Federal Balanced Budget Act. This is not always the case. Future members of Congress may have different views on Federal fiscal policy than the Congress that approved the Balanced Budget Act. This independence can lead to future Congresses deviating from the agreed upon fiscal policy and thus lead to a budget deficit.

This type of action is already on display in Washington, D.C. The Congress is currently debating the reauthorization of an act that would continue Federal spending on transportation projects. The 1997 Balanced Budget Act contained strict limits on the level of Federal transportation spending, yet the House of Representatives is currently considering a transportation funding bill that significantly exceeds these spending targets. To the extent that this bill passes, and no other adjustments are made to offset these spending increases, the 1997 Balanced Budget Act's goal of achieving a balanced Federal budget in FY 2002 may be in danger.

Conclusion

The 1997 Balanced Budget Act marks a significant commitment by the President and the Congress to bring the Federal budget into balance by FY 2002. If the plan is successful, it will mark the first balanced Federal budget in 34 years.

The 1997 Balanced Budget Act proposes to balance the Federal budget through a series of adjustments in both Federal tax and expenditure policy. Major Federal programs such as Social Security, Medicare and Medicaid will continue to experience significant growth under the plan over the next five fiscal years. Federal programs that provide direct aid to state governments will see their level of spending stabilized until FY 2002 when a large reduction in Federal aid to states is scheduled to occur.

Many issues could lead to a failure of the 1997 Balanced Budget Act over the next several years. These include changing economic conditions, unanticipated needs for Federal expenditures, and the potential unwillingness of future politicians to abide by the agreement reached in 1997. Only time will tell if the 1997 Balanced Budget Act achieves its goal or fails to bring the budget into balance as has occurred in several other instances in the recent history of the Federal budget.

¹⁾ Federal outlays are the expenditures of the Federal government during a fiscal year period.

²⁾ Federal receipts are the revenues collected by the Federal government during a fiscal year period.

³⁾ The Economic and Budget Outlook: An Update, Congressional Budget Office, September 1997.