Inflation, Savings And Budget Imbalances

Despite economists' confidence in the use of monetary and fiscal policies, inflation soared into the double-digits in the late 1970s, becoming the main economic concern in the United States. But, by the middle of the next decade, inflation had fallen dramatically, easing consumer concerns. How was this accomplished?

Several factors have been credited with contributing to the reduction in inflation. Two very important contributors were the sharp recessions of 1980 and 1982, which reduced much of the upward pressure on prices. They were triggered by the Federal Reserve's unusually tight control of money and credit. At the same time, worldwide food and fuel shortages eased. In particular, increases in the world supply of oil drove energy prices far below the levels that producers wished to maintain.

Yet the end of the recessions did not eliminate U.S. federal budget deficits. To what were these economic conditions due?

In general, the economic factors behind growth in the U.S. federal deficit have existed for several decades. Most basically, the federal deficit has grown because federal spending as a share of the gross national product (GNP) has risen substantially since the 1960s, while federal revenues (primarily taxation) as a share of GNP have risen modestly. Federal spending rose from 19 percent of GNP in the 1960s to 23.2 percent in 1990; federal revenues also rose but by a smaller increase, from 18.2 percent of GNP in the 1960s to 19.1 percent in 1990.

But most postwar U.S. government spending has followed a pattern. During recessions, the federal government runs a budget deficit to stimulate the economy. As economic expansion takes hold, the result over time is, or should be, a balanced federal budget. In the economic recovery of the 1980s and early 1990s, however, the federal government continued to run substantial budget deficits. Many economists and policymakers attributed this mainly to a decline in national saving, or a surge of consumption. Domestic private savings were insufficient to finance both exceptional federal deficits and a big investment boom. Inflows of capital from abroad have been used to help fill the gap between U.S. savings and investment levels.

Congressional concern with reducing the federal budget deficit in the 1980s led to enactment of the so-called Gramm-Rudman-Hollings deficit-reduction law, which mandated staged cuts in the annual deficit to culminate in a balanced budget in 1993. This law was generally credited with cutting the federal budget deficit from a record $221 thousand-million in 1986 to $149 thousand-million in 1987.

Although it may appear that a tax increase would be the simplest way to offset federal spending and reduce the federal budget deficit -- and thus reduce the drain on savings that is behind the savings-investment imbalance -- the administration and many congressional policymakers feared that increasing taxes and undoing tax reform would impair incentives to work, invest and produce, which would negatively affect future economic growth. Moreover, increases in taxes without effective restraint on spending growth could be insufficient for reducing the federal budget deficit, as was the case in the years from 1960 to 1980.

In the early 1990s, the federal budget deficit was heading upward again for a variety of reasons. It appeared almost certain that the Gramm-Rudman-Hollings targets could not be achieved without requiring massive cuts in federal spending which would reduce or eliminate many important programs, and possibly tip the economy into a serious recession. To prevent this, Congress and the Bush administration agreed on the Omnibus Budget Reconciliation Act of 1990. It raised to 31 percent the maximum income tax rate imposed on the wealthiest taxpayers (creating three income tax brackets), imposed a miscellany of other taxes, and imposed strict new "pay-as-you-go" guidelines for government spending (so that any new spending would have to be matched by offsetting new revenues or spending cuts). The act's aim is to cut the budget deficit by roughly $500 thousand-million relative to what it otherwise would have been over a five-year period, reducing the deficit from about 5 percent of GNP to less than 2 percent.

But nothing is certain when it comes to tax policy in the United States, and in the 1990s the Bush administration was pushing for a reduction in the long-term capital gains rate, which it argued would increase economic growth by stimulating saving, lowering the cost of capital, and encouraging investment. With the economy in the doldrums, advocates of cutting tax rates for middle-class Americans were again being heard.