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Budget Policy and Fiscal Risk: Implications for Defense

Authored by Dr. Dennis S. Ippolito. | September 2001

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SUMMARY

The fate of defense budgets is closely tied to the size, composition, and balance of the federal budget. Over the past decade, efforts to reduce the relative level of federal spending and to eliminate deficits yielded disproportionate cuts in defense. Now that the federal budget is in surplus, and expected to remain so for the next decade, the prospects for more adequate defense funding appear more positive.

The reality, however, is that fiscal constraints have not disappeared. For the immediate future, defense will be competing with domestic programs for the approximately one-third of the budget allocated to discretionary spending. This is a competition in which defense needs have not fared especially well in the past and where future outcomes are problematical at best.

More important in terms of defense planning, however, is the long-term budget outlook. Unless current federal retirement and healthcare entitlements are scaled back substantially, the margin to support discretionary spending will begin to shrink dramatically after 2010. The United States, like other advanced democracies, is facing demographic changes that could generate enormous spending pressures in 10-20 years. The challenge, here and elsewhere, is to minimize fiscal risk by ensuring that policy decisions made today produce budgets that are flexible and sustainable over time.

The purpose of this monograph is to provide a fiscal perspective for short-term and long-term defense budgeting. The budget outlook for the federal government is more complex than current surplus projections might suggest. That complexity needs to be appreciated by defense leaders and planners.

INTRODUCTION

Over the past decade, the federal government?s fiscal outlook has been transformed. During the early 1990s, budget deficits were widely viewed as not just a chronic problem but a growing one.1 From 1990 to 1994, annual deficits averaged almost $250 billion, or nearly 4 percent of gross domestic product (GDP), but by FY 2000, the budget was in surplus by more than $235 billion, and total surpluses of more than $5.6 trillion for FY 2002-2011 have recently been projected.2

Many other advanced democracies have improved their fiscal balances in recent years, but the shift toward budget balance and public debt reduction has been especially pronounced in the United States.3 Multiyear deficit-reduction agreements enacted in 1990, 1993, and 1997 have reduced discretionary spending to historic lows and raised revenue levels to peacetime highs.4 As a result of these policy changes and unusually favorable economic conditions, the United States has ushered in a new era of surplus budgeting.

The budget policy debates of George W. Bush?s administration will therefore take place in a fiscal environment very different from that of his predecessors. Rather than struggling to balance current budgets, the administration and Congress must decide how to minimize long-term fiscal risks?in effect, how to allocate surpluses among debt reduction, tax cuts, and spending increases without exacerbating the formidable entitlement financing problems that loom on the horizon.5 These problems represent the critical backdrop for today?s budgetary deliberations.

Although budget projections for the coming decade have become much more favorable over the past few years, the post-2010 outlook has actually worsened. The interaction between demographic trends?notably, increased longevity and population aging?and the federal retirement and healthcare commitments now in place will begin to generate extreme spending pressures in 10 to 20 years. According to the General Accounting Office?s (GAO) latest policy simulations, ?demographics will overwhelm the surplus and drive us back into escalating deficits and debt,? unless these commitments are changed.6 Fiscal sustainability therefore depends upon entitlement reform. Reform is also necessary to preserve budgetary flexibility, by ensuring that adequate margins will be available to support defense and other essential national needs. Fiscal constraints have forced defense to absorb a disproportionate share of the deficit-reduction burden over the past decade. While these constraints have eased, they could soon reemerge and pose a serious threat to long-term defense planning.

The search for sustainable and flexible budget policy is likely to be challenging. That search should begin with a clear understanding of the recent past. Historical perspectives on how the deficit problem was created and how it has been solved are an essential component of prudent decisionmaking for the future.

CONCLUSION

The fiscal problems posed by retirement and healthcare entitlements are not confined to the United States. Demographic trends in most of the advanced democracies will make it extremely difficult for them to maintain the social welfare systems now in place and to fund other needed programs without excessive deficits or excessive taxation.63 These deficit and tax options, moreover, are probably more limited than in the past. The internationalization of financial markets has created strong incentives to avoid deficit and debt financing, while globalization has made tax systems more competitive?a country?s ability to impose higher tax rates than its economic competitors is constrained by the growing mobility of capital and skilled labor and by the attendant effects on productivity and growth.64

The fiscal challenge for the United States is arguably less severe than that faced by its major economic competitors. Its demographic problems are not quite as serious, and its social welfare system is comparatively narrow. At the same time, the United States has defense requirements that are unique, and these requirements need to be taken into account as the President and Congress shape future budgets. The immediate problems are well understood. Underfunding of defense programs under the Clinton administration has compromised readiness and, especially, modernization. Redressing these deficiencies, while accommodating the Bush administration?s proposed missile defense system and other new initiatives, would require substantial real growth in defense budgets for an extended period.

The FY 2002 budget plan submitted by the Bush administration and the corresponding congressional budget resolution adopted this spring contain ?placeholder? numbers for defense, with funding levels almost flat in real terms over the next decade. Once the administration completes its defense strategy review, a revised and presumably larger defense program will be proposed for fiscal years 2003-2011. The President?s determination to have ?our defense vision . . . drive our defense budget? is certainly justified, but the severity of potential funding problems is daunting.65

If, for example, the strategy and programs now in place under the 1997 Quadrennial Defense Review are reaffirmed, defense funding requirements could exceed the current placeholder budgets by more than $200 billion over the next decade.66 If, on the other hand, a different strategy is pursued, these funding shortfalls could be reduced. The tradeoffs, however, would inevitably include substantial reductions in force levels?Army divisions, Navy carrier battle groups, and Air Force fighter wings?and a highly selective program of weapons modernization. Without these tradeoffs, and a diminished regional war capability, large budgetary reductions cannot be realized. In addition, defense needs do not disappear in 2011. If long-term fiscal flexibility is not protected, the nation?s ability to fund defense at needed levels will eventually be impaired.

The deficit-debt dynamic that the federal government encountered after the 1960s was caused by the unexpectedly high costs of expanded social welfare entitlements. That dynamic has been brought under control, at least for the immediate future, through defense cuts and tax increases. The entitlement financing problem, however, remains unresolved, and unless meaningful reforms are enacted fairly soon, spending pressures will become more concentrated and more intense. Adequate budgetary margins to fund discretionary programs, notably defense, will not be available. For the defense community, the decisions that the President and Congress make regarding defense budgets over the next several years will be extremely important. The long-term prospects for defense, however, will be shaped by broader decisions that determine the composition of future spending budgets.

During the Cold War, when the Soviet threat was clear and immediate, defense funding was volatile. A well-developed and widely-supported national military strategy could not insulate defense from competing budgetary pressures. In the post-Cold War world, the threat is less urgent, the strategic consensus is weaker, and competing budgetary needs are more politically potent. Despite budget surpluses, defense remains vulnerable to short-term political fluctuations and long-term fiscal trends.

ENDNOTES

1. From the end of World War II through 1960, there were seven budget surpluses and seven deficits. Over the next 3 decades, the budget was in deficit in all but 1 year (FY 1969). Publicly-held debt for this 30-year period rose from $237 billion to $2.4 trillion. By the time that the budget was again balanced in FY 1998, the debt had climbed to $3.7 trillion. See Historical Tables, Budget of the United States Government, Fiscal Year 2002, Washington: U.S. Government Printing Office, 2001, pp. 21-22, 116.

2. The Budget and Economic Outlook: Fiscal Years 2002-2011, Washington: U.S. Congressional Budget Office, 2001, p. xiv.

3. See James D. Savage, ?Budgetary Collective Action Problems: Convergence and Compliance under the Maastricht Treaty on European Union,? Public Administration Review, Vol. 61, January/February 2001, pp. 43-51.

4. Discretionary spending, which includes defense and non-social welfare domestic programs, is determined by annual congressional appropriations. Mandatory spending, which includes social welfare entitlement programs, is governed by laws other than appropriations acts (e.g., entitlement authorizations) and continues until and unless these laws are changed. Mandatory spending also includes net interest outlays. In the early 1960s, discretionary spending was nearly 13 percent of GDP; the current level is just over 6 percent. Over the same period, mandatory spending levels have roughly doubled?from 6 percent of GDP to 12 percent. Since FY 2000, revenues have been at or above 20 percent of GDP, the highest levels since World War II.

5. See Long-Term Budget Issues: Moving from Balancing the Budget to Balancing Fiscal Risk, Washington: U.S. General Accounting Office, February 2001.

6. Ibid., p. 1.

63.See Vito Tanzi and Ludger Schuknecht, Public Spending in the 20th Century, Cambridge: Cambridge University Press, 2000.

64. Ibid., pp. 252-253.

65. President Bush?s address to a joint session of Congress on February 27, 2001. Congressional Quarterly Weekly Report, Vol. 59, March 3, 2001, p. 498.

66. Estimates of budgetary shortfalls for current strategy and programs vary. Recent Congressional Budget Office analyses have placed the strategy-funding mismatch at approximately $25-40 billion annually. The Center for Strategic and Budgetary Assessments, an independent policy research organization has issued a series of reports with roughly similar assessments. A much larger, and therefore more controversial, estimate was reported by the Center for Strategic and International Studies (CSIS) in 1999. Its analysis of funding shortfalls for the Clinton defense program was $100 billion per year for fiscal years 2001-2005, with substantially larger funding gaps thereafter. For FY 2001-2020, the CSIS placed the funding requirements for existing programs at 4.0 percent of GDP. See Daniel Goure and Jeffrey M. Ranney, Averting the Defense Train Wreck in the New Millennium, Washington: CSIS, 1999, pp. xiv, 124.