America's Fiscal Constitution (44 page)

Though economic calculations of the budget’s impact on employment and inflation did not depend on whether revenues and spending occurred inside or outside the trust funds, the unified budget undermined an important rationale for separating trust funds from the rest of the budget. It made it more difficult to tell whether federal resources and commitments balanced
within
the federal funds budget. Revenues accumulating in the trust funds—principally for Social Security pensions, Medicare, highways, airports, and various federal employee retirement plans—could not be used to pay the interest and principal on the debt. Private businesses would be engaging in fraud if they counted trust fund reserves as income. Three decades later President Clinton sought unsuccessfully to remedy this distortion.

In 1969, however, future threats to fiscal discipline appeared only as clouds on a distant horizon. The parents of the Baby Boom generation could take pride in having reduced their children’s burden of federal debt. The federal funds budget when Johnson left office consisted of tax revenues at 14.6 percent of national income, somewhat less than outlays
amounting to 15.1 percent.
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This relatively small gap did not seem particularly risky in light of the twenty-four-year decline in total federal debt as a share of national income. Unmonetized federal debt, $298 billion in 1969, had grown by only $54 billion since the end of World War II.
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Debt held by creditors outside the federal trust funds was virtually unchanged from the end of that war. American citizens held about 15 percent of the debt, or $52.2 billion, in savings bonds.
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The inflation-adjusted value of federal debt had decreased by about a third, the same scale of reduction achieved in the quarter of a century following World War II. Tax revenues could pay for debt service and much more. By 1969 unmonetized federal debt was only double the amount of annual federal funds revenue. In contrast, at the end of World War II debt was seven times the revenue available to service debt. Debt rose to nine times that amount by 2013.
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T
HE
L
IMITS OF
T
AX
R
EFORM

Johnson’s successor, Richard Nixon, referred to the economy only once in his 1969 inaugural address, when he asserted that the nation had “learned to manage its continued growth.”
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The economy appeared strong, with the unemployment rate at a fifteen-year low of 3.3 percent and inflation hovering at 4.7 percent.
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Nixon had lost two elections in eight years before being elected to the presidency with only 43 percent of the popular vote, and these experiences contributed to his obsession with reelection. The president understood the breadth of public support for domestic commitments such as Medicare. He sought to govern as a progressive on domestic spending programs and a conservative on what his staff called “the social issue,” a cultural agenda that called for slowing down desegregation, appointing conservative judges, and backing public aid to Catholic schools.
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Nixon confided to his staff that he would secure his place in history by easing Cold War tensions, an aspiration based in part on the president’s belief that Americans had tired of the Cold War’s tax burden.

Nixon respected the political power of traditional values, including those undergirding limits on debt. Even with the continuing expense of the Vietnam War, he intended to balance the budget unless the economy faltered. The president had to choose between extending Johnson’s surtax, which was set to expire in mid-1969, or running a deficit. He chose the surtax and garnered congressional support for its extension by assuring
Democratic leaders that he would support tax reform. Political momentum for the reform of tax laws had gained ground after publication of a report showing that more than one hundred Americans with very high incomes paid no income taxes.

A bipartisan coalition of centrists and conservatives in Congress extended the surtax until the end of the year. Congress then incorporated an additional extension as part of a separate bill, the Tax Reform Act of 1969. The Nixon White House hoped that tax reforms would raise revenues to assist in financing its new domestic initiatives such as “revenue sharing” with states and the Family Assistance Plan, which guaranteed a minimum income to poor families. But the Ways and Means Committee changed the tax code without any projected increase in tax revenues.

Mills was accustomed to bringing his committee’s bills to the House floor with a special “closed rule” that prevented amendments. In late 1969, however, the Rules Committee refused to grant that closed rule unless the Ways and Means Committee amended its tax bill to reduce taxes for Americans with low and middle incomes. Within hours the committee altered its bill to comply with that requirement, even though the change resulted in a significant net loss in estimated revenue. The Tax Reform Act of 1969, as passed by the House, increased some deductions while extending the war surtax, raising the tax rate on capital gains, limiting deductions for oil producers, and initiating the Alternative Minimum Tax.

Senate debate on the Tax Reform Act mirrored public discontent with high Cold War taxes. Democratic Senator Al Gore Sr., who was facing a tough battle for reelection in 1970, sponsored a populist tax cut. He initially proposed to raise the standard personal exemption or standard deduction to $1,250, up from the $600 that had been in place since 1948. After a Treasury official estimated that his proposal would result in an enormous loss in tax revenues, the Senate Finance Committee rejected even a scaled-back version of Gore’s amendment. On the Senate floor, however, ten Republicans joined forty-eight Democrats to raise the standard deduction to $800. Nixon threatened to veto the bill but signed it after the conference committee raised the standard deduction to $750, phased in over three years.
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President Johnson’s former budget director, Charles Schultze, criticized Democratic support for the Tax Reform Act. Schultze argued that the revenue reductions would ultimately force Congress to cut funding for programs valued by Democrats in order to balance the budget. Gore lost
his reelection, but his challenge to the Cold War income tax foreshadowed an intense debate a decade later.

B
ORROWING WHEN
U
NEMPLOYMENT
R
ISES

A slowing economy in early 1970 eliminated the slight surplus that had been projected for the next fiscal year. That prompted White House Budget Director Charles Mayo to recommend various spending cuts. Mayo, a nonpartisan budget expert, had been hired by Nixon based on the recommendation of chairmen Mills and Mahon. Rather than paring down federal spending, Nixon replaced Mayo with George Shultz, who had been serving as labor secretary. The president acknowledged that the downturn would result in a modest deficit, but on July 18, 1970—with Shultz’s encouragement—he explained his rule for budget planning: “Except in emergency conditions, expenditures should never be allowed to outrun the revenues that the tax system would produce at reasonably full employment.”
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Herbert Stein, the chairman of the Council of Economic Advisers in Nixon’s White House, had championed the concept of the budget balanced at “reasonably full employment.” The rule blended the traditional practice of “pay as you go” budget planning with the more pragmatic goal of balancing the budget across economic cycles. After all, it was impractical to change tax rates and spending within each budget year based on fluctuations in economic activity. Declaring the budget balanced at “reasonably full employment” also served Nixon’s political desire to rationalize the existence of a modest deficit. The president claimed that borrowing to offset revenues lost from higher unemployment served as a “self-fulfilling prophecy” that would lead to higher employment and a balanced budget. The theory did not impress many traditional conservatives, including a Nixon cabinet member who called it “economic bullshit.”
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Stein believed that a “balanced budget at full employment” provided an acceptable criterion for limiting deficits during downturns. It was not not a prescription for ending the business cycle. Since temporary borrowing was to be repaid out of surpluses once the economy rebounded, the president asked Congress for only a “temporary” increase in the debt ceiling in 1971. Through the troubled economy of the next dozen years, Congress did not alter the permanent debt ceiling of $400 billion—largely representing debt from World War II and Vietnam—and labeled each increase in the ceiling as “temporary.”
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Nixon counted on aggressive expansion of the money supply to boost economic growth before the 1972 election. For that purpose he turned to Arthur Burns, whom he nominated in 1970 to be the chairman of the Federal Reserve Board. When Nixon appointed Burns, he expressed hope that the new Federal Reserve chairman would “independently” conclude that the president’s views “are the ones that should be followed.”
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Burns quickly leaned on his colleagues on the board to expand the money supply and ease interest rates through aggressive purchases of federal debt. From 1970 to 1971 the Federal Reserve bought $13.6 billion in Treasury obligations, monetizing more debt than in any two-year period since World War II.
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Afterwards the Federal Reserve carried on its balance sheet almost 17 percent of Treasury debt, a higher share than at any previous time.
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That monetary expansion continued for years and ultimately led to the nation’s most severe peacetime inflation. Shortly after leaving the chairmanship, Burns admitted that the Federal Reserve could have restricted the money supply and slowed the economy “to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.”
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The shift in monetary policy coincided with another economic transition. In 1971 the value of US imports exceeded the value of its exports for the first time in seventy-four years. President Nixon privately predicted a long-term decline in the competitive position of American manufacturing. The trade deficit and monetary growth posed an immediate threat to the Treasury’s gold supply.

Chronic trade deficits also signaled a trend that weakened the federal tax system. As taxable corporate profits declined under the pressure of international competition, so too did the share of national income paid as corporate income taxes. By 1971 many American business leaders and economists began advocating lighter corporate taxation as a means of encouraging domestic investment.

Nixon and Treasury Secretary John Connally, a former Texas governor, announced in August 1971 that the United States would abandon the gold standard, levy a fee on imports, and impose mandatory wage and price controls. Before the 1972 election Nixon tried to boost spending by accelerating the rate of outlays by various federal departments. The economy grew, and price controls temporarily suppressed price inflation.

Nixon’s unorthodox approach to economic policy coincided with an innovative foreign policy, symbolized by the president’s trip to the People’s Republic of China. The president’s popularity soared along with the tantalizing possibility of an end to the costly Cold War.

T
HE
S
OCIAL
S
ECURITY
A
CT
A
MENDMENTS OF
1972

Neither President Nixon nor the American people desired to scale back Medicare despite its soaring costs. In Medicare’s first five years, the number of enrolled Americans had increased slowly, while the cost of hospitalization rose by an annual average of 13.2 percent and medical fees by an annual average of 7.5 percent.
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Private insurers experienced an equivalent jump in costs.

Federal medical costs were still relatively small compared to federal funds outlays for defense and for several domestic programs. In 1970 general (or federal funds) revenues paid for only 24.6 percent of the $7.5 billion spent for Medicare.
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In 1970 federal funds revenues for Medicare and Medicaid amounted to less than four-tenths of 1 percent of national income, roughly equivalent to the level of federal transportation grants.
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Dedicated payroll taxes funded the entire $5.3 billion cost for Medicare’s hospitalization coverage.

Federal leaders offered competing plans to expand medical coverage. Many Democrats, led by Senator Ted Kennedy of Massachusetts, sought to raise payroll taxes to fund greater medical insurance for working Americans. Nixon’s alternative required employers to offer medical coverage through managed care plans with federal subsidies for premiums. Senate Finance Chairman Long and House Ways and Means Chairman Mills resisted the cost of these proposals. Then, in 1972, Congress undertook sweeping changes in Social Security pensions and Medicare. Those changes would largely exhaust the perceived capacity of the payroll tax to fund further expansions of federal medical coverage.

Between November 1954 and March 1968 Congress had raised pension benefits just three times—by 7 percent in February 1959, 7 percent in February 1965, and 13 percent in March 1968.
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Payroll tax rates supporting old-age and disability pensions rose from 2 percent of covered payroll in 1954 to 8.4 percent in 1970.
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According to actuaries, benefits at those levels could be sustained at defined and predictable rates
of payroll taxation. After 1968, however, Mills began to lose control of benefit levels.