17th Annual Roundtable on the President's Budget and the Economy

ROBERT REISCHAUER: Let me welcome everybody to what I believe is the 17th Urban Institute Annual Budget Discussion. As has been the case in the past, we've asked a number of people to kick off the discussion with a few opening remarks about aspects of the budget or the environment that are relevant to the budget. But this is meant very much to be a discussion. It's meant to be a discussion not only among those who are sitting at the table, but also the folks who are sitting elsewhere in the room.

We have, to kick this off, as I said, a number of individuals. And I won't go through any introductions for them. They are individuals who most of us know and have listened to before. We will start with Doug Holtz-Eakin saying a few words about fiscal policy and go to Bill Hoagland, who will talk about non-defense discretionary [spending]. At some point, John Hamre from the Center for Strategic and International Studies (CSIS) will come and will talk about—say a few words about defense. Eric Toder will be introducing the issue of revenues and taxes. Scott Gudes and Belle Sawhill are going to say a few introductory words about budget process, Gene Steuerle on entitlements, and Joe Antos on health. So why don't we get underway and hear from you, Doug?

Oh, I should warn you, as I have in years past, that I have brought my meat timer with me again. And it's set on five minutes, and it will make little beeping minutes, which indicates you're cooked. So try and hold the introductory remarks to a fixed time. Go, Doug.

DOUGLAS HOLTZ-EAKIN: Okay, I'm supposed to talk about fiscal policy, and I'm now on record as saying the United States doesn't have one. So that remains the case. I mean, we get fiscal outcomes because we have a house, a Senate, and an administration, and nobody controls all the levers. And this budget presents us with, I think, nothing especially new in the likely fiscal policy outcome front. There are some modest innovations, but, you know, you can really think of this as what happens in the near term, where the stated goal of the administration is to bring the budget deficit down to a target that's half of a forecast high two years back. But where I think, realistically, the central issue is—where will we end up in that band between 2 percent, 3 percent of GDP over the next couple of years and where the risks, quite frankly, are up and not down because we've got risks on the upside in defense. We've got risks on the upside in non-defense discretionary spending, and we've got the AMT lingering out there as something that everyone would like to get off the books, but with no new revenue-neutral replacement in sight. So I think those are all, you know, risks to the upside over the near term.

The issue that I think really hasn't gotten as much attention—and I'll steal a little bit of John Hamre's time—is defense. I think the defense issues are very important and very real. It has been the case for a while that the stated policy of the administration—the Future Years Defense Program—is much more costly than even the base defense budget projected out. And so there was always this mismatch about whether the policy would come down or the budgeting would go up. When they put out the Quadrennial Defense Review last Friday, same basic mismatch prevailed. They said, you know, we haven't really changed the top lines very much, but they also pretty much acknowledged that they're interested in fighting "the long war against terrorism." And what that would suggest is that the things that are now considered supplemental really are here to stay and that we've mismeasured the base defense budget. And so we may have a hint of the answer, which is, the budget is going up. The policy is not coming down. That's, I think, an interesting development.

On the non-defense side, the question is, what will the policy be that can hold spending this tight? And on tax policy, the goal, of course, is to replace the AMT in a revenue-neutral fashion for tax reform. And that would be entirely desirable because, past the next couple of years, the fundamental fiscal policy dilemma is the fact that Social Security, Medicare, and Medicaid just ramp up and go so far north that no one can imagine it. And I think, you know, the key insight is that, at least in the Congressional Budget Office, projections that had come out in December—that there was a dividing line in terms of sustainable and unsustainable policies. And the dividing line was a world in which real defense spending went down by 25 percent, not up, non-discretionary defense—or discretionary non-defense spending was frozen in real terms, and health care costs only rose at the same rate as the economy instead of 2.5 percent faster. Then you can stay at 18 percent of GDP, and you can live with the current tax code. Otherwise, you start going north, and you need a tax code that's a lot more efficient to finance bigger government.

And so I think, though, the long-run fiscal policy question is really simple. How much will we rein in the growth and the overall size of the government? And how will we possibly get a reform that would finance that without crippling the economy? So those are the key issues that are all going to be touched on by people around this table, and I'm going to beat the meat timer and quit right there.

MR. REISCHAUER: Thank you. Unfortunately, your time cannot be passed on to the next—(cross talk.) Why don't we go right to Bill, and then have a little discussion, then go on to some of the other topics?

BILL HOAGLAND: Bob asked me to talk about non-defense discretionary spending. Probably for the vast majority of Americans out there, this is the federal government—all the alphabet soups from SBA to CDC to NSF, down the line. Almost—I checked this morning—almost two-thirds of the government workforce is employed by non-defense agencies. So many Americans out there probably have direct contact with these agencies. So it makes sense from the public's perspective that they would equate, whether they know it or not, non-defense discretionary to the federal government itself, even though we budget geeks call it non-defense discretionary. You combine that with this first chart, this color chart that I distributed, that shows that a broad definition of this category of spending has grown rapidly in the last five years, six years, up 8 percent by that chart, a rate not seen since the late '70s. Add in the media attention last fall to bridges over troubled waters and other things, and you get a discussion about spending your marks. And I don't think it's any surprise then, for the average citizen out there, that they conclude that it's in this area of the government that spending is out of control.

Realistically, though, I think everybody in this room knows that this is a wildly disproportionate issue to the share of what non-defense discretionary makes up—19 percent of the budget and declining. I think to some officials who are loath to address the 54 percent of the budget that's growing, the focus on non-defense discretionary provides a convenient distraction, while at the same time showing their concern for taking spending out of control. What did the president propose? The budget continues to focus spending restraint in this one area of the budget, claiming to reduce non-security discretionary spending by $2.2 billion or half a percentage point. In fact, and if you include the cost of the savings, personal accounts, and Social Security that's in this budget that not too many people caught, this the only area of the budget that contributes to deficit reduction over the next five years. It's only non-defense, non-homeland security spending that actually has a reduction—if you believe the numbers, about $120 billion in savings over the next five years, reducing it, if you get there in the year 2011, to 14 percent of the budget, the lowest ever as I can ever find recorded in budget history.

Now there's a second table that's attached to this that's got a couple errors on it, but it basically makes my point. One of the big difficulties with this is how you define non-defense discretionary spending. I start up there at the top line by taking the total amount of discretionary spending less defense. And as you'll see that if you look at it that way, we've actually probably had a—the president's budget is proposing about a $20 billion reduction or 4.2 percent. But then you have to remember that he talks about non-security, and so we take out homeland security, which is difficult—spread across many agencies, not just the Department of Homeland Security—which is an actual increase in this area. And then I think it's kind of difficult for the average citizen out there to think that economic support to Israel, Pakistan, Jordan, Egypt is a discretionary—the best of discretionary. So I take out the international affairs, which is one of the largest increases in discretionary spending in the president's budget this year.

Then, just for comparison purposes, you take out the domestic emergencies. Obviously for '05, you see the big number there of $75 billion associated with Katrina, Rita, and the other hurricanes. And you end up with numbers then—we have the adds and subtracts. We had terminations in 2006—about $6.5 billion, the largest of those being the Hubble spacecraft. The president is proposing another round of terminations and reductions. And those particularly focus on proposals that were proposed last year, a number of education programs—141 programs he's proposing to terminate here with a savings of 14.7 (percent)—this gives you the room to add back in other areas. And where does he add back? I think the really interesting part to me in this discretionary budget is, while something like the National Institutes of Health out here—biological sciences—are flat, the National Science Foundation now becomes the favorite agency in town with a proposal to double its budget over the next 10 years for mass science technology. So there are these ups and downs.

You end up with the point I'm making here that you reduce non-defense, non-homeland, non-international, take out the emergency, you're actually reducing it by almost a percentage point. Let me just—there are some other facts there that you could look at—but let me just, because I know my time is going to run out here, let me talk. What will Congress do with this? Bob asked what has he proposed, and what will Congress do? I fully expect that process will dominate policy in this area this year. I expect Congress will find ways to make legislative earmarks more transparent and maybe even set up a process for removing them through something like we have in reconciliation called the bird rule. I expect at least in the Senate a little bit of an extended debate. Scott would disagree with me on this maybe on biennial budgeting and line item veto or enhanced rescission. Again, I expect that's going to come pretty quickly because we're going to have to increase the statutory debt limit in about a month. So I expect process there.

And I expect, quite frankly, the president's top line on domestic discretionary spending that I've outlined here will be pretty much adhered to, but not necessarily because of any overt action on the part of Congress, but mainly by default. The blueprint that we're operating under for right now that the budget committee put together last year has numbers for 2007. Ironically, they're very, very close to the president's request overall. So we technically don't have to do anything but stay within last year's budget resolution and not take on those hard choices of scrapping or increasing or decreasing programs.

Finally, on the last chart, maybe not terribly interesting, but it gives me some hint at least as to where the final numbers in this area might come out. I've gone back and looked at when the president presented his budget in January, February, for an estimate made at the time of submission, in both defense and non-defense categories and where the final outcome was. And you'll see that, at least on looking just one year in advance—one year in advance—the average, we're off by close to 17 percent on average for defense and almost 9 percent for non-defense, just looking one year out. So roughly you can—I conclude here that we'll not be looking at $413 billion for non-defense discretionary, but probably closer to $450 billion when we settle the books a year or so from now.

MR. REISCHAUER: Okay, since Bill brought up process, why don't we ask Scott and then Belle to say a few words about the budget process since it's out on the table? Scott.

SCOTT GUDES: I'm going to change what I was going to say actually now that I've heard from my leadership. Actually, what I was going to say is that process reminds me a little bit of reorganization in the executive branch, where people could do things. But they think, if only I could reorganize, I could find a different way to get people to do what I want to do. And what I think people can find is all the levers are there. All the mechanisms are there to do what you need to do with existing processes. I'll give you an example. Line item veto—90-something percent of what the administration wants to veto is in report language from the Appropriations Committee, which I used to work for. The president already has the authority. Every agency—John Hamre had the authority in our defense department to say, thank you, we're not doing that. It's just report language from a committee. And they don't need a law. They don't need a constitutional decision to do that. They just need the desire to upset Congress and say, we're not doing what the Appropriations Committee says—we don't need a law to do that. Enhanced rescissions is the same sort of thing.

Biennial budgeting—I'd love to see one-year budgeting, no changes, no supplementals, live with one year's budget. Hey, you know, John remembers. There was a two-year—Senator Nunn brought this up—Goldwater-Nichols two-year budgeting, right? What happened? Defense department submitted a two-year budget—am I taking too much time? (Cross talk.) Two-year authorization—Goldwater-Nichols said to do it. What happened? The Pentagon didn't get its first year number, and it sent an amended second year budget, and there was an amended second year authorization. It was the same thing as a brand new authorization, brand new budget, brand new appropriation. But we had a two-year budget.

So I do agree with what Bill said. I think that there will be a lot of attention this year in Congress on those three issues, earmarking being the other one. And I would say earmarking and authorization bills as well, if nothing else, because the highway bill finally got the world to realize that the only people earmarking are appropriations. Now having said that, I actually interpreted the question to be much larger. After having been on the budget committee for a year, I would say that the budget process is far too complicated, far too much of an insider's game, far too much so even the insiders have problems. I'll give you a great example. Last summer, Bill Hoagland and I were dealing with an issue having to do with reconciliation and told the finance committee they could do something. And two days later, our general counsel said, excuse me, that's a 302F point of order. You fixed one problem. You didn't fix another. It's way too complicated. So it needs to be changed for that.

But there're far too many loopholes, I think, in what's being done. Emergency spending, which Dr. Holtz-Eakin referred to, is a great example. What was set up in 1990—agreement to be an escape valve for must-pays—is now a fifth of the federal budget, something like—of discretionary budget. I'm not sure if Bill's numbers included the emergencies or not. But if you take a look at what we say is defense spending, we might say in 2006, within the caps, there's something like $410 billion, but that's not right. It's really $530-something billion if you take the president's latest numbers.

So there needs to be a real change in reform. There needs to be a change in emphasis to where the money is, to go back to a few comments I've made. There needs to be much more focus on the entitlement, mandatory side. It's been moving in that direction. And what the debate is—I'm sure that the act really focuses on it as much as it should. There are far too many things that, as an outsider coming in, don't make sense to me like rules that apply in the Senate and not in the House, and the way we're continuing the Budget Act now through the resolution. If any of you read the resolution, you'll find all sorts of things that say in the Senate. It doesn't say in the House. So there are, for example, appropriation caps that everybody talked about—not multiyear caps in the House. Those don't exist. This long-term point of order that was created last year for new entitlements, which a number of people have pointed to and said what a good thing—that's only in the Senate. It's not in the House. And you can go through, and there are far too many contradictions in there between the two.

The reconciliation process that we went through this year was being used far too infrequently—this was the first spending reconciliation meeting giving head to the resolutions of 1997. And frankly, I'll have to tell you it was—you needed to have a time capsule and be able to find people around the last time they did one to be able to know what the rules were—and what we found was that far too often the rules are determined by what the Senate parliamentarian says they are, not anybody—people around this table who had been working on the budget. And often the rulings were different than the rulings in the past. It shouldn't be that way. It shouldn't be a subjective sort of decision of what's the bird rule, not the bird rule, what you can do, and what you can't do. It needs to be much tighter.

And then finally, I would say that going to where the money is, moving toward entitlements, and real teeth within the resolution—and there's my meat timer. If the budget process worked like the meat timer, it would all work. There you are.

MR. REISCHAUER: Well, that was a very good handoff to Bel, knowing what she's going to talk about. So Bel.

ISABEL SAWHILL: Thank you. This is in the category of what the president should have proposed and what the Congress should still enact. And it's an idea that I actually borrowed from Bob Reischauer, although he may want to deny paternity after he hears my variant of it.

MR. REISCHAUER: (Off mike.)

MS. SAWHILL: No child support, Bob. Just give me a couple of extra—

MR. REISCHAUER: No, there's longer paternity than that. I mean, I stole it from other people.

MS. SAWHILL: The proposal that I would like to put forward for discussion is that the Congress or the administration set a goal for deficit reduction—it could be halving the deficit by 2009, it could be something else. And then call for temporary suspension of indexing of both taxes and benefits until that goal is achieved. I would include an exception for programs targeted to the poor, but otherwise this would be an across-the-board suspension of indexing, which would affect income tax brackets and Social Security benefits primarily. And the rationale for this kind of proposal is along the following lines: first of all, it would require broadly based sacrifice. Rather than pitting one group against another, the change would affect almost everyone in a way that, I think, is affordable for any individual family and relatively easy to administer. It would ask everyone to sacrifice a little bit to pay for homeland security, for the war in Iraq, and for rebuilding after Katrina.

Second, it would give the public a reason to hold their elected officials accountable for making progress against whatever the goal was and bring public pressure to bear on those who are ultimately responsible because the public would be feeling it in their own pocketbooks and feeling it broadly. Third, it would affect both the benefit side of the budget and the revenue side, requiring that each side in this debate compromise a little, but not in a way that threatens basic commitments to keeping current tax rates low and the current structure of Social Security benefits intact. Fourth, it could be viewed as a first step in revamping the CPI and replacing it with a more accurate measure of inflation down the road, something that I note that Alan Greenspan has talked about incessantly. Fifth, it would take the pressure of off discretionary programs and put it more where it really belongs, which is on taxes and on entitlements. It wouldn't, of course, be a substitute for undertaking fundamental reform of both taxes and entitlements, but it would give us a little time to accomplish those more difficult goals, which are obviously highly contentious and therefore are not likely to take place until after 2009, when we have a new president in office. And finally, it would reduce the deficit substantially during the period it was in effect, much more than anything that Congress has accomplished with huge difficulty on the spending side along and which they are then about to erase by passing a tax reconciliation measure that will undo the spending cuts.

Do I think such a measure would be easy to enact in the current environment? Absolutely not. Almost anything has been impossible to enact to reduce the deficit in the current environment. But it might have as much of a chance as anything, and so my fantasy is that Barack Obama might team up with Lindsay Graham and do it.

MR. REISCHAUER: Okay, that concept is not unrelated to what the president has put in his budget for Medicare. So why don't we turn to Joe and ask him to say a few words about health?

MR. ANTOS: Well, the health budget—I've got a few slides here. There were some surprises in this for me. After all, there was all this hype in the newspaper, you know, a few weeks ago. It's going to be a major health speech, and then we got a couple hundred words out of that. And so on the basis of that, what would you expect? Not much of anything, right? But, no, indeed, there he is. He's got some proposals. So you know, tax policy—I think there was a lot of surprise there. First of all, all this hype about giving an across-the-board deduction, above-the-line deduction for out-of-pocket spending on health care—that is something that I think Al Hubbard believes in sincerely, Al Hubbard being the guy at the White House and not Glenn Hubbard who's associated with AEI, who is one of the coauthors of a book. And what are they talking about? Well, they're talking about what they like to think about as leveling the playing field between out-of-pocket spending and tax-preferred premium payments for health insurance.

Well, the other approach, which is the more typical approach that you hear non-politicians talk about, is to reduce tax breaks for health insurance, not increase tax breaks for out-of-pocket spending. Obviously, nobody who says that could ever be elected to office. Now, it's HSAs or bust—it's remarkable. In general terms, the 2006 Blue Book and the 2007 Blue Book are remarkably similar. In general terms about the policy, it's a refundable tax credit in both. Last year, it was a general tax credit for any insurance that you bought, as long as you were a low-income person. This year, you have to buy an HSA type of a policy. Last year, there was premium deduction for buying the HSA. This year, it's actually an enhanced deduction. Now you can get a tax credit for the payroll tax that you didn't pay, but HSAs only again. And then, finally, there was a break for small employers who contributed to the savings account last year. Now it's for individuals who contributed to the savings account.

There are two themes here, I think—one is, if Congress wasn't going to be interested—both parties weren't going to be interested in a refundable tax credit, why not propose a refundable tax credit that pushes for a policy that (at least the White House guys think) would add efficiency to the system? I think that's their rationale. Second, you have to read the fine print, but most of these breaks are for people who are buying non-group coverage. Third, it's a miracle. People will start saving money like never before.

MS. SAWHILL: Skeptical.

MR. ANTOS: Possibly, I could be skeptical. Okay, what about Medicare? Well, George Bush has become a budget cutter at long last. If you look at the last chart, you'll see an interesting pattern mostly for Medicare. You'll notice that you don't find too many even-numbered years. Except for the last line here, we're really talking, the dates are really the dates of enactment. You don't find too many even-numbered years when we pass big budget cuts in Medicare. I suppose that's a coincidence. But there is, you know, a $36 billion cut at long last. It's been a long time. He has another $100 billion to go depending on how you want to look at that. It's a bad year to be in the hospital business because you have to spend a lot of money convincing Congress to do something they're not going to do anyway.

What about the physician payment fix? You know, not to be mentioned in the budget is just as bad as to be mentioned in the budget—a 4.5 percent cut next year, maybe. Okay, prescription drug cost estimatesCBO says over, let's see, 650—$850 billion, which is really just their estimate from last year updated a little bit. CMS says a number smaller than that—something like $800 billion, but they were up higher before. Remember, they were optimistic about all this. Over the relevant budget period, CBO says, at least so far, $1 trillion. They might change that. It's a little premature, I think, on the basis of two months of enrollment, to conclude that we're going to save money for the next 10 years compared with what we had before. One last thing—I didn't get to the sequester. Medicaid cuts—mostly non-legislative—that's something worth noting. A lot of administrative cuts—we'll see if they can do it. And what's intriguing is this sequester—the equivalent of a dime tip in Medicare, you know, a billion here, a billion there—that after a while, it adds up to $1 billion.

MR. REISCHAUER: Okay, why don't we hear from Gene? Where are—oh, there you are.

EUGENE STEUERLE: Well, there's an old joke about—what's the difference between an optimist, a pessimist, and a budgeter? The optimist thinks the glass is half-full, the pessimist thinks the glass is half-empty, and the budgeter thinks we need a new glass. We've been at this budget roundtable for about 15 years, and I guess what I remember most about it is about 15 years ago we were saying, you know, those baby boomers are going to be retiring. And gosh, around the middle of the first decade of the 20th century, they're going to even show up in the five-year budget window because the 2008-2009—very few people pay attention to this—the growth in GDP is actually lowered indirectly by the decline in the growth in the rate of labor force. So now we're here.

And it bothers me a bit that we go section after section, and we—I suppose it bothers me even in the field we're in that it's always so easy for us to criticize. That's what we do. I'm always reminded of Samuel Johnson's line, you know, that censure is willingly indulged because it always implies some superiority, that we get trapped into this notion of always being critical. And in fact, there are a lot of good things in the budget. They're often things that don't get discussed a lot. They're items that year after year the OMB puts or perhaps they've taken them from CBO, and those are the ones that are usually announced as dead upon arrival. And then we go on and debate the items we don't think are going to work so we can censure them. So I suppose my first comment is just that there are a number of good things in this budget, despite all the problems and despite the fact that it doesn't add up and that we don't have a process that works.

And in fact, we all agree that the budget is broken, but I think another mistake that we make is to think that the problem has to do only with the deficit. In fact, focusing on the deficit, I think, is misleading. I mean, government does not exist to reduce its own deficit. And I remember the few years when we actually had a surplus, and groups like Concord were sitting around and saying, gee, how are we going to convince people they should pay any attention to us if we can't even talk about deficit reduction if we don't think there's a deficit. I mean, government exists to make programs run better. If it's not going to have programs, if we need to have smaller government—government doesn't exist to reduce its size. It exists to do certain things and to do it well. So we focus on the deficit. My fear is that it's not a prescription for good government. It's just a prescription for making sure that the savings aspect of government sort of works its way out so that we don't have too many problems there.

I mean, this leads me to concur with those people who think that part of the solution has to do with the process. And by process, I don't just mean those explicit rules. I also mean the implicit rules under which Congress operates. We need to have a process that regains control over what sometimes narrowly we call the baseline. And largely it's a matter of the automatic part of the budget versus the discretionary. And I've prepared a few charts. They're not much different from what a lot of you do—one just showing the inevitable squeeze between Social Security, Medicare, Medicaid, and receipts in the budget. And the reason I point this out is not so much to emphasize what's happening in Social Security, Medicare, and Medicaid, as to point out that that squeeze on the rest of the budget is very real. And it's taking place right now, and so it comes out when Bill Hoagland talks about what proposals for discretionary or discretionary domestic spending. But that squeeze is very, very real. And if we don't deal with the squeeze—and it's not an issue for 10 years from now or five years from now; it's an issue for right now. If we don't deal with the squeeze, we're not really dealing with the budget as a whole.

Rudy and I have one suggestion on how to deal with at least the process of trying to get Medicare issues to be addressed. Joe Antos, I think, disagrees with them. We noticed that the president actually did put that in the budget—another item that's announced as dead on arrival. We suggested it not so much because we thought it was the perfect solution as we just thought that one had to deal with this budget process and put the automatic part of the budget and the discretionary part of the budget on a more level playing field, something that Scott also alluded to. If they're not on a level playing field, this squeeze is inevitably going to continue.

And just to put it again in historical perspective, never in the history of our nation has so much been promised for so far in the future. I don't care whether it was the Louisiana Purchase or a war or anything else. If you did a budget anytime until very recent years and you projected it out enough years into the future, the budget would go into surplus. Why is that? Because the discretionary spending would be flat. Revenues would rise with the growth in the economy, and you would eventually move into a surplus so there was slack. And then we debated about how to spend that slack. Now we just debate over how to regain control over what promises that we made we can't keep.

My final point is, if you look at the president's budget and you compared what happened over the first five years of his tenure with what he proposes for the next three years, you'll see there's almost a complete reversal on policy in every major item of the budget in the sense of percent of increase in spending in various categories versus percent of proposed decreases. I'm not saying these will happen. But I just want to say that it's a sign that we really are moving into a very, very different period than we have in the last five or 10 years.

MR. REISCHAUER: Okay, enough talk of the losers. Let's have John Hamre talk a little bit about defense.

JOHN HAMRE: Well, Bob, first thank you for inviting me. I mean, I look around this room. It's kind of scary. I mean, I divide the room into threes. I used to work for a third of the people in the room, and I used to work with a third of the people in the room. And so that leaves the remaining third, and I'm reminded of that old saying that, you know, you never have a second chance to make a good first impression. So I've blown it with two-thirds of the people here—try to work on what's left.

You know we're in the sixth year of a presidency and the third year of a war, and so there's not a lot of real direction in the defense program. So I think it's—what I'd like to do is to step back and make what few comments I'll make in a larger context. I started working up on the Senate Armed Services Committee in 1984 for the fiscal year '85 budget, and that was the year that the program tipped. It was the famous KGB amendment—Kassebaum-Grassley-Boschwitz amendment—that tipped the defense program, you know, toward a 16-year decline. So it's memorable, and I go back and I look at the purchasing power of the budget back in 1985 and the purchasing power of the budget in 2006, and they're roughly the same—roughly $450 billion in real purchasing power terms.

But I look at what we were buying in '85, and what we're buying in 2006. In 1985, we had 2.2 million people in uniform. Now we've got 1.3. In '85, we bought 50 ICBMs. Today we buy none. We bought 32 surface combatants in '85. This year, we're proposing six, and that's stretching it because one of them is a support vessel. We bought 1,200 tanks, 1,800 Bradley fighting vehicles then. This year, there are 100 Striker vehicles. We bought 900 combat aircraft in 1985. This year, the request is for 230 and then another 130 RPBs, you know. We had 20 prime contractors in 1985. Now we've got four-and-a-half. You know, so you get a startling picture of a budget roughly in the same purchasing power terms that's buying so much less. And not—by the way, that does not include war costs. I'm not—none of this has the war in it.

And so you ask yourself, what's going on? And I think there are two things that are going on that are important. One is people-costs have just skyrocketed. Military pay alone is up 30 percent in five years. And if you take the cost of people, you know, it's up probably 40, 45 percent because of the way we've—it's actually higher than that because of an artifice of the—we changed our retirement policy. So the cost per person to have them in uniform is now quite high, and it's frankly getting—it's not manageable. The Navy, for example, has had to cut 10,000 people a year out of its end strength just to pay for the personnel costs every year. I mean, so we're in a very difficult spiral on costs on people.

MS. SAWHILL: Is a lot of that health care?

MR. HAMRE: Some of it's health care. It's a big part of it, and I'll talk just briefly about the health care issue as a very important, controversial issue this year. The other is the cost of producing things in the factories. It is astounding how high the overhead factor has now become in producing weapons systems. So what we have is a military that is stretched by the difficulty of the war, of course, but that the underlying structure of what we can afford is out of balance in the long run. It's not a commentary about this budget. They're coping with it in this budget, and I think you'll see some elements of that. This is the first time that I have seen service chiefs recommend end strength reductions in budgets—the very first time in 15 years that I know of. They've fought it all the time before, and now they're leading the way because of these people costs. That's remarkable.

Second, I think it's absolutely unavoidable that you're going to see a shift in a lot of the support structure going into the private sector in years ahead. You know, when an average blue collar worker in the military costs $115,000, an average blue collar worker in the private sector costs $45,000, it's just an inevitability. It has to move in that direction. And frankly, we don't have a very good model for working with the private sector. It's a model that's inherited from the 1980—mid-1980s with big prime contractors, multiple contracts, many new starts. You manage through competition. You can't do that anymore. So we don't have good models.

The SCN budget is unsustainable. You can't have four ships and six shipyards. It just doesn't work. There was a big increase in Special Operations program, but it's people only. It's no hardware. We're going to have 30 percent more people flying 35-year-old airplanes. So it's a big initiative, but it's out of whack. And then finally the ratio between R&D and procurement is not sustainable. You can't have $75 billion of R&D and an $80 billion procurement budget because you can't build the stuff you develop. So we have a program which is kind of out of whack, and it's hard to get that back in balance. Forgive me, Bob, for going over. It's hard to get that back in balance when you're in the middle of a war. I mean, it's tough. I'll stop.

MR. REISCHAUER: Next, we have the answer—Eric Toder talking about taxes.

ERIC TODER: I'm happy that I haven't been doing this for the past few years because you'd probably be hearing me say the same thing three years in a row. And now you only have to hear it once. I'll talk about three issues—overall revenue, tax cuts versus spending through the tax system, and then I'll just touch briefly on HSAs. The president's proposals would reduce revenue by $29 billion in 2007, rising to $315 billion in 2016, and $1.7 trillion over the 10-year budget window. That's about 1.4 percent of GDP if you project out the GDP growth at the growth it was in 2011, the last year they show. The revenue figures are, by the way, in the Treasury's Blue Book, which give a lot more detail on the 10-year losses than the budget does.

The revenue and losses are very backloaded. If revenue loss grew at the rate of GDP, the 10-year loss would be about 2.3 times the five-year loss. It's actually about six times greater than the five-year loss. Now part of that is because there are built-in tax increases that are in the budget that are not taking place. And part of it is because of some back-loaded provisions, particularly the savings incentives. The costs are actually a bit understated on the tax provisions because these don't include the outlay effects of refundable credits. Those are again shown in the Blue Book. That's going to be $394 billion in—that's going to be $78 billion in 2016. And if you take CBO's figures and assume that AMT relief were indexed instead of just being extended for one year, that would be another $72 billion by 2016.

Second issue—spending through the tax code—the concepts of tax and spending are, of course, muddy because many social and economic programs are carried out through special tax benefits instead of direct spending. The OMB classifies provisions into normal tax provisions and tax expenditures, although those classifications have been changing. And they're kind of muddy from year to year. I did make a quick calculation—(audio break, tape change)—other being mostly the estate tax cut, and I came up with figures about 35 percent from net increases in tax expenditures, about 45 percent from income tax cuts, and about 20 percent from the rest. That's mostly state tax. And these figures include the outlay portion of tax expenditures.

So that's a very big story. The president's tax reform panel recommended eliminating the AMT once and for all and paying for this by removing or scaling back a number of popular tax breaks. The budget goes in the opposite direction. It expands some tax expenditures; it doesn't really cut back any big ones, and it pushes the AMT back only one year. And by the way, that one-year pushback this year costs $33 billion over two fiscal years, just to extend it for one year. So it is bigger and bigger to extend the AMT.

Finally, HSAs—Joe was talking about that. I don't really have much to add other than the fact that it's very interesting because they've really tilted the playing field where previously tax policy subsidized what you might call conventional health insurance plans. It's now tilting in favor of high deductible health insurance plans by allowing certain individual costs to be deducted only for those kinds of plans, and so that's a big shift in policy.

This is really part of an overall increase in the unwinding due to higher costs of the employer support for health insurance, and I believe the long-run effect of that may paradoxically be ultimately to create more support for national health care as the private system unwinds, but that's going to take a long time to happen.

Finally, since I have a few seconds before the egg timer, I want to follow Gene's suggestion and say one good thing that I liked in the budget, as an old IRS guy. There is a proposal in the budget that IRS employees who filed their tax returns late but have a refund due will no longer get in trouble for filing their tax returns late. And this is said that it would improve employee morale, and I applaud that proposal. (Laughter.) And by the way, the revenue effect of that is zero. (Laughter.)

MR. REISCHAUER: Okay, thank you. (Chuckles.) I don't know why the New York Times hasn't paid more attention to that proposal. (Laughter.)

Okay, the floor is open. Anybody who wants to speak at the table put up your card. Those who want to speak in the audience, wave, make eye contact, something like that. Alice.

ALICE RIVLIN, Brookings: I wanted to go back to process and to "Gramm-Rudman-Sawhill." The point of things like that has usually been to create something so awful that it will force the Congress to go to something more sensible. At least that's what Gramm-Rudman-Hollings was supposed to do and it didn't work very well. But it does occur to me that perhaps Gramm-Rudman-Sawhill might just work in the sense that—Gene referred to the days when revenues went up faster than spending. That was mostly, or partly at least, because we didn't have indexing, and if we could get ourselves back, perhaps by accident, to that happy period when, generally speaking, nothing was indexed, maybe it wouldn't be so terrible.

MR. REISCHAUER: Let me just—since Belle associated me with this—say that there are a couple of aspects where I would differ with the Sawhill proposal, and one of them would be the exclusion of low-income programs, I mean, that I—I see this as you want to make it absolutely unpleasant for everybody. And when you begin sort of saying, well, this group is not affected by it, then somebody on the other side wants some aspect changed as well.

And second, I would have this as a partial reduction with a maximum in indexing, meaning, you couldn't go over a reduction of more than half of the automatic index, so there would be a touch of indexing, not a complete elimination of it. But anyway—

MS. RIVLIN: The point I also forgot to make was that we're in a period of much lower inflation than we were when we were talking about this before, so maybe it wouldn't be all that painful.

(Unidentified): Just on that quickly, can we get a five year.... You mentioned it was big but you didn't give us a number.

MS. SAWHILL: I was thinking about over three years that it would be at least $100 billion. I haven't done a refined estimate of it, but just the tax and the Social Security portions are going to be at least that much. If you go to something partial, Bob, then maybe you want to go all the way to just correcting the flaws in the current system.

MR. REISCHAUER: No, see, I'd do that too. I mean, I wouldn't let that be part of it.

MS. SAWHILL: But then why take on—I mean, there's obviously going to be some political heat to go beyond that. I mean, there would be political heat even just to do that, but to go beyond it just a little tiny bit doesn't seem to me to be worth it.

But anyway, sure, I'll take that as an amendment.

MR. REISCHAUER: I think a lot of it's symbolic.

MS. SAWHILL: Yeah.

MR. REISCHAUER: It's the ability to go to your representative and say, goddammit, you're hurting my—

MR. HOLTZ-EAKIN: Why is the solution more bad tax policy? (Laughter.) This is a terrible tax policy. All the Hill stuff is terrible tax policy, and we have a tax problem. So, I mean, why are we always creating worse tax codes? We've got to just stop it. I mean, this is nuts.

MR. REISCHAUER: Let me ask, does anybody else who has a raised cardboard thing want to talk on process? Van, okay.

VAN OOMS, CED: Yeah, I wanted to also say something contingently in support of the Sawhill proposal, with the first of the Reischauer amendments. And in response to Doug Holtz-Eakin, I guess—this is a political issue. This is not a good tax policy issue. I don't think—I mean, we all sit around here, and we do it every year, and there is nothing else we can do because this is what we're trained to do, and besides, it wouldn't be very productive to just sit around and talk about how bad the political arrangements are, but in fact, I don't think anyone around this table or in this room who isn't blind and deaf believes that a sort of rational process of budget reduction of the kind that implicitly follows from all of the discussions here or elsewhere is going to happen. It's certainly not going to happen large enough and soon enough, as Gene Steuerle was saying, to have any effect on the big problem.

So the question is, is there anything that can act politically? Now, the reason my comment is contingent is, I don't think anything happens politically either until there is a crisis of some kind, and that's a whole other subject for debate as to whether Alan Greenspan's theoretical constructs and the Chinese political issues will finance us forever. But the point is that unless there is a some kind of a forcing mechanism, I don't think anything happens. In other words, the question is, how do you convert Charlie Schultz's termites in the woodwork into a couple of large wolves. And I don't think there is any way of doing that outside of a forcing process of some kind.

However, if you have that forcing process—the reason I like Bill's proposal is I spent about 15 years on the Hill or in the White House, a large part of which had to do with dealing with summits and various gangs of five or seven or 17 or 19 or whatever it was, and the one thing that emerged from all of those discussions is the things that would tend to have some appeal bipartisanly were proposals that were very simple, that appeared to have some kind of balance and equity, whether that was true or not, and we didn't get into the issues about whether it was good or bad tax policy very often because that really wasn't what was relevant. The relevant thing was, is there something that can force the process along?

I do think if we get into that situation, a proposal like the one Belle is making has a lot of possibility in those kinds of discussions. Short of that, I hold out no hope for getting this thing straightened out soon enough or large enough. Thanks.

MR. REISCHAUER: Bill?

MR. HOAGLAND: I think I'll probably second Doug; I'm skeptical of a process fix. And this comes from—some of my previous work in a previous life was on Canada, and Canada actually has a non-indexation provision, I think somewhat similar to what's been proposed. Since their inflation is below a certain rate—it's 2 or 3 percent—they skip indexation. And Canada has a very transparent government—there is a very thin layer of politicals atop every ministry—but they have a completely non-transparent budget process. It verges on the outright dishonest. And it causes tremendous problems for them. Essentially people stop believing the budget numbers and the budget process.

And so it's really akin to Wall Street, where people don't believe Wall Street estimates anymore, and then you talk about the whisper number, and are you beating the whisper number, and things like that. And so that's the sort of thing that leads me to be skeptical of this process fix.

MR. REISCHAUER: Rudy, former Canadian—(laughter)—can you talk about this?

RUDOLPH PENNER, Urban Institute: Just to follow up on that, I've become very disturbed at the extent to which the numbers we're using these days are illusory. Over the last two years, the budget has overstated the deficit for the year that you're in—the year that's three months old at that point—by over $100 billion. This year we're talking about a $105 billion increase in the deficit between '05 and '06. If you look at the first four months of the year, the deficit is $15 billion lower than it was last year.

Now, obviously everybody expects some slowdown in the rate of growth of revenues and spending to surge because of Part D Medicare, but even if you take account of that, it's really implausible to me that you get up that high without some really amazing things happening.

And if the administration is doing this purposely so they can claim progress during the year, I really wish they'd stop, for the very reason that Phil said—budget projections are losing all credibility on the Hill, on Wall Street, and it's very hard for people like me to argue we have a real budget problem in 2030. And the Wall Street guy will say, well, you can't even estimate the deficit within $100 billion when the year is three months over already.

And of course the problem is exacerbated by the fact that CBO has had its own problems. It's $60 to $70 billion less than the administration this year, given reasonable policy assumptions, but it's reduced its projection of the 2006 deficit by some $84 billion because of economic and technical adjustments just since March of last year.

I have great respect for the professionals who do these things, and the administration and CBO, but I think we actually could do better. But that's a whole other topic for some other day.

MR. REISCHAUER: Okay, Jim Horney.

JIM HORNEY, CBPP: Several things people said struck me. One—I think it was Doug—said no fiscal policy—that we don't have a fiscal policy. I think he was probably right. I have to sort of go back to the budget. And a very minor note, but one that I thought was telling—I don't know how many of you, when you first get the budget and get the summary tables, the first thing you turn to is the table that shows the change from the baseline deficit, the policies, and then the deficit. It's not in there. That table is missing this year for the first time in my memory.

Now, they did provide one in a backup table, but probably the reason it's in the backup stuff that not everybody gets is that it actually shows the deficit increase when the story was supposed to be, we're cutting the deficit in half, but of course the budget actually does add to the deficit.

But I think the other thing that is clear about this budget, several people here talked about a level playing field, and there is nothing in this budget that encourages a level playing field. Both—I think Bill and several others talking about the difference between treatment of discretionary spending and mandatory, that discretionary spending, which has gone up in recent years but as a percent of GDP has gone down—in the long run, it's not the budget problem; it's not the major contributor. In fact, since it's gone down as a percent of GDP, it hadn't contributed to the increase in the deficit relative to GDP, but that's where all the cuts are.

You do get cuts in mandatory spending if you exclude the president's personal Social Security personal accounts, but they're still relatively small compared to the non-defense discretionary cuts. Defense and homeland security of course have big increases. It's very difficult in the current situation to have a debate about that, but that means you don't have a level playing field because you don't have the debate.

But of course the big area where you're not level is with taxes, that the budget says we're concerned about deficits, we're cutting—we want the deficit to be cut in half, but they have tax increases—very large tax increases over five years and the next 10 years. And—I'm sorry, tax cuts—tax cuts over that period. So it's not a level playing field there; it's okay to have tax cuts. And the procedures—they want to extend pay-go but don't apply it to taxes. They want to do this long-run point of order, but it doesn't apply to taxes. And not only does that mean that it's a fiscal problem, that if we're concerned about the long-run deficits—and Gene is right, it's not just deficits we should be concerned about, but that's part of it—but if we're concerned about that, the tax cuts can add to that. But it's also on the policy side. It means that all the policies are tilted toward doing policies on the tax side—the major part of the health care initiatives are done though tax incentives, whether or not that's the best way to do it. And the budget itself and the procedures that it has put in place discourage the kind of debates you should have: if you want to encourage people to do different kinds of insurance, what's the best way to do that? It's not obvious that it's just through tax cuts. So I think it could be a big step forward if, in a variety of ways, both from a policy standpoint and through process, we did have more of a balance.

I have to say just quickly on the process, I don't think there's any process in the world that can make the Congress and the president do anything they don't want to do. And the problem is I don't know how you can fine-tune the pain to make them do it. If you do like Gramm-Rudman-Hollings where you make—I mean, that was painful. We were talking about—what was it, a 40-percent cut in defense in fiscal year 1990?—34 percent cut in defense. Well, that was painful, but that meant everybody knew it wasn't going to happen. Nobody took that seriously. If you design one that people take seriously, then it's probably not going to do very much. So the question is, do you want to put in place a process that makes changes and say, okay, those are the changes we're going to do, or do you want to do one that forces changes? I don't think you can get there.

So I think you really do need to change people's perceptions. The reason the 1990 summit worked, I think, wasn't because of Gramm-Rudman, wasn't because of the pending sequester; it was because George Bush and others actually thought if they didn't do something about the deficit there was a political price to pay.

MR. REISCHAUER: Rosemary.

ROSEMARY MARCUSS, BEA: Thank you, Bob. I want to echo John's comments that I'm daunted by all the general practitioners and knowledgeable budget people. I've always specialized in some particular bodily function or another, and now it's how you track the effect of fiscal policy on the economy. And I want to emphasize that in fact it's not a budget that you see in the GDP; it's really just a sector of production. And I see Martin there, and last quarter the GDP grew at 1.1 percent, and had we not taken out the prepayment of pension by the military, it would have been over 2 percent.

So just to remind people that it's a very different cat, and so, for following the immediate effect on the economy, the GDP federal sector is really quite different from the budget, and not to be confused by that.

CHRIS EDWARDS, Cato: I'll just give you a very brief, quick take on the budget. It seems to me this budget is sort of like a blueprint for probably the next 10 or 15 budgets we're going to get here in Washington. It's a muddle-through budget. It doesn't do very much. But it seems to me—I've increasingly come to conclude that this is our future, because if you—you know, you look, we have an over $400 billion deficit and it will probably remain over $400 billion for the rest of the decade and growing beyond, but if you looked at 2015, even beyond that, and you look—if there are no substantial spending cuts in the future, if we sort of muddle through on taxes with some extensions—I mean, you're talking—even if you're talking $500, $600, $700 billion deficits by 2015, as a share of GDP it doesn't—that doesn't account to that much—maybe 4 percent of GDP. We've had much bigger deficits as a share of GDP in the past.

So what I'm saying is that I don't think—Congress is not going to be—it's comfortable where it is, and no party really has an incentive to make any radical move right now. It's a closely divided Congress, and unfortunately—I mean, we can muddle through, I think. It appears that, you know, the large deficits we have don't have much impact on economic growth or interest rates. So our future, we may be sitting around here 10 years from now with another very similar budget—a muddle-through, gigantic, horrible projections off in the future, but Congress might not really do that much. I mean, it does seem, looking at the last couple decades, the only time that even modest restraint happens is when you have a big sort of electoral revolution, like in 1980 and 1994, and you get a year or two of change but then things settle back down to the Washington way of business.

You know, the message I get from the budget this year—I mean, if the going gets tough, as it is with Social Security and President Bush's plan—you know, this administration has just given up. We have a president who I think was pretty brave to take on the issue. He's not up for reelection now but he's given up on Social Security more or less for the time being, and unfortunately that's a bad message that it sends to future presidents and future reformers. I don't see any serious reformer running for office in 2008—perhaps someone like a John McCain could make a substantial difference because he relishes his sort of independent radical role.

So the future seems to me, whoever comes into office next, is just many micro-proposals. I mean, President Clinton came into office with some big plans for big capital investment and this sort of thing, but very quickly he was sort of slapped down by the Washington establishment, and he just spent all this time doing sort of micro-proposals. In this budget, we see that sort of thing. I mean, micro-proposals allow politicians to create the symbolism of doing something for science or doing something for education without really changing the long-term budget picture.

So we've all got some great ideas, like Bel's, to reduce the deficit. I mean, there's lots of things I'd like to see, like price indexing of Social Security, but it appears, you know, moving ahead, that it's going to be a muddle-through for many years in the future, and I'd be curious to know—and actually, another sort of indicator of that was the recent House majority leader election. They chose a safe and comfortable establishment insider rather than the real reformer.

So, unfortunately, all the indicators, it seems to me, are for many more years of muddle-through.

MR. REISCHAUER: Well, having heard from the optimists—(laughter). Susan, did you want to say something?

SUSAN IRVING, GAO: Poor Bel, she's going to own something she floated. Of course it's bad tax policy. I mean, I feel like saying, and your point is? I'll restate Van's point. This is not a—I mean, I don't think it's a policy proposal; it's a political proposal, although I didn't think it was to make something so terrible they do not—I mean, I think the point is that there is this fascination with perceived balance, and just as you sat there and went like this, yeah, that's the whole point. It's simple to explain, it looks like it's balanced, and maybe because I'm so old I remember when we didn't have indexing and Congress got to cut taxes every year. And of course it won't last, but it will stop things from getting worse until somebody does something. I'm not saying it's a great idea, but I don't think to dismiss it because—I mean, I don't think it's any worse tax policy than beginning to run 6 million programs through the tax code because we want to pretend we're controlling spending—and so it's bad tax policy compared to what?

MR. REISCHAUER: Do you want to defend yourself or—

MR. OOMS: No.

(Cross talk, laughter.)

MR. REISCHAUER: You're far down the list here. Oh, okay—

(Cross talk.)

MR. HOLTZ-EAKIN: I don't think a group like this should ever be actually proposing bad policies if there is something else you could propose. I mean, I really just think that's a terrible message to send. So what would be something that would be balanced, have both revenues and spending, and within spending cuts across mandatories and discretionaries, as they're currently labeled? Well, the net difference accumulating over time is debt in the hands of the public. We have a debt limit. It's a silly debt limit. Redefine the debt limit to be debt in the hands of the public, pay attention to how much goes out there, and make these guys vote on it. It's a democracy. We're close to that already. It's very simple. And, you know, target someone like that.

And I want to defend the Canadians. The Canadians did this.

MR. REISCHAUER: Do you want to take that one step further and say, okay, so we have—

MR. HOLTZ-EAKIN: The Canadians did this. They had 100 percent debt to GDP, and they said, we're going to bring it down, and they practically put budgets in place to bring that thing down. That's the long-run problem, the mismatch, the fact that—

(Cross talk.)

MR. REISCHAUER: And what do you attribute this to, the mechanism or a parliamentary system?

MR. HOLTZ-EAKIN: Oh, the parliamentary system is a huge part of it, I know—

MR. REISCHAUER: Uh-oh.

MR. HOLTZ-EAKIN: But we don't have a parliamentary system, but I think that if you're going to target something, target something that is the real issue: What is the net mismatch cumulatively over time? That's the issue. And use the mechanism we have—make them vote on it.

MR. REISCHAUER: Gene, do you want to—

MR. STEUERLE: I want to jump in here and be a politician. I want to say to Bel, you're right, you're right. I want to say to Doug, you're right, you're right. I want to say to Doug, you're right, you're right. I want to say to Van, you're right, you're right. And Bob's going to say, didn't they all contradict each other, and I'll say, you're right, you're right. But the point I'm going to make is the following: I do think it's incumbent upon us as a group to offer expenditure tax tradeoffs that are realistic. My problem with the Sawhill proposal, as it's currently designed, is I don't think it's at all balanced. And it's not just bad tax policy in the sense that I think some people are interpreting Doug as, well, you should have done base-broadening instead of rate increases, but in fact the rate increases in this particular policy hit worse on the low-income people. Percentage increases in taxes are mostly on the low-income people.

And on the Social Security side, the percentage cuts and benefits are most on the old, old, who are the poorest. So it's bad expenditure policy, it's bad tax policy, the indexing, and if you look at it in terms of a balance, it's a permanent tax increase, and it's only a temporary spending cut, at least if you look out in the future, because the new beneficiaries aren't affected at all by the fact that temporarily cut back on the price index.

So I think it's all in balance. However, that doesn't mean we shouldn't get at the indices, and the big indices in the system are things like wage indexing of Social Security benefits, which does cause long-term growth. It's the fact that all health care gets automatically included—well, almost all health care gets automatically included in health care, if you want to call that an index. It's the fact that we get more and more years of retirement support. Those are indices that are really big and we did need to tackle.

So I guess I agree that we need to be doing these types of tradeoffs, but I don't know why we want to pick at one that's that imbalanced and that bad, as I say, on both the tax and the spending side.

MS. SAWHILL: Can I just clarify something that Doug said? When you talk about make them vote on the debt as a target, I mean, they already have to do that; the problem is they can't not vote because it's got a nuclear bomb set of consequences. You know, the government can't operate anymore.

MS. RIVLIN: They've not voting on incurring the debt; they're voting on paying it.

MR. HOLTZ-EAKIN: Right. I want to make them—if you can make them vote on discretionary targets going forward, you can make them vote on the debt limit going forward as well—the same way we have budgets. I mean, these are budgets. We're voting on things going forward. It's got to be a forward-looking measure or it's not useful.

(Cross talk.)

MS. RIVLIN: —I thought the arguments were the wrong ones, but what's the balance proposal that you think we should be advocating?

MR. HOLTZ-EAKIN: Just the one I—you know, something that includes taxes, spending, and all kinds of spending. That doesn't touch all kinds of spending. I think Gene is right. The tax code—I mean, the income tax is not a broad-based revenue raiser anymore. Half the people don't pay income taxes. So if we're really going to be balanced, let's just get everything.

MR. REISCHAUER: I'd just like to say to Gene, you're right. We could really design something that was fairer and more rational, and so complex that nobody outside this room would understand it. And I think what Belle and I are doing, having been through the same process that Van has been through, is thinking of things that can fit in a sound bite. And I thinklike it or not, that's an essential ingredient of a solution.

Scott.

MR. GUDES: I was going to make a comment on something that was brought up before by Dr. Hoagland, Dr. Hamre, and Dr. Rivlin. It's safer to say "doctor" here actually, so I'll be safe.

Comments John was making about the defense budget—what it buys, what it doesn't buy, and how difficult it is, I want to point out that when Dr. Rivlin was talking about changes—draconian changes to the budget, Senator Hollings also proposed the hard freeze as one of his ideas. And as Bill was pointing out, on the non-defense, non-international, non-homeland, to be exact, we are at a hard freeze in the president's budget, and frankly in the congressional budget that was adopted, and going back in the out years.

If your number is 10 this year, your number is 10 in five years, and the president's budget and the agency budgets outside of defense are not allowed to have out-year numbers. When I ran the National Oceanic Atmospheric Administration, I had systems as well, and satellites to buy, and buildings to buy and pay to take care of. But the ruling for non-defense is you don't have out-year estimates. Your out-year estimates are flatlined—they're like the CBO baseline but no inflation. That's what they are. And they're totally, if you will, unrealistic.

The president's budget—if OMB were here—cannot, in any programmatic way, explain how you get to the same number in five years. But our budget adopts that, or the president's budget adopts that. The congressional budget adopts that, and nobody has really been talking about that here. We're assuming, I don't know, $120 billion or more of savings within the CBO baseline by assuming that that's fact. We've already sort of implicitly adopted that. And I would just say that all those things about the all-volunteer force and how they're affecting defense and procurement issues—and I think those are all real—are also real on everything else that we talk about as government, whether it's people costs in a shrinking workforce and attracting, whether it's running the CBO, whatever—those are very real things that right now, even though we're taking advantage of those numbers, programmatically, policy-wise we haven't faced up to what they require.

MR. REISCHAUER: Let the record show that OMB was invited. I feel like I'm the New York Times—the phone call was not returned.

Before I go to Joe, I just want to—because I think somebody in the audience or at the table might know the answer to this question—we haven't talked at all about the suggestion in the president's budget that if the limit on Medicare spending supported by general revenues is exceeded, that the Medicare Modernization Act had a proscription that if in the projections over the next seven years, the actuaries found that general revenues were going to support more than 45 percent of Medicare outlays (and they did this estimate two years in a row), the president had to submit a plan to bring it down under 45 percent, and the Congress had to consider this proposal or a substitute for it in an expedited fashion. And this is likely to hit during the presidential campaign in 2008.

The president's budget has in it a suggestion that if this occurs, the payment updates for all providers, it says, will be nicked by 0.4 percentage points. If in the following year the excess continues, it will be another 0.4 percentage points, so it will be cumulative.

And there is a certain attractiveness to this, but I was wondering if Bob Helms or Joe or anybody who deals a lot with Medicare had done any estimates to see if this isn't in a sense a perpetual cutting machine, because as we all know, roughly 60 percent of the Medicare spending is in Part A, which is financed by payroll taxes, and 40 percent is in Part B, which is premium and general revenue supported. And so if you cut them both by 0.4 percentage points, don't you always have the excess continuing? And so in and of itself it reduces total spending on Medicare but does nothing to bring the triggering device back into balance. Am I right or wrong or—

MR. ANTOS: You're absolutely right. I don't think that was the purpose of it at all. I mean, who knows what the purpose of it really was, but, yeah, it's just taking 0.4 percent off of—I mean, let's focus on Part B. You know, Part B is 75 percent paid by general revenues, so miraculously we're going to somehow nick about half a billion dollars out of Part B. And even if that accumulates, nonetheless there is nothing in the mechanism whatsoever to make any of the behavior change. And that's the problem. This is the point I would make generally if—this is something that Jim said and other people said too. If you actually had a policy like this that actually had teeth in it, we could call it in Medicare this sustainable growth rate. Doctors are looking at 4.5, 5 percent cuts forever.

Well, all that's done is create bad budget policy. Congress can't find a way to solve that problem, and so every year they'll go up to the brink and in most years they will solve it for one year. And of course every time they do that, the next year the permanent solution is more expensive, so we're further and further away from the mechanical budget fix, and we're not addressing whatsoever anything about the behavior of physicians or patients or anybody else that's driving this.

MS. RIVLIN: But wasn't that the point? I mean, providers are sufficiently well organized; they might be expected to come in and fight this and get a more rational solution. Isn't it just another Gramm-Rudman whatever?

MR. ANTOS: You'd believe that if it wasn't four-tenths maybe. I mean, a good question is where did you get four-tenths? And I like to think of it as 10 percent of the physician cut, or maybe 5 percent of the average rate of growth of Medicare in the last couple of years. I mean, will they notice four-tenths?

MS. RIVLIN: Not the first one maybe—

MR. ANTOS: Not the first one.

MS. RIVLIN: —but they sure will after a while.

MR. ANTOS: I think Congress has learned from this experience, and so it's a moot point.

(Off mike.)

MR. ANTOS: Right, exactly. I mean, their big proposal this year was let's not be held accountable for what we do; just pay us. And Congress went along with it.

MR. HOLTZ-EAKIN: I think the Medicare part is the interesting part of the budget because we know that Medicare and Medicaid and Social Security are the game over the long term. So the fact that they went there was a good thing, in my view. They didn't go there like they went last year. Last year they went to Social Security—it wasn't in the budget at all, which—you know, if you're going to do policy, it should be in the budget. It wasn't there at all. And they didn't go through the Congress; they went over the Congress. They went to the people, and it was a disaster. Here it's in the budget; it's in the budget both in these $36 billion, $100 billion over 10 years sort of provider cutbacks; that's not dramatic but it goes into the DNA of the process. That's a good thing. It's got this second piece, which is a trigger, which is meant to just organize opposition to the mechanical cut and make them come up with a policy.

And then there is this third thing, which is the Entitlement Commission, which is just a desperate cry for some ideas, because the first two clearly will not solve the problem. So I think that's, you know—

MR. REISCHAUER: So you put your money on the commission.

(Laughter.)

MR. HOLTZ-EAKIN: Compared to the other two? I mean, it's a relative ranking issue here.

(Laughter.)

MR. REISCHAUER: I got a better place for you to put your money. Dallas.

DALLAS SALISBURY, EBRI: Just a couple of comments on things that have come up before. One is just to underline that in the health proposals there also is the call for a very substantial change in regulatory structure, and essentially moving a lot of the regulation that's now a state insurance commissioner's to the federal government.

The second is to reinforce something Eric said, that there were some floor statements in the Senate, the firmest one by Senator Kyl, in endorsing the president's proposal and quite directly saying this is a desirable step in eliminating and bringing an end to the unsuccessful employment-based health system. So it's not a hidden agenda; it's quite explicitly part of the debate.

At an academy health meeting yesterday in response to those statements, two of the staffers from the Democratic side in the House made it clear that they felt that that was one of the strongest reasons that their members would oppose the changes being proposed by the administration, and the Republican staff said that they would not support the proposals by the administration for changing the federal/state regulatory mix since the relative committee chairman was a former state insurance commissioner and didn't believe it—so, I mean, the changes there are intended to be a fundamental change in policy at several levels, which may or may not occur.

The third point on those is that the shift ends up in the high-deductible market and the HSA market. One thing that is showing up is very, very high turndown rates for applicants, essentially which occurs in the individual insurance market because of individual underwriting on a very common basis, and that's happening in this as well, which is one of the reasons the administration is looking at regulatory change.

To the comments John Hamre made, one of the interesting changes in the four-and-a-half manufacturers that the Defense Department are still dealing with is a major reason that those expenses and overheads are very high, as he knows, and this is because the tradition of the Defense Department has been to fully reimburse those contractors for retiree medical expenditures, for their active worker benefits, as well as what have been very rich defined benefit pension plans. Lockheed Martin just recently announced they were going to move away from the retiree medical provision. They were going to move away from the defined benefit pension provision and change their cost structure for competitive reasons. That could end up creating an interesting pressure on the other major defense contractors that bet against Lockheed Martin on some things to bring those expenses down.

On the blue collar expense differential between the contracted out and the defense, the Compensation Commission appointed by the president is looking at restructuring a full defense compensation and benefits systems, and finds that a big reason for that cost difference is because many of the blue collar workers that they outsource to don't have pensions or health care promises that are anywhere near as rich as the governmental programs. And that commission is looking at fundamentally changing the federal pension provision for military in order to bring that cost down. So there's a lot that's not in the budget there that is in play vis-à-vis benefit programs, which is a slightly different way of answering Bel's question of how much of it is health cost. Pension and retiree health does play a fairly big role in a lot of those defense budget issues and the private versus public costs.

And then a third point, which just wasn't raised but was in the paper this morning and had gotten some attention on the hill yesterday, is a piece where the president proposes to help the deficit to the tune of well over $15 billion by a premium increase for the Pension Benefit Guarantee Corporation in addition to the one that is to be signed this week by the president. And that is something that, at this point, doesn't even look like it's in the pension bill that they're saying, well, additional changes. So there are also some things in addition to what Congress is managing to do where there are some funny numbers in this that aren't likely to come to play. So that ultimate deficit number, Jim, is likely to be even larger than the worksheet hidden in the backup papers when you start looking at things in there on—at least, we've looked at on the benefits side, that are not likely to happen that are being anticipated to produce additional federal revenue.

MR. REISCHAUER: John.

MR. HAMRE: I agree. There's one budget battle you ought to watch on defense that will be the bellwether for the year. Imbedded in the administration's budget is a proposal that they return to a three-to-one cost share arrangement on pharmaceuticals. That was originally in place when Tricare was put in, but nobody enforced it, and so the ratio has drifted upward for the government, downward for beneficiaries. Their proposal is to, in law, go back and put in that the government's costs are capped at 75 percent. If they do that, that will—and this is only for retirees below the age of 65, so it's a cadre of retirees because the average retiree for an enlisted person is 41 years old, you know—so it's a cadre that they're trying to limit. Now if they do that, that will eliminate roughly half of the cost increase they project for their medical liabilities.

The chance of them succeeding, I think, is quite low. Congress has been throwing an enormous amount of money in a patriotic fervor at voters—military voters. But this becomes a bellwether event. Now, I'll tell you what's going on is that, because Tricare is such a generous retirement system, companies and governments are directing their employees who are former military that they must take Tricare, and they may not qualify. Matter of fact, five states have enacted legislation that prohibits employees from using the state retirement or health care system if they qualify for Tricare.

And so what's really going on with this move is not so much to save the costs on the pharmaceuticals directly, but to discourage the migration of retirees over to the Tricare system. So it really is—it's a cost-aversion, cost-avoidance strategy that they're really trying to implement. But it's a big deal. Watch this. This one battle alone will give you a sense of whether or not—(audio break, end of tape)—

MR. REISCHAUER: So Bob and then Chris and then we will wrap it up.

BOB BERENSON: Just a comment on Medicare, I mean, clearly they have taken a nick out of providers and modeled the cuts on MedPAC recommendations, but they didn't follow the MedPAC recommendations on payments to health plans, and so there are a number of—well, there is some systematic overpayment to health plans. It's another source of potential savings but it goes against administration policy and it's not there.

MR. REISCHAUER: Chris?

CHRIS EDWARDS: Canada was mentioned by Doug and Bill. Doug sort of hinted that it was sort of to do with political—candidates have this remarkable performance in recent years that they have had years and years of surpluses, the dept to GDP ratio has plummeted, but my impression was it wasn't due to any kind of heightened political backbone or even because of the parliamentary system, which of course makes the—a prime minister with the majority government sort of like a dictator.

It was mainly due to the fact they haven't had a recession since the early 1990s. They have had very strong economic growth partly because in recent years they were a very oil- and mineral-based economy. China's demand for their products has soared, and their revenues have soared into the federal government for a couple of reasons.

One is that because the economy has grown very strongly, they have got a highly progressive individual income tax system, and in the late 1980s, if memory serves, they de-indexed their individual income tax even for inflation. And for a decade or so the revenues were pouring in because people were getting bumped up to a higher bracket, so I mean, their top rates, which are much higher than ours, start at very low levels, and so the individual income tax has been a real cash cow or revenue machine.

So, you know, I don't think their politicians have any more backbone than our politicians. It is true, though, that I think—as a final note, they are more scared of deficits in Canada than down here because it's a small economy. Big deficits have real impacts on their currency and their interest rates, much more than here, and you even see the far-left parties coming into power in Canadian provinces. They suddenly switch into fiscal conservatives because they get really scared about the deficits and the implications for the short-term growth. So I think those were the explanations.

MR. REISCHAUER: And so the message you take back to Cato is that high and growing marginal tax rates are not inconsistent with rapid economic growth. (Laughter.) I have often wondered what the Cato line was on this. Bill, do you—no. With that, let me thank you all for participating. We had some interesting discussion and look forward to next year. Thank you.

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