A Beastly Question

By Charles P. Alexander. Reported by Bernard Baumohl/New York and ChristopherRedman/Washington

The budget deficit threatens to grow much bigger, but is it worth the worry?

One of the most important bits of business that Congress left unfinished last week was lifting the federal debt ceiling, which already stands at a Himalayan height of $1.57 trillion. Without a higher debt limit, the U.S. Treasury could lose its license to borrow and have a serious cash-flow problem beginning as early as this week. That prospect is unthinkable for a free-spending Government that even by optimistic Administration projections will chalk up a deficit of $166.9 billion in fiscal 1985, which began Oct. 1.

The need to push up the debt ceiling raises once again some perplexing questions that still bedevil economists and have even split members of the Reagan Administration: Will the deficit shrink or rise even further out of sight? How should it be attacked? What impact does the burgeoning national debt have on the economy? Do deficits, in fact, really matter at all?

In the past few weeks', Walter Mondale has tried to make the deficit question a central issue in the presidential election. In campaign speeches, he says that Government red ink threatens to "hike interest rates, choke off investment, clobber trade, destroy rural America, kill jobs and shrink our future." He proposes reducing the deficit by two-thirds over the next five years, mostly by curbing the growth of defense spending and raising taxes for families with annual incomes of more than $25,000. Reagan remains adamant against tax hikes, arguing that spending reductions and strong economic growth will trim the deficit. Says he: "We have a deficit problem because the Federal Government has spent too much and taxed too much far too long."

Economists are also polarized. On one side are Reagan critics, like Walter Heller of the University of Minnesota, who maintain that the budget gap must be sharply narrowed even if that means raising taxes. Says he: ".Unless we tackle the creeping disease of the deficit, it is going to undermine our economic future." At the other extreme are the supply-siders, who maintain that Reagan's tax-cut program will stimulate enough economic growth to shrink the budget shortfall into insignificance. Asserts Supply-Sider Paul Craig Roberts, a former Assistant Treasury Secretary in the Reagan Administration and now a professor of political economy at Georgetown University: "Deficits are on the way out."

Who is right? To the dismay of mainstream economists, much of the evidence so far buoys the supply-side argument.

Despite forebodings about the deficit, the economic recovery has been stronger than any other expansion in the past three decades. Growth in the gross national product this year is now projected to be about 6%, considerably higher than the 4% to 5% that many economists originally predicted. That spurt helped reduce the deficit to an estimated $174.3 billion in fiscal 1984, from a record $195.4 billion in 1983. Most economists, though, fear that deficit spending has fueled a false prosperity that will soon fade. Already, progress against unemployment shows signs of coming to a halt. The civilian jobless rate declined slightly in September, from 7.5% to 7.4%, but that was still higher than the 7.1% recorded in June.

Nonetheless, the surprising robustness of the economic expansion so far has hurt the credibility of the doomsayers. Says Economist Edward Yardeni of Prudential-Bache Securities, who admits to being uncertain about the impact of the budget: "After hearing most economists shout wolf for two years about the deficit, people are starting to wonder whether the supply-siders might be right after all." The swift recovery has made it difficult for Mondale to exploit the budget issue against Reagan.

The Administration forecasts continued declines in the deficit. According to projections by the Office of Management and Budget, G.N.P. growth will average about 4% a year for the rest of the decade, and that will help reduce the budget gap to $139.3 billion by 1989. If that happens, the deficit will drop from 6.1% of the G.N.P. last year to only 2.6% in 1989.

Most mainstream economists, however, remain convinced that the budget dilemma will not go away. "At some point down the road, these deficits are going to haunt us," says Kenneth Mayland, chief economist of the First Pennsylvania Bank. As the economy expands, rising loan' demands by businesses will collide with Government borrowing. The eventual result, says Economist Henry Kaufman, partner in the Salomon Brothers investment house, could be "an explosion in interest rates." If rates rise, federal borrowing costs will go up and so will the deficit. Thus, many economists argue, large deficits and high interest rates feed each other in a self-perpetuating cycle.

The nonpartisan Congressional Budget Office predicts that unless Congress acts to narrow it, the budget gap will widen steadily, reaching $263 billion in 1989. By that time, the national debt would hit $2.5 trillion. The annual interest bill on that debt, says the CBO, could amount to $214 billion and absorb 16% of all Government spending, up from 11% in 1983.

As bad as that outlook sounds, it may be overly optimistic. The CBO made the questionable assumption that no recession would occur for the rest of the decade. History shows, however, that over the past century the economy has suffered a downturn every four years on average, and few economists believe that the business cycle has been repealed. A survey conducted last month by the National Association of Business Economists revealed that 95% of the members polled expect a recession to strike by 1986 at the latest. When asked what would be the causes of the downturn, 79% of the NABE economists blamed high interest rates and 71% cited large federal deficits.

A recession would reduce Government tax revenues and boost spending for such programs as unemployment insurance and food stamps. As a result, the deficit would grow worse than it already is. Chase Econometrics, a consulting firm in Bala Cynwyd, Pa., estimates that even a brief, six-month recession would increase the budget shortfall to $300 billion.

Many economists think that the only thing currently saving the economy from a crunch is the capital flowing in from abroad. Lured by the lofty interest rates and attractive business opportunities available in the U.S., foreigners are pouring about $100 billion this year into American investments, including bank accounts, stocks, bonds and Treasury securities. Without that influx, U.S. interest rates would be even higher. Says Martin Feldstein, a Harvard professor who served for two years as Reagan's chief economic adviser: "Although no one knows when the capital from abroad is going to dry up, the U.S. should not continue to live on borrowed time."

While most economists agree that the deficit is a threat, there is no consensus on how to slash it. Many, including conservatives like Feldstein as well as liberals like Alice Rivlin of the Brookings Institution, believe that tax increases are unavoidable. Others, like Allan Meltzer of Carnegie-Mellon University and David Meiselman of Virginia Polytechnic, think that the emphasis should be on reductions in spending. In the NABE survey, economists were almost evenly split on the issue: 42% said that the deficit should be pared solely through spending cuts, while 41% supported some form of tax increase or reform.

A similar rift has long prevailed within the inner councils of the Reagan Administration. The Administration's supply-siders, led by Treasury Secretary Donald Regan, have consistently urged the President to oppose income tax hikes. Another faction, known as the "pragmatists" and led by Budget Director David Stockman, has counseled Reagan to keep open all options, including a tax increase. The pragmatists fear that the strength of the economy may convince the President that the supply-siders are right. Says one Administration official: "The President is going to be aw fully tempted to believe this fairy tale about the deficit going away."

Treasury Secretary Regan floated a proposal last week that may form the basis of a compromise between supply-siders and pragmatists, and be tween Democrats and Republicans in Congress. He said that if Reagan wins reelection, the Treasury might recommend that the President push during his second term for a "modified flat tax" plan similar to proposals now percolating in Congress.

Under such a scheme, the top tax rate for high-income people would drop from 50% to 35% or less, and most Americans would pay a low flat rate of perhaps 14%. At the same time, many deductions and loopholes would be eliminated, so that the total amount of income subject to tax would sharply increase. In that way, Congress could reduce tax rates and thus encourage investment and growth, while simultaneously raising revenue by sweeping away unproductive tax shelters.

Advocating a flat-tax plan would let Reagan have it both ways. The President could claim he was standing by his pledge to lower taxes. He could also say he was using tax reform to trim the budget deficit. It would be a bold strategy and one that might be fiercely opposed by taxpayers and special-interest groups who benefit from loopholes. But nothing less than a master stroke can ensure that the U.S. economy will not be overwhelmed by the mushrooming federal debt.

With reporting by Bernard Baumohl/New York and ChristopherRedman/Washington