point the finger of blame. There's enough of it for everyone. Those who say we ought to raise taxes only, you know, they have their constituency. Those that say cut spending have their constituency. In my view, it will take a more balanced approach to do the job. So we are acting in response to the instruction. I also believe, as Senator Danforth pointed out, that it's our hope that these hearings will raise the level of debate about budget deficits. We have some outstanding witnesses. And we believe there is a lot of interest. I visited my State recently. Cattle loans are still 14 percent. Mortgage interest loans are still 131⁄2 percent. And as Senator Baucus indicated, there are some who believe that it may start to deteriorate earlier than others believe.

There are all kinds of figures, but in addition to the one that Senator Baucus pointed out, it's difficult to conceptualize the size of the projected deficits unless it is reduced to a personal level. The public debt now stands at about $6,000 for every man, woman, and child in the United States. If nothing is done to reduce the deficits over the next 5 years, that debt is going to go to about $10,000 per person. And at this level, by 1989, will take about 50 percent of all Americans' personal income tax payment or $1,100 per person just to pay the Federal Government's interest bill. I think it's obvious that we must do something.

Many Americans will find home buying more difficult with higher deficits. Consider a family purchasing a home at today's current interest rate, averaging about 121⁄2 percent with a $55,000 mortgage. If the deficits push interest rates up, total interest costs over the 30-year term will be $15,000 more per each 1 percentage point increase. So it's a matter that ought to affect consumers, and it's my hope that we can have some discussion. I know there will be some good questions.

It is now my pleasure to welcome for the first time since you have assumed your new responsibilities as Congressional Budget Office Director, Dr. Rudolph Penner to the Finance Committee. You may proceed in any way you wish, Rudy. Either summarize your statement or read it in its entirety, but it will be made a part of the record.

STATEMENT OF DR. RUDOLPH G. PENNER, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE, WASHINGTON, D.C. Dr. PENNER. Thank you, Mr. Chairman. I will just summarize it for now.

I am pleased to have the opportunity to testify on the economic and budgetary outlook. As you know, economic conditions have improved greatly since the end of last year. The economic recovery is proceeding at a rapid pace, about in line with past recoveries. Unemployment has already declined substantially though it remains high. Inflation was greatly reduced during the recession, and while it has not declined further in recent months, the recovery has not generated any significant acceleration in the rate of price increases. The near-term economic outlook also looks favorable. Although economic growth is not likely to proceed at the brisk pace of the last two quarters, most forecasters expect it to be substantial.

The horizon is clouded, however, by large Federal deficits, which have not yet been dealt with decisively. The first budget resolution for fiscal year 1984 took an important step toward reducing future deficits, but the resolution has not yet been fully implemented. Consequently, many fear the deficits will not decline significantly as the recovery proceeds.

Nevertheless, the short-run forecast that we published in August looks pretty accurate with real economic growth and prices close to their projected paths. The one inaccuracy is a happy one. Unemployment has fallen much more quickly than expected, and has already reached 8.4 percent, a level that we earlier did not expect to reach until well into 1984.

To the extent that the very large deficits have caused crowding out, it seems to have focused on the trade sector, and to some extent on housing, which is absorbing less of the GNP than would normally be expected at this stage of the business cycle. Otherwise, the recovery is proceeding normally, aided in no small part by borrowing from abroad with funds attracted by our abnormally high real interest rates.

As usual, a number of uncertainties cloud the short-run outlook. Four risks in particular are noteworthy. The interest rates in the CBO forecast were based on the assumption that the deficit reduction program of the budget resolution would be implemented. However, whether that will actually occur is an open question today, and, thus, higher rates are a real possibility.

Prices could be more sensitive to economic growth than assumed in the CBO forecast. Also, the prospect of large Federal deficits could have more serious effects on inflationary expectations. In addition, the forecast assumes no inflationary shocks such as another bad harvest, a serious interruption in oil supplies, or a very rapid depreciation of the dollar in foreign exchange markets.

The debt problems of a number of developing countries seem to have eased at least temporarily, but remain serious. Even a small increase in interest rates or a further delay in the recovery of the industrial countries could tip the balance with serious consequences for U.S. exports. A loss of confidence in the dollar because of dismay over U.S. fiscal policy or other factors could significantly raise interest rates and inflation.

The longer run economic projections shown in table 3 in my prepared statement were originally prepared for the House Budget Committee staff to show what might happen if productivity rebounded to its historical growth rate. The figures for 1985 through 1989 are thus not a forecast. Rather, they are noncyclical projections that assume the economy moves gradually toward higher employment levels without price shocks.

The growth implied in this projection may be optimistic. Economic growth has become slower in advanced economies generally, and some economists believe that the conditions that gave rise to the rapid growth in the fifties and sixties are no longer present. The heavy debt burdens of some developing countries endanger the short-run forecast, but they are a long-run problem as well. In addition, current U.S. monetary and fiscal policies are unusual and may not be consistent with the projected growth path.

Finally, if recovery should threaten to spark renewed the Federal Reserve might take anti-inflationary steps t temporarily slow economic growth. Perhaps the greatest ty is in the interest rate projection. It was made on the as that the Congress would take deficit reducing measures i session. A serious prospect of permanently large deficits tensify pressures on U.S. capital markets, and risk a loss dence in the dollar, which could raise interest rates and rates above those in the projections.

Using the CBO August short-run economic forecast, longer run economic assumptions in table 3, we recently some preliminary baseline budget projections for fiscal ye 89. With real defense growth assumed to continue at 5 pe annum, table 5 in my complete testimony shows the budget picture through 1989. Under our preliminary bas sumptions, both revenues and outlays keep pace with GNP growth. Revenues as a share of GNP remain slightly percent, and outlays hover around 24 percent. As a re budget deficit remains at about 5 percent of GNP through

The composition of spending, however, is likely to cha stantially over the next 5 years. As shown in table 6, defer icaid and medicare, and net interest all grow faster th while other items grow at a slower rate.

The risk associated with these baseline deficits are hard accurately because the ratio of the deficit to GNP wil higher for a sustained period than anything experienc World War II. When policy variables move outside the rang torical experience, analysts can no longer assume with co that empirical relationships estimated on the basis of past d remain relevant to analyses of the current situation.

Clearly, however, unless current taxing and spending pol changed, the budget deficit will grow and add to interest ra sure. The CBO projections assume that interest rates will gradually in part as I already noted, because we assumed plementation of the budget resolution. High interest rate have serious adverse effects. For example, as the recovery ues, business capital formation may experience more crowd than has occurred thus far in the cycle. The potential for e growth will then be reduced, and standards of living will b in the long run.

Conversely, growing capital inflows from abroad may o some extent the reduction in U.S. capital formation. But t plies an increasing commitment to pay interest and divid foreigners which likewise will reduce future U.S. living sta As noted earlier, heavy reliance on foreign capital also lea United States vulnerable to changes in the psychology of investors.

While controversy will undoubtedly continue regarding th nitude of the risks described above, one effect of large de almost inevitable. The net interest bill on the national de grow and grow. Table 6 shows the net interest bill under b assumptions. Even with declining interest rates, the net i bill grows by $73 billion between fiscal years 1984 and 198! 70 percent. If instead we assume that interest rates rema

stant at the levels of October 1983, the net interest bill would rise about $131 billion between 1984 and 1989, or by $58 billion more than the baseline projections.

A further 1 percentage point rise in interest rates would raise the 1989 net interest bill by still another $31 billion. These numbers show, Mr. Chairman, that the debt has just gotten so large out there that even small changes in your interest bill can significantly alter the outlook.

In other words, the large, current deficits limit your future spending options. More important, large, current deficits have a way of generating increased future deficits. Even with the interest rates assumed in this analysis, the net interest bill grows faster than the GNP in our projection. The tax increases or other spending cuts necessary to offset this rise become more and more arduous as time passes. Eventually, financing the U.S. debt could become so burdensome that some would urge that the Federal Reserve absorb a portion of the deficits in order to avoid the necessary budgetary actions to reduce the debt burden.

But if the Federal Reserve succumbed to such pressures, and Chairman Volcker has strongly stated that it will not, the money stock would grow rapidly and sharply higher inflation would follow.

While large deficits may create major risks, abrupt or poorly designed measures to reduce deficits can also be a threat to economic efficiency and to the health of the economic recovery. Ideally, major spending cuts and tax changes should occur gradually or with long advance notice so that individuals and firms dependent on current tax and spending policies have time to adjust. Moreover, those affected must have some confidence that the changes will not be reversed at the last minute or soon after they have been implemented.

The first budget resolution attempted to invoke such a gradual strategy by putting off major tax increases until 1986. Any analysis of the potential for reducing deficits in a major way by cutting spending must start with the fact that a large portion of Federal outlays is devoted to only a few budget categories, as is shown in table 6. Defense, entitlements, and net interest constituted 86 percent of outlays in 1983, and that proportion is expected to grow to 88 percent by 1989.

In turn, social security and medicare and medicaid constituted 63 percent of entitlements in 1983, growing to 73 percent by 1989. Note that by 1989 defense, social security, medicare, and medicaid, and the net interest will absorb almost 100 percent of the revenues that we project for that year.

The possibility of cutting other programs should not be ignored, but since they have already been declining relative to GNP, it seems reasonable to believe that major changes in defense, social security or medicare will be required if the course of total spending is to be altered significantly.

If changes in spending laws are deemed desirable, they should be undertaken soon. Cuts in defense procurement, for example, show up in reduced outlays only after a long time lag. Cuts in social security and medicare ought to be phased in gradually so that

beneficiaries and providers of health care services have time to adjust.

My complete testimony goes into a number of possible spending options in some detail. I won't do that here. But the basic message, I repeat, is that if spending is to reduced significantly in the future, like Willie Sutton, you have to go where the money is. And that is defense, social security, and medicare.

Other areas should not be ignored, but cuts there could not be expected to contribute in a major way to deficit reduction.

CBO has started its annual review of possible strategies and options for reducing spending, and will present the results to the Congress within a few months. We are also taking a close look at the major recommendations of the President's private sector survey on cost control, known as the Grace Commission, and will publish a separate analysis of these with the assistance of the General Accounting Office.

On the revenue side, there are basically three broad classes of options. One can raise tax rates; one can broaden the base of the existing tax system; or introduce new taxes.

Again, my testimony looks at some of these things specifically. I would be glad to discuss them in more detail, if you like.

The CHAIRMAN. Thank you.

[The prepared statement of Dr. Penner follows:]