THE UNITED STATES has dealt with the terrorist attacks from a position of financial strength, namely, historically large federal, state and local government budget surpluses. Indeed, the ability to marshal significant resources during times of war is one of our country's great strengths. To be sure, the war on terrorism is decidedly unlike previous conflicts. No one now knows the scale of governmental resources that will be necessary to prosecute the war. But because the nation entered the conflict with a solid government financial position, the consequences for the economy are unlikely to include large tax increases and the uncertainty that would accompany them.

The federal government recorded a $69.2 billion unified budget surplus in fiscal year 1998; by fiscal year 2000, the surplus had grown to just under $240 billion, or 2.4 percent of GDP. The government attained this budget position through a combination of fiscal restraint and better-than-expected economic growth. The higher economic growth rate reflected an increase in the growth of labor productivity beginning around 1995, which most economists attribute to the marked rise in investment in high-tech capital equipment. That investment was financed in part through the surpluses in the federal budget. Paying down federal debt released funds for private investment.

This virtuous cycle, in which a strong economy increased federal revenues, and a federal budget surplus helped to support private investment that boosted economic growth, continued until the recession of 2001 set in, starting in March. Previous growth had taken the economy to a much higher level than it would have achieved had growth remained relatively low in the late 1990s; as a consequence, despite the mild recession, the federal budget was in much better shape than it otherwise would have been.

In May of last year, passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, reduced, but did not eliminate, prospective budget surpluses. Consequently, federal resources were deemed available to deal with circumstances that changed dramatically after the terrorist attacks. Soon after September 11, President Bush proposed a $20 billion emergency aid package to assist those individuals, businesses and government administrators directly affected by the attacks. Congress quickly doubled the size of this package, which also authorized funds for increased military and security measures, and then sent it to the president, who signed the legislation into law September 18. Subsequently, emergency legislation totaling $15 billion was signed into law to help stanch the losses suffered by domestic air carriers. Then, Congress passed and the president signed into law the Aviation Security Act of 2001, which authorized federal oversight and responsibility of most airport security measures, including inspection of passenger baggage; increased use of federal air marshals; and awarded grants to air carriers to improve in-flight security measures. Given that the traveling public will cover about half of the cost of these measures through increased fees, the Congressional Budget Office estimates the net cost of this legislation over the next five years at a little more than $9 billion.

Going forward, it is possible that additional monies will be required if the war extends longer than expected, if threats of additional attacks crop up or if additional attacks are carried out successfully. Is the federal government positioned to cope with these new fiscal strains? What about state and local governments, which also have an important role to play?

The central question in this regard is whether the economy's growth rate in coming years will be high enough to generate required revenues at current tax rates. The key issue is the rate of productivity growth, a subject of much dispute and limited actual knowledge. The prevailing view among most forecasters and academic economists is that labor productivity has accelerated--perhaps sufficiently to push the economy's sustainable rate of output growth up from the roughly 2.5 percent pace that prevailed between 1974 to 1995, to around 3.25 percent. If such estimates are correct, then budget surpluses may still be more likely than deficits over the next 10 years. Despite the fiscal policy actions taken in response to September 11, the United States is very far from being fiscally stretched. (See sidebar.) Should substantial additional security expenditures be required, some combination of modest tax increases and modest spending restraint in other areas of the federal budget will likely provide the resources needed to address security requirements.

The United States has benefited from a fiscal policy that focuses on efficient use of federal resources and attention to the policy's effects on economic growth. This policy crosses both political parties and has been maintained over many years. Much more could be done to improve the efficiency of federal spending and tax policies, but the point here is that the strong U.S. fiscal position has served the nation well in dealing with the stresses of the terrorist attacks.

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