October 31, 2014

The CBO January Baseline: A Deceptively Benign Outlook

The outlook for the federal budget is deceptively benign under the January 2006 baseline assumptions of the Congressional Budget Office (CBO). In its latest 10-year projections, CBO describes a budget that will reach balance in 2012 and stay balanced through 2016, the end of the projection period (see Table 1). Indeed, unlike the genre of television programs that highlight the intense struggles of victors despite overwhelming odds, the baseline makes budget balance appear a little too easy.

Table 1. CBO Baseline Projections, January 2006














Total

Total

 













2007-

2007-

 


2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2011

2016

 
















 

In billions of dollars

 

On-Budget Deficit

-518

-466

-476

-474

-473

-380

-238

-243

-230

-218

-226

-2,269

-3,424

 

Off-Budget Surplusa

181

196

217

233

250

266

276

283

288

291

293

1,162

2,592

 


Total Deficit

-337

-270

-259

-241

-222

-114

38

40

57

73

67

-1,107

-832

 
















 

Memorandum:














 

Social Security Surplus

180

195

214

231

246

262

271

278

282

286

287

1,148

2,552

 

Postal Service Outlays

-2

-1

-3

-2

-4

-4

-5

-5

-5

-6

-6

-14

-40

 
















 

As a percentage of GDP

 

Total Deficit

-2.6

-2.0

-1.8

-1.6

-1.4

-0.7

0.2

0.2

0.3

0.4

0.3

-1.4

-0.5

 
















 

Debt Held by the Public

37.6

37.8

37.7

37.5

37.2

36.3

34.6

32.9

31.3

29.6

28.1

n.a.

n.a.

 
















 

Source: Congressional Budget Office.


 

Note: n.a. = not applicable.













a.

Off-budget surpluses comprise surpluses in the Social Security trust funds as well as the net cash flow of the Postal Service.















Total

Total

 













2007-

2007-

 


2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2011

2016

 
















 

In billions of dollars

 

On-Budget Deficit

-518

-466

-476

-474

-473

-380

-238

-243

-230

-218

-226

-2,269

-3,424

 

Off-Budget Surplusa

181

196

217

233

250

266

276

283

288

291

293

1,162

2,592

 


Total Deficit

-337

-270

-259

-241

-222

-114

38

40

57

73

67

-1,107

-832

 
















 

Memorandum:














 

Social Security Surplus

180

195

214

231

246

262

271

278

282

286

287

1,148

2,552

 

Postal Service Outlays

-2

-1

-3

-2

-4

-4

-5

-5

-5

-6

-6

-14

-40

 
















 

As a Percentage of GDP

 

Total Deficit

-2.6

-2.0

-1.8

-1.6

-1.4

-0.7

0.2

0.2

0.3

0.4

0.3

-1.4

-0.5

 
















 

Debt Held by the Public

37.6

37.8

37.7

37.5

37.2

36.3

34.6

32.9

31.3

29.6

28.1

n.a.

n.a.

 
















 

Source: Congressional Budget Office.


 

Note: n.a. = not applicable.













a.

Off-budget surpluses comprise surpluses in the Social Security trust funds as well as the net cash flow of the Postal Service.


                                                               


The Baseline: What’s In and What’s Not

When compared with baseline projections that CBO issued last August, the new estimates show surprising improvement. Last August, CBO estimated that deficits would total $2.1 trillion between 2006 and 2015. In its January report, CBO now projects that deficits will total $1.2 trillion over the same 10-year period. The change in the 10-year outlook results from two principal sources, neither of which result from conscious policy choices:

· Increases in revenue projections resulting from changes in CBO’s economic assumptions. CBO has boosted its estimates of gross domestic product (GDP) throughout the 10-year horizon and increased is projections of corporate profits. Higher GDP means higher revenues. Greater profits mean higher corporate tax bills. The GDP increase, however, does not reflect stronger underlying economic activity. Instead, it stems from accounting adjustments to GDP estimates in 2005 and increases in the rate of inflation in 2005 due to energy price increases.

· Decreases in estimates of discretionary spending largely because new funding enacted so far in 2006 for activities related to Iraq and Afghanistan ($50 billion) is lower than 2005 levels ($76 billion). The increasing use of supplemental appropriations, rather than “upfront” budgeting for expected costs, can create large swings in baseline projections that are misleading. CBO expects that the Congress and President will add more funding for Iraq and Afghanistan. However, those amounts are not included in the new projections. Had they been included in the 2006 appropriation bill for the Department of Defense (DOD), the baseline would include a more realistic level of funding.

In constructing its baseline, the CBO is required to incorporate assumptions about current laws and statutes. According the report, the baseline “…is therefore not intended to be a prediction of future outcomes: instead it is meant to serve as a neutral benchmark that lawmakers can use to measure the effects of proposed changes to spending and taxes.”

The apparent shift in the budget’s outlook since last August illustrates why the baseline cannot be interpreted as the most likely path for the budget. CBO informally estimates that the deficit in 2006 will be around $360 billion—$23 billion higher than the published estimate of $337 billion—when lawmakers add funds for DOD and hurricane-related flood insurance claims that the baseline is precluded from incorporating.

Beyond current law, CBO bases its projections on economic and technical assumptions that reflect past outcomes, not future events. Thus, even if the Congress were to refrain from passing any legislation not consistent with the baseline assumptions, the budget’s future outcome is likely to deviate from CBO’s projections. It could be better. It could be worse

Table 2 illustrates the types of pressures that will affect the budget’s course over the next decade.


Table 2. The Baseline: What’s In and What’s Not

What’s In

What’s Not

Discretionary spending keeps pace with the rate of inflation over the next decade, growing an average of 2 percent a year.

A growth in spending more consistent with historical experience. Since 1985, non-defense discretionary spending has remained relatively stable as a share of gross domestic product (GDP), averaging growth of 5.6 percent a year.

Continued funding for the military activities in Iraq and Afghanistan: $50 billion in new funds in 2006, continued at an inflation-adjusted level through 2016 ($557 total in spending authority).

Additional funding requirements could boost needs in the near term, adding to the deficit in 2006 and 2007. If circumstances permit, funding requirements could decrease and result in lower deficit estimates.

However, there is no provision in the baseline for military contingencies that could arise in other parts of the world.

New spending related to Hurricanes Katrina and Rita of $29 billion a year at an inflation-adjusted level, totaling $265 billion between 2007 and 2016.

Additional funding for hurricane recovery may be less than the amounts included in the baseline, but may be more front-loeaded, which would increase near-term deficits and add to interest costs throughout the projection period.

No new funds for any new catastrophic disasters—domestic or international.

Revenue projections that reflect current laws, including the scheduled expiration of tax cuts enacted in 2001-2003

Additional relief for alternative minimum taxpayers in 2006 and beyond, continuation of the individual income tax rate reductions, refundable child tax credit, and marriage penalty fix beyond 2010, extension of estate tax phase-out beyond 2010, and continued rate reductions for capital gains and dividends after 2008.

Average annual growth in the economy at the historical pace.

Near-term adverse economic events that could cause projected revenues to fall short of baseline projections and add to deficits.

Changes in the international financial climate that could affect the willingness of foreign investors to absorb U.S. debt. Without those investors, U.S. interest rates would rise above current levels. In addition to the directly aeffect on the budget’s interest costs, higher interest rates would have an indirect impact on the budget through their negative effects on the overall economy.

Costs related to private pension insurance provide through the Pension Benefit Guaranty Corporation (PBGC) based upon historical experience.

Greater exposure to the federal government due to weaken condition of major corporations. If more large employers abandon their pension liabilities (example: United Airlines) the federal government could incur major additional costs.

Annual growth in Medicare and Medicaid spending averaging 8.3 and 8 percent.

Pending reductions to Medicare and Medicaid in the Deficit Reduction Act of 2006. CBO estimates that those reductions will total nearly $50 billion through 2015, but those savings are not included in the baseline because they have not been enacted into law.[1]

In addition, health spending is unpredictable. Costs for the new Medicare prescription drug program could be higher of lower than projected. Changes in the finances of private health care could add to federal bills. An economic slowdown could increase the number of Medicaid beneficiaries.

Consequently, attaining and maintaining a balanced budget—while possible given the baseline assumptions—will be far more difficult than it looks. That is particularly true because: (1) there is no firm consensus within the Congress or the White House that the budget balance is the appropriate goal; and (2) lawmakers lack enforceable rules that would encourage them to live within whatever budget limits they do set for themselves.

Over the next 10 years there will be two presidential elections and five congressional elections. Without a firm commitment to fiscal discipline backed up by budget enforcement rules, deficits are more likely to increase than decrease. Budget process tools, such as statutory limits on discretionary spending and a pay-as-you-go (PAYGO) requirement for entitlement program and tax law changes, helped policy makers achieve a balanced budget in 1998. The need for such rules is even more acute now.

A More Plausible Budget Outlook

A more plausible outlook for the budget shows persistent and growing deficits throughout the projection period (see Figure 1). That scenario would: adjust funding upward for Iraq and Afghanistan in 2006 and 2007, but phase it down starting in out in 2008 and leveling out beyond 2010; incorporate spending for discretionary (annually-appropriated) programs at the rate of GDP growth; and renew and extend relief from the AMT (without which the number of returns subject to the AMT will jump from 4 million in 2005 to 20 million in 20106). IBut if the White House convinces the Congress to make the 2001-2003 tax cuts permanent, the budget’s bottom line will be in far worse shape.



[1] The $50 billion estimate probably overstates eventual savings related to Medicare. The bill contains an adjustment in the payment rates for physician services for to keep them from being cut below 2005 levels which has a net cost of $7.3 billion between 2006-2010. The bill assumes that rates will be cut deeply in 2010-2015 to offset those costs, a highly unlikely assumption. The provision ensuring that payments to doctors are not cut below 2005 levels only applies for 2006, but there will be considerable pressure to extend this provision to prevent a cut in payments in subsequent years. CBO estimates that extending this freeze permanently would cost $27 billion over five years.

.

 

Demographic Delusions

CBO’s budget projection period now extends well into the early retirement years of the post-World II baby boomers. The oldest boomers turn 60 this year. Over the next two decades, assuming no change to current laws, the movement of the baby boomers out of the active workforce and into retirement will exert enormous pressure on the budget. CBO’s latest long-term analyses indicate that spending for Social Security, Medicare and Medicaid will exceed total projected revenues beginning in 2047 (see Figure 2).[1] According to CBO, spending will reach 38 percent of GDP—88 percent larger than today’s budget.

None of those developments is new news. Not only have policy makers failed to address long-term budget problems, they have made them worse (see Figure 3) by adding a major new entitlement—the Medicare prescription drug benefit—w without adding adequate financing.




[1] Estimates reflect Scenario 2 in the CBO report. That scenario assumes that: (1) revenues will climb to 18.3 percent of GDP, their historic average level, and be maintained there; and (2) spending will take an intermediate path (defense spending declines to its historic real level and that “excess” cost growth in Medicare and Medicaid declines from current levels of 2.5 percent above the annual rates of inflation and beneficiary growth growth, to 1.0 percent.).

 


Debt levels as high as those contained in CBO’s projections would not be sustainable. The CBO report states:

A budget policy that caused federal debt to grow continually faster than GDP could seriously harm the economy. Rising government debt can sap national saving, slow private capital formation, lower economic growth, and in the extreme, produce a sustained economic contraction. Moreover, such a policy could increase the United States indebtedness to other nations. Implying that more of the economy’s output would have to be used to pay interest on the debt and less would be available for U.S. residents.

Under the intermediate scenario shown above, interest on the debt grows faster than health care costs. By 2050, if the projection shows spending for net interest equivalent to one-third of all spending and nearly equal to the level for Medicare and Medicaid combined.

CBO cautions that there are no easy solutions. The U.S. in not likely to be able to grow its way out of the imbalances between spending and revenues implied by current policies. Under current policies, non-interest spending in 2050 is projected to be nearly 7 percent higher as a share of GDP than it is today. Paying for that increase exclusively by raising taxes could hurt economic growth by adversely affecting individual incentives to work and save, while reductions of that size in projected spending for benefits could have a large and negative impact on the standard of living of future retirees.

The report provides some indication of the potential impact of various policies on the gap.

· Revenues under current law will rise by 4 percent of GDP between now and 2050, CBO projects. That assumes, however, that the income tax rate reductions enacted in 2001 and 2003 expire and that there is no modification to the AMT to accommodate inflation.

· Indexing the AMT for inflation would reduce the growth in revenues to 2 percent of GDP in 2050. Without that type of modification, CBO estimates that 65 percent of tax returns in 2050 would be subject to the AMT—a sharp increase from the 2 percent of returns affected today.

· Simply allowing the 2001 and 2003 tax cuts to expire on schedule would raise revenues by about 1 percent of GDP throughout the time period.

· Reducing cost-of-living adjustments in Social Security to the consumer price index less 0.3 percent would provide small savings of about 0.3 percent of GDP in 2050.

· Raising the eligibility age for full Social Security retirement benefits to age 70 (affecting anyone born in 1967) and indexing it for longevity would reduce spending by 0.8 percent.

· Raising the Medicare eligibility age to 67 would reduce spending by 0.2 percent of GDP in 2050. Increasing it to age 70 (consistent with the increase in eligibility age for Social Security describe above) would reduce spending by 0.9 percent of GDP in 2050.

In today’s climate, none of those changes would be easy to enact into law. They do illustrate that there are policy choices that would help put the budget onto a sustainable path over the long term. Although baby boomers have a reputation for not acting their age, there is no denying the fiscal impact of their continued aging.

Fiscal Insecurity

Balancing the budget is not an end in and of itself, but a means to an end. A balanced budget provides evidence of sustainable fiscal policy and responsible governance. Deficits accumulated over the last four years total nearly $1.3 trillion—approximately $4,300 for every man, woman and child living in the United States today. Explanations for those deficits abound (recession, terrorism, war, natural disasters, etc.). More than half of the deterioration in the budget outlook since January 2001 (when CBO projected $5.6 trillion in budget surpluses for 2002-2011) results from enacted legislation, which policy makers do control.

Over the next 10 years there will be two presidential elections and five congressional elections. Without a firm commitment to fiscal discipline backed up by budget enforcement rules, deficits are more likely to increase than decrease. Budget process tools, such as statutory limits on discretionary spending and a pay-as-you-go (PAYGO) requirement for entitlement program and tax law changes, helped policy makers achieve a balanced budget in 1998. The need for such rules is even more acute now.

It isAt a minimum, elected officials should agree not to make problems any worse. That means, for a start, returning to enforceable budget discipline—spending limits for discretionary programs and pay-as-you-go (PAYGO) requirements for entitlement and tax law changes. t True, thate Congress ispassed working on part of a budget reconciliation package that includes spending reductions of $99 billion over the 2006-2015 period. HoweverIf enacted, those savings would amount to a little more than 50 cents out of every $100 in spending for entitlements and other mandatory programs on over that 10-year period. Even that marginal progress would be offset by the proposed extensions of the 2001 and 2003 tax cuts, which would cost 16 times the amount of pending spending cuts.

What is striking about the current budget debate is the obvious lack of any consensus within the Congress about priorities and the goals of fiscal policy. The controversy over the 2006 reconciliation agreement is as much about balance as it is about the incidence of the spending cuts. Whereas successive deficit reduction legislation in the 1980s and 1990s focused on revenue increases, as well as spending restraint, the current, exclusive emphasis on spending cuts threatens to undermine serious efforts to address fiscal imbalance.

Pressures are mounting throughout the economy—on private firms as they attempt to address problems with their global competitiveness including the cost of health care and retirement benefits for their employees; on baby boomers, many of whom are balancing the need to support children as well as aging parents; and on state and local governments that are struggling with their own fiscal gaps. The ability of the federal government to be the “insurer of last resort” and to be in a position to address emerging national needs is compromised by the policy makers’ inability to confront the budget’s shortcomings. That injects uncertainty and instability into the economy, when what is required is decisive leadership. The result is fiscal insecurity for both current and future generations.