Economic Uncertainties Require a Margin for Error

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By Rob Ryan

The state of the economy is a crucial determinant of the federal budget outlook. Even slight changes in key economic indicators can lead to major shifts in federal revenues and outlays.

The Congressional Budget Office (CBO) outlined economic uncertainties and their potential fiscal impacts in its recent report, “How Changes in Economic Conditions Might Affect the Federal Budget.”

The word “might” is an important qualification;  while economic analysts can make projections, they cannot do so with certainty — particularly for the medium and long term. That should provide an extra incentive for Congress and the president to provide a margin for error in deficit reduction efforts and to pursue policies that will support economic growth.

In the new report, CBO analyzed the budgetary impacts of slight shifts in four economic indicators from their baseline predictions: (1) labor force growth, (2) productivity growth, (3) interest rates, and (4) inflation. CBO found that even a 0.1 percentage point shift every year in each of these factors can significantly alter the budget outlook over 10 years.

In all cases of less favorable conditions in each economic indicator, federal deficits increase over the decade. Lower labor force growth or less productivity growth would lead to significantly less government revenue, while higher interest rates or inflation would spur net spending increases.

For example, CBO estimates that if productivity growth is 0.1 percentage point slower each year than in its baseline projection, the deficit would be $52 billion higher in 2028 and $228 billion higher over 10 years.

If interest rates are 0.1 percent higher each year, the deficit would be $28 billion larger in 2028 and $164 billion larger over 10 years. This is particularly sobering because it implies that a fairly modest 1.0 percent increase in projected interest rates, which are low by historical standards, would cause a $1.7 trillion spike in federal government interest payments over 10 years.

Conversely, more favorable economic conditions — lower inflation, lower interest rates and higher labor force growth and productivity — could lead to lower deficits over the next decade than current projection show.

There are several key takeaways from CBO’s report.

First, economic and fiscal forecasts are not straight-forward certainties but estimates that are subject to change due to unforeseen circumstances. Lawmakers should take this inherent uncertainty into account in considering how to meet the fiscal and economic challenges facing the country.

When in doubt, they should overshoot on deficit reduction. This can also have a side effect of helping to keep interest rates down. Lawmakers should also be restrained in their assumptions about the presumed economic benefits of their preferred policies.

While narrowing the gap between federal revenue and spending, elected officials should also pursue an agenda that can produce more positive outcomes in the key components of economic growth highlighted by CBO: labor force growth and productivity growth. While lawmakers first and foremost must be willing to make politically challenging tax and spending decisions to reduce deficits, promoting an economic agenda that fosters steady and sustainable growth can help.

For example, Congress could improve labor force growth projections by expanding legal immigration. In a recent op-ed in The Hill, Robert L. Bixby, The Concord Coalition’s executive director, said that increased immigration can spur both labor force and productivity growth, noting that while it is not “a magic bullet,” it would be “a source of strength for the economy.”

In addition to pro-growth immigration reform, Congress could restructure federal spending in a way that maximizes needed investment in the economy in order to increase productivity growth.

As Concord outlined in a recent issue brief, federal investment spending has plummeted in recent decades while spending on transfer payments has skyrocketed. Congress must reverse this trend.

While there will always be uncertainty, policies that improve baseline projections would improve results even in the event of unexpected downturns because the economy would be starting from a stronger position.

By enacting such far-sighted policies, Washington could boost the economy while reducing future deficits and improving the nation’s fiscal outlook. At a time when the federal debt is projected to rise over the next decade to 96 percent of GDP, up from the current 77 percent, now more than ever policymakers must promote stable and sustainable economic growth.

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