Long-Term Budget Outlook

June 30, 2010

Recently, the federal government has been recording the largest budget deficits, as a share of the economy, since the end of World War II. As a result of those deficits, the amount of federal debt held by the public has surged. At the end of 2008, that debt equaled 40 percent of the nation’s annual economic output (as measured by gross domestic product, or GDP), a little above the 40-year average of 36 percent. Since then, large budget deficits have caused debt held by the public to shoot upward; CBO projects that federal debt will reach 62 percent of GDP by the end of this year—the highest percentage since shortly after World War II. The sharp rise in debt stems partly from lower tax revenues and higher federal spending related to the recent severe recession and turmoil in financial markets. However, the growing debt also reflects an imbalance between spending and revenues that predated those economic developments.

This morning CBO released the latest in its series of reports on the long-term budget outlook. (Addendum: I presented the key findings of the report to the National Commission on Fiscal Responsibility and Reform.) The report examines the pressures on the federal budget by presenting our  projections of federal spending and revenues over the coming decades. Under current laws and policies, an aging population and rapidly rising health care costs will boost outlays for Social Security benefits and sharply increase federal spending for health care programs. Unless revenues increase at a similar pace, such spending will cause federal debt to grow to unsustainable levels. If policymakers are to put the nation on a sustainable budgetary path, they will need to let revenues increase substantially as a percentage of gross domestic product, decrease spending significantly from projected levels, or adopt some combination of those two approaches.

The Outlook for Major Health Care Programs and Social Security

Growth in spending on health care programs remains the central fiscal challenge facing the nation. CBO projects that if current laws do not change, federal spending on major mandatory health care programs will grow from roughly 5 percent of GDP today to about 10 percent in 2035 and will continue to increase thereafter. (Mandatory programs are those that do not require annual appropriations; the major mandatory health care programs include Medicare, Medicaid, the Children’s Health Insurance Program, and the subsidies that will be provided through the insurance exchanges that will be established as a result of the new health care legislation.)

That estimate includes all of the effects of the recently enacted health care legislation. Although, CBO expects the legislation to reduce federal budget deficits over the first 10 years and in subsequent decades (through its effects on both revenues and spending), it is expected to increase federal spending in the next 10 years and for most of the following decade; by 2030, however, that legislation will slightly reduce federal spending for health care if all of its provisions are fully implemented, CBO projects. (The estimates for the health care legislation that are used in this report are unchanged from the ones that CBO and the staff of the Joint Committee on Taxation published in March, when the legislation was being considered.)

Under current law, spending on Social Security is also projected to rise over time as a share of GDP, albeit much less dramatically—from 5 percent to 6 percent of GDP. (Later this week, CBO will release a report on a number of different policy options for changing Social Security.)

All told, CBO projects, the aging of the population and the rising cost of health care will cause spending on the major mandatory health care programs and Social Security to grow from roughly 10 percent of GDP today to about 16 percent of GDP 25 years from now if current laws are not changed. (By comparison, spending on all of the federal government’s programs and activities, excluding interest payments on debt, has averaged 18.5 percent of GDP over the past 40 years.)

Budget Outcomes Under Two Long-Term Scenarios

In the report, CBO presents the long-term budget picture under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Budget projections grow increasingly uncertain as they extend farther into the future, so this report focuses largely on the next 25 years.

One scenario, the extended-baseline scenario, adheres closely to current law. That set of policies would result in steadily higher average tax rates because they incorporate the assumptions that most of the tax cuts enacted in 2001 and 2003 expire and that the alternative minimum tax applies to more and more people each year—and because the combination of economic growth and the structure of the tax system generates additional tax revenues as a percentage of income. Those rising rates, combined with the tax provisions of the recent health care legislation, would push total revenues to 23 percent of GDP by 2035—much higher than has typically been seen in recent decades—and to larger percentages thereafter. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt—activities such as national defense and a wide variety of domestic programs—would decline to the lowest percentage of GDP since before World War II. Despite those substantial revenue increases and constrained spending for a portion of the budget, the rising costs of health care programs and Social Security would lead to continued budget deficits, and federal debt held by the public would grow from an estimated 62 percent of GDP this year to about 80 percent by 2035.

The budget outlook is much bleaker under the alternative fiscal scenario, which incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period. In this scenario, CBO assumed that Medicare’s payment rates for physicians would gradually increase (which would not happen under current law) and that several policies enacted in the recent health care legislation that would restrain growth in health care spending would not continue in effect after 2020. In addition, under the alternative scenario, spending on activities other than the major mandatory health care programs, Social Security, and interest would fall below the average level of the past 40 years relative to GDP, though not as low as under the extended-baseline scenario.

More important, CBO assumed for this scenario that most of the provisions of the 2001 and 2003 tax cuts would be extended, that the reach of the alternative minimum tax would be kept close to its historical extent, and that over the longer run, tax law would evolve further so that revenues would remain at about 19 percent of GDP, near their historical average.

Under that combination of policy assumptions, federal debt would grow much more rapidly than under the extended-baseline scenario. With significantly lower revenues and higher outlays, debt would reach 87 percent of GDP by 2020, CBO projects. After that, the growing imbalance between revenues and noninterest spending, combined with spiraling interest payments, would swiftly push debt to unsustainable levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2025 and would reach 185 percent in 2035.

Neither of those scenarios represents a prediction by CBO of what policies will be in effect during the next several decades—but these projections, encompassing two very different sets of policy assumptions, provide a clear indication of the serious nature of the fiscal challenge facing the nation.

The Impact of Growing Deficits and Debt

In fact, CBO’s projections understate the severity of the long-term budget problem because they do not incorporate the significant negative effects that accumulating substantial amounts of additional federal debt would have on the economy:

  • Large budget deficits would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment—which in turn would lower income growth in the United States.
  • Growing debt would also reduce lawmakers’ ability to respond to economic downturns and other challenges.
  • Over time, higher debt would increase the probability of a fiscal crisis in which investors would lose confidence in the government’s ability to manage its budget, and the government would be forced to pay much more to borrow money.

Keeping deficits and debt from growing to unsustainable levels would require raising revenues as a percentage of GDP significantly above past levels, reducing outlays sharply relative to CBO’s projections, or some combination of those approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that long-term changes to spending and revenues are agreed on, and the sooner they are carried out once the economic weakness ends, the smaller will be the damage to the economy from growing federal debt. Earlier action would require more sacrifices by earlier generations to benefit future generations, but it would also permit smaller or more gradual changes and would give people more time to adjust to them.