The Economic Outlook and Fiscal Policy Choices

September 28, 2010

I testified this morning to the Senate Budget Committee about the economic outlook and CBO’s analysis of the potential impact on the economy of various fiscal policy options. You can read a summary of my testimony (the full version, which is rather long, is also available), or you can glance at the slides I used, which are below.

Policymakers cannot reverse all of the effects of the housing and credit boom, the subsequent bust and financial crisis, and the deep recession. However, in CBO’s judgment, there are both monetary and fiscal policy options that, if applied at a sufficient scale, would increase output and employment during the next few years. But there would be a price to pay: Those same fiscal policy options would increase federal debt, which is already larger relative to the size of the economy than it has been in more than 50 years—and is headed higher. If policymakers wanted to achieve both stimulus and sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it relative to baseline projections after a few years.

To assist policymakers in their decisions, CBO has quantified the effects of some alternative fiscal policy options. In a report last January, we analyzed a diverse set of temporary policies and reported their two-year effects on the economy per dollar of budgetary cost, what one might call the “bang for the buck.” The overall effects of those policies would depend also on the scale at which they were implemented; making a significant difference in an economy with an annual output of nearly $15 trillion would involve a considerable budgetary cost.

In brief, CBO found the following: A temporary increase in aid to the unemployed would have the largest effect on the economy per dollar of budgetary cost. A temporary reduction in payroll taxes paid by employers would also have a large bang-for-the-buck, as it would both increase demand for goods and services and provide a direct incentive for additional hiring. Temporary expensing of business investment and providing aid to states would have smaller effects, and yet smaller effects would arise from a temporary increase in infrastructure investment and a temporary across-the-board reduction in income taxes.

Today’s testimony went on to address the effects of another set of fiscal policy options. At the request of the Chairman of the Senate Budget Committee, we have now estimated the short-term and longer-term effects of extending the 2001 and 2003 tax cuts, extending higher exemption amounts for the alternative minimum tax, and reinstating the estate tax as it stood in 2009 (adjusted for inflation). The methodology for this analysis was quite similar to the methodology that CBO follows in analyzing the President’s budget each spring; we used several different models and made different assumptions about people’s behavior.

We examined four alternative approaches to extending the tax cuts: a “full permanent extension” that would extend all of the provisions permanently; a “partial permanent extension” that would extend permanently all of the provisions except those applying only to high-income taxpayers; a “full extension through 2012” that would extend all provisions but only through 2012; and a “partial extension through 2012” that would extend through 2012 all provisions except those applying only to high-income taxpayers. As shown in the following figure, all four of the options would raise national income, output, and employment during the next two years, relative to what would occur under current law. That would occur because, all else being equal, lower tax payments increase demand for goods and services and thereby boost economic activity.

Ranges of Effects of Four Tax Policy Options on Real GNP in 2011 and 2012

But the effects of those policy options on the economy in the longer term would be very different from their effects during the next two years. The averages of the estimates across different models and assumptions indicate that all four of the options would probably reduce income relative to what would otherwise occur in 2020 (see the figure below). Those effects are largely the net result of two competing forces: All else being equal, lower tax revenues increase budget deficits and thereby government borrowing, which reduces economic growth by crowding out investment. At the same time, lower tax rates boost growth by increasing people’s saving and work effort.

Effects of Four Tax Policy Options on Real GNP in 2020

Beyond 2020, and again relative to what would occur under current law, the reductions in income from all four of the policy options would become larger. Either a full or a partial extension of the tax cuts through 2012 would reduce income by much less than would a full or partial permanent extension.

In sum, and as CBO has reported before: Permanently or temporarily extending all or part of the expiring income tax cuts would boost income and employment in the next few years relative to what would occur under current law. However, even a temporary extension would add to federal debt and reduce future income if it was not accompanied by other changes in policy. A permanent extension of all of those tax cuts without future increases in taxes or reductions in federal spending would roughly double the projected budget deficit in 2020; a permanent extension of those cuts except for certain provisions that would apply only to high-income taxpayers would increase the budget deficit by roughly three-quarters to four-fifths as much. As a result, if policymakers then wanted to balance the budget in 2020, the required increases in taxes or reductions in spending would amount to a substantial share of the budget—and without significant changes of that sort, federal debt would be on an unsustainable path that would ultimately reduce national income. Similarly, even temporary increases in government spending would add to federal debt and reduce future income, and permanent large increases in spending that were not accompanied by other spending reductions or tax increases would put federal debt on an unsustainable path. Compared with the options examined here for extending the expiring tax cuts, various other options for temporarily reducing taxes or increasing government spending would provide a bigger boost to the economy per dollar of cost to the federal government.