The Outlook for the Economy and the Budget

February 25, 2011

I spoke yesterday to the National Economists Club, highlighting some key aspects of our recent Budget and Economic Outlook. As summarized in my slides, I made these points:

  • Although CBO expects that production and employment will expand this year and in coming years, a return to normal economic conditions will take years. Payroll employment, which declined by nearly 9 million between the end of 2007 and early 2010, has recovered by just a shade over 1 million since then. Only by 2016, in our forecast, does the unemployment rate reach 5.3 percent, close to our estimate of the natural rate.
  • If current laws remain unchanged, as we assume for CBOs baseline projections, the economic recovery and scheduled expiration of major tax provisions would cause budget deficits to drop markedly over the next few years as a share of output. Still, CBO projects that deficits would average 3.6 percent of GDP from 2012 through 2021, totaling nearly $7 trillion over that decade. As a result, the debt held by the public would keep rising, reaching 77 percent of GDP in 2021.
  • Suppose instead that three major aspects of current policy were continued during the coming decade: 1) the higher 2011 exemption amount for the alternative minimum tax (AMT) was extended and, along with the AMT tax brackets, was indexed for inflation; 2) the other major provisions in the recently enacted tax legislation that affected individual income taxes and estate and gift taxes were extended, rather than allowed to expire in January 2013; and 3) Medicares payment rates for physicians services were held constant, rather than dropping sharply as scheduled under current law. If those policies were extended permanently, deficits over the coming decade would average about 6 percent of GDP and would cumulate to nearly $12 trillion. Debt held by the public in 2021 would rise to almost 100 percent of GDP, the highest level since 1946.
  • Assuming the continuation of those policies, balancing the budget in 2021 would require an additional cut in spending of about one-quarter, an increase in tax revenue of about one-third, or some combination of those approaches. On the spending side, a cut of that size would be a little more than total projected spending on Social Security; almost as much as combined spending on Medicare, Medicaid, and other health programs; and much more than spending on defense. Such a cut would also be a bit larger than all other federal spendingincluding spending related to transportation, education grants, federal justice, unemployment assistance, and retirement benefits, for exampleapart from net interest and the programslisted above. On the revenue side, an increase of that size would be more than a tripling of revenue from the corporate income tax or a substantial increase in individual income tax revenue.

Projected Federal Revenue and Spending in 2021 with the Continuation of Certain Policies

  • During the past few decades, the significant increase in Social Security, Medicare, and Medicaid spending has been accommodated in the federal budget by a marked decline in defense spending relative to GDP. Between 1970 and 2007, outlays for Medicare, Medicaid, and Social Security as a share of GDP increased by a little more than 4 percentage points; over that same period, outlays for defense as a share of GDP decreased by a little more than 4 percentage points. Looking ahead, outlays for Social Security and federal health programs will continue to expand more rapidly than GDP as the baby boomers retire and health spending per person increasesclimbing nearly another 4 percentage points in CBOs projections by 2021. With defense spending running between 4 percent and 5 percent of GDP in the past few years, significantly reducing deficits will require changes to programs or tax payments that people will feel much more directly than they felt those past changes in defense spending.

Components of the Federal Budget

  • Budgetary changes of the magnitude that will ultimately be required could be disruptive. Therefore, Congress may wish to implement them gradually so as to avoid a sudden negative impact on the economy, particularly as it recovers from the severe recession, and so as to give families, businesses, and state and local governments time to plan and adjust. Allowing for such gradual implementation would mean that remedying the nations fiscal imbalance would take longer and therefore that major policy changes would need to be enacted soon to limit the further increase in federal debt.