How Would Some Changes to Current Law Affect the Economy over the Next Decade?

February 2, 2012

This morning I testified before the Senate Budget Committee on our annual Budget and Economic Outlook, which was released on Tuesday. As I did in my testimony before the House Budget Committee, I highlighted many of the points that were included in Tuesday’s blog post. In today’s post, I want to discuss in more detail an issue I addressed in my testimony: how some possible changes to current law would affect the economy over the next decade.

CBO’s baseline is crafted, as directed in law, so as to provide a benchmark for assessing the budgetary impact of possible changes in laws governing taxes and spending. Of course, future fiscal policy is likely to differ from that embodied in current law in at least some respects. To illustrate how some changes to current law would affect the economy over the next 10 years, CBO examined an alternative path for fiscal policy (an "alternative fiscal scenario") that would maintain some tax and spending policies that have recently been in effect but would differ, under current law, in the coming decade.

Maintaining the policies encompassed by that scenario would have different short-term and long-term effects on the economy. Doing so would:

  • Boost the economy and allow people to pay less in taxes and benefit more from government programs in the next few years,
  • But would put the nation on an unsustainable fiscal course by increasing budget deficits and federal debt relative to what they would be under current law. Over time, the resulting larger deficits would reduce private investment in productive capital and result in real GDP that would fall increasingly below the level in CBO’s baseline projections.

What Policy Assumptions Underlie the Alternative Fiscal Scenario?

This budgetary scenario incorporates the assumptions that all expiring tax provisions (other than the payroll tax reduction), including those that expired at the end of December 2011, are instead extended; that the alternative minimum tax is indexed for inflation after 2011 (starting at the 2011 exemption amount); that Medicare’s payment rates for physicians’ services are held constant at their current level; and that the automatic enforcement procedures specified by the Budget Control Act do not take effect (but the original caps on discretionary appropriations in that legislation remain in effect).

How Would Budget Deficits Differ Under the Alternative Fiscal Scenario?

Each of those policy changes would add to budget deficits, which would be significantly larger than those in CBO’s baseline projections. As a result, federal debt held by the public would accumulate much more rapidly. Deficits would average 5.4 percent of GDP over the 2013–2022 period, rather than the 1.5 percent reflected in CBO’s baseline projections. Debt held by the public would climb to 94 percent of GDP in 2022, the highest figure since just after World War II.

How Would the Alternative Fiscal Scenario Affect the Economy?

As shown in the table below, CBO estimates indicate that real GDP would be higher in the first few years of the projection period than in CBO’s baseline economic forecast, primarily as a result of increased aggregate demand:

  • Real GDP would be greater than projected under current law by between 0.2 percent and 0.8 percent in the fourth quarter of 2012 and by between 0.5 percent and 3.7 percent in the fourth quarter of 2013.
  • Higher GDP would result in a lower unemployment rate and somewhat higher interest rates over the next few years.

But ultimately, economic growth would be dampened:

  • Although the lower marginal tax rates under those alternative assumptions would increase people’s incentives to work and save, the larger budget deficits would reduce (or "crowd out") private investment in productive capital.
  • By the end of 2022, real GDP would be between 2.1 percent smaller and 0.2 percent larger than it would be under current law, CBO estimates, depending on the particular assumptions employed.
  • In years beyond 2022, the impact on GDP would tend to become more negative, as the projected impact of the alternative fiscal scenario on deficits, and therefore investment, rose.

Economic Effects of Policies in CBO’s Baseline and Under an Alternative Fiscal Scenario

A policy’s effects on gross national product (GNP) provide a better measure of its impact on U.S. residents’ income than its effects on GDP—because GNP excludes foreigners’ earnings on investments in the domestic economy but includes U.S. residents’ earnings overseas. CBO estimates that:

  • The effects of the alternative fiscal scenario on GNP would be similar to its effects on GDP in 2012 and 2013.
  • Real GNP would be greater than projected under current law by between 0.2 percent and 0.7 percent in the fourth quarter of 2012 and by between 0.5 percent and 3.5 percent in the fourth quarter of 2013.
  • By the end of 2022, real GNP would be between 3.7 percent and 1.0 percent smaller than it would be under current law.

If policymakers wanted to achieve both a short-term economic boost and medium-term and long-term fiscal sustainability, they would need to enact policies that leave deficits significantly wider than in our current-law baseline for the next few years but significantly narrower than in our alternative fiscal scenario for later in the decade.

The slides I used during my testimony can be found here.