NEWS CONFERENCE ON SUMMER UPDATE:
BUDGET AND ECONOMIC OUTLOOK

Thursday, August 23, 2007

The News Conference was convened, pursuant to notice,
at 11:00 a.m. in room 483 of the Congressional Budget Office.

Speaker: Peter Orszag, Director
Opening remark: Melissa Merson, Associate Director for Communications

MERSON: Good morning everybody. Thank you for coming. This morning the Congressional Budget Office has released its summer update to the Budget and Economic Outlook. Our briefing this morning will be conducted by our Director, Peter Orszag. The report is available on the internet at www.cbo.gov. The director will do a quick walk-thru and explain the report and changes since our last Economic Outlook and Budget Outlook and then we'll take your questions. Thank you again for coming.

ORSZAG: Okay, good morning. I'm going to walk you through the highlights of our report and just very briefly there are two basic points. First, the short term--in the short term the budget outlook has improved somewhat. But the long-term fiscal outlook remains daunting and the fact that the risk associated with the long-term fiscal outlook do not appear to be priced into financial markets. And no way means that those risks are not real.

And, secondly, that although the economic outlook is clouded the most likely scenario is for continued solid economic performance. And I'll try to describe both of those features in a little bit more detail.

First, with regard to this year's deficit, we are now projecting a deficit of $158 billion for fiscal year 2007. That is down $19 billion since our $177 billion projection that was issued in March 2007. And that improvement reflects a combination of a small increase in outlays, $16 billion, mostly the effect of the enactment of some supplemental appropriations which were enacted after our March 2007 projections were issued, and an improvement of about $35 billion in revenues for the year. That's only about a 1.5 percent improvement relative to what we had projected, but, still, $35 billion increase in revenues relative to what we had projected in March.

The net impact is, therefore, a deficit that is $19 billion lower than in March. Again, a very small improvement, but an improvement, nonetheless, for the 2007 deficit. That 2007 deficit is down--$158 billion--that's down from $378 billion in 2003. And that improvement over the past three or four years really needs to be broken down into two different periods, because the story is much different between 2003 and 2006, as one period, and the last year.

In particular, in that earlier period, 2003 to 2006, the fiscal improvement was driven predominantly by a surprising increase in corporate tax revenue. Over the last year, however, the improvement has been driven by a mixture of an increase in individual income tax revenue and a temporary blip down in outlays as a share of the economy.

Let me try to describe that in a little bit more detail. In 2003, the budget deficit was 3.5 percent of the economy, 3.5 percent of GDP. This year, we are projecting it to be 1.2 percent of GDP, so that's an improvement of over 2 percent of the economy.

If you look from 2003 to 2006, which is the first set of figures, you can see that outlays actually increased somewhat. And therefore all of the improvement in the budget picture between 2003 and 2006 was driven on the revenue side, where revenues increased from 16.5 percent of the economy in 2003 to almost 18.5 percent in 2006.

And that revenue increase, in turn, was driven disproportionately by an increase in corporate tax revenue. So the yellow 1.5 percent of GDP increase in corporate tax revenue as a share of the economy explains the vast bulk of the overall fiscal improvement over that three-year period.

When you look at 2006 to 2007, however, that is, over the past year, corporate tax revenue growth has slowed markedly and, in fact, now, has stopped growing as a share of GDP. It's projected to be 2.7 percent of GDP last--it was 2.7 percent of GDP last year. It's projected to be that again this year. And the improvement in the fiscal picture over the last year, the decline from 1.9 percent of the economy to 1.2 percent of the economy, therefore reflects a mixture of two things.

One is an increase in individual income tax revenue, which rose by .5 percent of GDP, and a temporary blip down in outlays, as a share of the economy, mostly driven by the fact that, in 2006, there was some temporary spending, for example, associated with Hurricane Katrina relief, that was not repeated in 2007. And the result was that outlays, as a share of the economy, actually declined by almost .5 percent of GDP.

Looking forward over the next 10 years, which is shown on the next chart, our baseline projections embody deficits that continue to be somewhere between 1 percent and 1.5 percent of the economy, as we're projecting it for this year, through 2010. And you can see that bouncing around a little bit over the next few years.

And then, because our baseline takes current law as it is today, the various tax provisions, in particular, associated with the 2001 and 2003 tax legislation expire, as scheduled under current law, at the end of 2010. And the additional revenue associated with that then pushes the budget into a small surplus of less than a half a percent of the economy from 2011 through 2017.

Many observers, as the next chart will put in more detail, many observers have noted that that baseline takes current law literally, which it does, and that is a very important thing for various different budget purposes. But outside budget analysts and other observers believe that there will be various different changes in policy.

And one of the things that we did in this report is in Table 1.8, which is in the first chapter, provide the budgetary impact of various changes in policy that could be enacted. This graph shows you the combination of one particular combination of such changes in policies. In particular, the alternate path assumes that the scheduled expiration of the 2001 and 2003 tax legislation does not occur; that is, that the tax provisions are continued past 2010.

It also prevents the scheduled increase in the alternative minimum tax. Under our baseline, the number of tax filers on the alternative minimum tax is projected to grow from 4 million tax filers last year to almost 40 million by 2017. And this alternate path would prevent that from happening.

It also embodies a reduction in the number of troops fighting in Afghanistan, Iraq, and other places abroad in the war on terrorism over time. And I can describe that in more detail. And that it increases other discretionary spending in line with the overall economy rather than just in line with inflation, which is the assumption that's embodied in our baseline. And you can see that, under that alternate set of policies, the budget path over the next decade is quite different than under the baseline.

I would also note, before moving on, that our baseline for the next 10 years has changed only modestly from what we projected in March. There's actually been some slight deterioration, but mostly that is the result of the enactment of the supplemental appropriation subsequent to the issuance of our March 2007 projections.

We are required to take enacted appropriations and then inflate them out over the next 10 years. And because that supplemental appropriation was enacted and it's now been enacted, it's inflated out in our baseline. That causes a slight deterioration in the baseline. If you abstract from that, the other factors actually go in the other direction, and there's been a slight improvement.

But overall, there's been no big change in the 10-year budget outlook.

All of this is predicated on a set of economic projections. And, as many of you may know, the economic outlook is particularly clouded right now, as problems in the subprime mortgage market and financial market turbulence have created concerns about ongoing economic activity.

Our view is that, although significant economic risks exist, the most likely scenario is for continued solid economic performance. And in particular, these projections embody an assumption that economic growth will slow somewhat this year from somewhat above 3 percent growth last year to 2.1 percent this year and then recover to 2.9 percent next year.

Now, as I noted, these sets of assumptions do have some risks associated with them, and I'd like to turn to some of those risks. But, again, we believe these are the most likely scenario for the next couple years.

As many of you know, over the past several years there's been dramatic growth in subprime mortgages. Subprime mortgages are extended to borrowers who have poor credit histories, who lack certain documentation, or who make small or perhaps no downpayment on their houses. Many of those subprime mortgages also carry adjustable interest rates; that is, interest rates that are adjusted at fixed time intervals. And the delinquency rate on subprime adjustable mortgages has risen dramatically over the past couple years, which has created concerns about the mortgage market more broadly.

One of the key questions facing the economic outlook, though, is the degree to which this problem is contained in the subprime mortgage market or spreads to the rest of the financial markets. And one of the reasons that there's been broader concerns recently is precisely the concern that problems in this subprime market may spread to the rest of the financial markets because the subprime mortgages were held in various different places in the financial market system, and a lack of transparency about where those securities were being held created concerns that credit problems could arise in all sorts of unexpected places.

What we've seen to date, though, as shown on the next chart, is that interest rates--this is credit spreads on various different kinds of bonds relative to Treasury securities. So this measures, basically, the marketplace of risk. And what you see is that high-yield bonds--that is, bonds that have lower quality and higher risks associated with them--have experienced a significant uptick in their credit spreads relative to Treasury's. But there are two things that are worth noting from this graph.

First, that increase, although significant, comes after a period in which credit spreads were unusually low. So one aspect of what is happening is that market pricing of risks seems to be returning, you see, to somewhat more normal levels, perhaps, after a period in which credit spreads and market pricing of risk was unusually low.

The second thing to note from this graph is that that increase seems to be disproportionately concentrated thus far in those high- yield bonds. That is, higher-rated bonds with better quality associated with them, lower risk, have experienced some changes, but they have been quite modest. That is a key indicator to be tracking in terms of whether the problems in the subprime market and in the pricing of risk spread to the broader economy. When high-quality--that is, the AAA-type bonds--start to experience very significant increases that can impede investment by firms, and that can spread to broader problems in the economy. Thus far, those effects have been quite muted.

So, again, our view is that, although there are risks to the economic outlook, the most likely scenario is that the economy will continue to grow solidly and, in particular, as we move into next year, that economic growth will start to increase to levels approaching 3 percent. One of the other experiences that I would hope would be learned from recent market troubles is that risks that analysts have long pointed out that are not reflected in financial market prices may still exist. That is, the argument that financial markets are not pricing some risk does not mean that those risks are nonexistent.

And one of the most significant risks that we as a nation are facing that every serious budget analyst looking at the long-term picture agrees with is that we are on an unsustainable fiscal path. And that unsustainable fiscal path is concentrated disproportionately in our health-care programs, Medicare and Medicaid.

Within the next 10 years, those two programs, Medicare and Medicaid, which are shown in the lighter colors here, will rise from 4.6 percent of the economy of this year to 5.9 percent of the economy by 2017, under our projections. At the same time, Social Security spending will rise from 4.2 percent of the economy to 4.8 percent of the economy.

In other words, even over the next 10 years, you can see that the growth is disproportionately in those health programs. And then it's somewhat exacerbated by the aging of the population and the increase in Social Security spending. That observation is underscored even more as you look out beyond the 10-year window. The next chart shows you what will happen to Medicare and Medicaid spending under different scenarios for the rate at which health-care spending grows compared to income.

We are currently, for Medicare and Medicaid, at 4.6 percent of the economy. Over the past four decades, health-care spending has risen roughly 2.5 percentage points faster than income per person, on average, each year. If that rate continues over the next four decades, Medicare and Medicaid will rise from 4.5 percent of the economy today to 20 percent of the economy by 2050. That is the top line on this graph.

The bottom line on the graph shows the pure effects of aging on these programs. It isolates the impact of demographics on Medicare and Medicaid. And I think what you can see is that, under that bottom dotted line, where you wind up in 2050 is higher than where you begin in 2007, but that that increase is much smaller than the difference, in 2050, between the bottom dotted line and the top one.

In other words, the rate at which health-care spending grows compared to income per capita is the key factor affecting the nation's long-term fiscal imbalance, and it is substantially more important than the aging of the population. Whether we succeed in bending this curve and how much we succeed in bending this curve will determine the path of the nation's fiscal future, period.

There is, however, embodied in this central long-term fiscal challenge, an opportunity. And that opportunity is that there's a wide variety of evidence suggesting that there are opportunities to reduce health-care spending without harming quality. This is an opportunity that is difficult to capture, but it is nonetheless real.

Perhaps the most compelling evidence in favor of that proposition, that there are opportunities to reduce costs without harming quality in the health system, comes from the very dramatic variation in health-care spending that you see across different parts of the United States, for reasons that cannot be explained by the underlying riskiness of the patients, cannot be explained by the wage rates in various different markets and cannot be explained by hospital costs or other factors.

What you see here is the darker regions of the country with spending levels that are very substantially higher than the lighter areas, again, for reasons that cannot be explained by any factors that academics and others have used. Spending in Miami is very substantially higher than in Minneapolis. Spending in Sun City, Arizona is very substantially lower than in Sun City, Florida.

The kicker, though, is that the higher-spending regions do not seem to generate better health outcomes than the lower-spending regions, as the next chart shows. And that illustrates that embedded in this key fiscal challenge facing the United States is an opportunity to take costs out of the system without harming the health outcomes for Americans. The real question is the degree to which we will be able to capture that opportunity.

Thank you very much.