Recently, the federal government has been recording budget deficits that are the largest as a share of the economy since 1945. Consequently, the amount of federal debt held by the public has surged. By the end of this year, CBO projects, federal debt will reach roughly 70 percent of gross domestic product (GDP)the highest percentage since shortly after World War II. As the economy continues to recover and the policies adopted to counteract the recession phase out, budget deficits will probably decline markedly in the next few years. But with the aging of the population and growing health care costs, the budget outlook, for both the coming decade and beyond, is daunting.
This morning CBO released the latest in its series of reports on the long-term budget outlook. The report examines the pressures on the federal budget by presenting our projections of federal spending and revenuesunder two different scenarios discussed belowover the next 25 years. Tomorrow, I will testify on the key findings of the report before the House Budget Committee.
The Key Points
The retirement of the baby-boom generation is a key factor in the nations long-term fiscal outlook. It portends a significant and sustained increase in the share of the population receiving benefits from Social Security, Medicare, and Medicaid. Moreover, under current law, per capita spending for health care is likely to continue rising faster than spending per person on other goods and services.
As a result, if current laws remained in place, the federal governments spending on Social Security and the major mandatory health care programs (Medicare, Medicaid, the Childrens Health Insurance Program, and the health insurance subsidies that will be provided through insurance exchanges) is projected to grow from roughly 10 percent of GDP today to about 15 percent of GDP 25 years from now. (By comparison, spending on all of the federal governments programs and activities, excluding interest payments on debt, has averaged about 18.5 percent of GDP over the past 40 years.) That combined increase of roughly 5 percentage points of GDP is equivalent to about $750 billion today.
CBO presents the long-term budget outlook under two scenarios that embody different assumptions about future policies governing federal revenues and spending.
- The extended-baseline scenario adheres closely to current law, following CBOs 10-year baseline budget projections through 2021 and then extending the baseline concept for the rest of the long-term projection period. Under that scenario, revenues would reach 23 percent of GDP by 2035much higher than has typically been seen in recent decadesand larger percentages thereafter. Nevertheless, annual spending would be greater, and federal debt held by the public would grow from an estimated 69 percent of GDP this year to 84 percent by 2035. (At the end of 2008, that debt was equal to 40 percent of GDP.)
- The alternative fiscal scenario incorporates several changes to current law that are widely expected to occur or that would modify some provisions that might be difficult to sustain for a long period. Under that scenario, which many budget analysts believe is a more realistic picture of the nations underlying fiscal policies, revenues would remain close to their historical average of 18 percent of GDP, and federal debt would exceed 100 percent of GDP by 2021 and would balloon to nearly 190 percent by 2035.
Federal Debt Held by the Public (Percentage of GDP)
Those projections of federal debt under the long-term scenarios do not include the harmful effects that rising debt would have on economic growth and interest rates. If those effects were taken into account, projected debt would increase even faster.
CBOs Analysis
The Extended-Baseline Scenario. Under this scenario, the expiration of the tax cuts enacted since 2001 and most recently extended in 2010, the growing reach of the alternative minimum tax, the tax provisions of the recent health care legislation, and the way in which the tax system interacts with economic growth would result in steadily higher revenues relative to GDP. At the same time, government spending on everything other than the mandatory health care programs, Social Security, and interest on the federal debtactivities such as national defense and a wide variety of domestic programswould decline to the lowest percentage of GDP since before World War II.
That significant increase in revenues and decrease in the relative magnitude of other spending would offset muchthough not allof the rise in spending on health care programs and Social Security. Federal debt would increase slowly from its already high level relative to GDP. With both debt and interest rates rising over time, interest payments, which absorb federal resources that could otherwise be used to pay for government services, would climb to 4 percent of GDP (or one-sixth of federal revenues) by 2035, compared with about 1 percent now.
The Alternative Fiscal Scenario. The budget outlook is much bleaker under the alternative fiscal scenario, which incorporates very different assumptions about revenues: that the tax cuts enacted since 2001 and extended most recently in 2010 will be extended; that the reach of the alternative minimum tax will be restrained to stay close to its historical extent; and that over the longer run, tax law will evolve further so that revenues remain near their historical average of 18 percent of GDP.
This scenario also reflects the assumptions that Medicares payment rates for physicians will remain at current levels (rather than declining by about a third, as under current law) and that some policies enacted in the March 2010 health care legislation to restrain growth in federal health care spending will not continue after 2021. In addition, the alternative scenario includes an assumption that spending on activities other than the major mandatory health care programs, Social Security, and interest on the debt will not fall quite as low as under the extended-baseline scenario.
With significantly lower revenues and higher outlays, debt held by the public would grow much more rapidly than under the extended-baseline scenario, reaching levels far above any ever experienced in U.S. history.
The Impact of Growing Deficits and Debt
CBOs projections in most of the report understate the severity of the long-term budget problem because they do not incorporate the negative effects that accumulating additional federal debt would have on the economy, nor do they include the impact of higher tax rates on peoples incentives to work and save. In particular, large budget deficits and growing debt would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investmentwhich in turn would lower income growth in the United States. (Chapter 2 of the report presents estimates of the economic effects of growing debt and the impact of those economic changes on the trajectory of debt under both scenarios.)
Rising levels of debt also would have other negative consequences:
- Higher levels of debt imply higher interest payments on that debt, which would eventually require either higher taxes or a reduction in government benefits and services.
- Rising debt would increasingly restrict policymakers ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises.
- Growing debt also would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the governments ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates.
The implications of this analysis are clear: There is a substantial mismatch between what the government would have to spend to maintain existing programs in their current form and the revenues that taxpayers are accustomed to providing the government to pay for those programs.
To keep deficits and debt from climbing to unsustainable levels, policymakers will need to increase revenues substantially as a percentage of GDP, decrease spending significantly from projected levels, or adopt some combination of those two 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 medium- and long-term changes to tax and spending policies are agreed on, and the sooner they are carried out once the economy recovers, the smaller will be the damage to the economy from growing federal debt. Earlier action would permit smaller or more gradual changes and would give people more time to adjust to them, but it would require more sacrifices sooner from current older workers and retirees for the benefit of younger workers and future generations.