Congressional Budget Office
Robert A. Sunshine, Acting Director
Director’s Blog

A Wall Street Journal blog posting mischaracterizes CBO’s testimony earlier this week on the net budget impact of the Treasury proposal to buy troubled assets. The Wall Street Journal blog states that the plan “likely won’t have any effect on the 2009 budget deficit.” That is incorrect.

Here’s what I said in the testimony:

“In particular, the federal budget would not record the gross cash outlays associated with purchases of troubled assets but, instead, would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the expected value of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them). In CBO’s view, that budgetary treatment best reflects the impact of the purchases of financial assets on the federal government’s underlying financial condition. The fundamental idea is that if the government buys a security at the going market price, it has exchanged cash for another asset rather than caused a deterioration in its underlying fiscal position.”

The testimony then noted that even though the gross cash outlays would perhaps amount to $700 billion, the net budget impact would be substantially smaller because the government would be acquiring assets with some value. It did not say, though, that the net budget impact would be zero, as the Wall Street Journal suggests.

So what will the net budget impact be, even if it’s substantially smaller than $700 billion? That depends on three factors: (a) the degree to which the transactions result in a gain or loss to the government; (b) the administrative costs of running the program; and (c) any interactive effects with other government programs. The first issue is central, and the testimony noted that “whether those transactions ultimately resulted in a gain or loss to the government would depend on the types of assets purchased, how they were acquired and managed, and when and under what terms they were sold.”

The testimony went on to explore the forces that could affect any gain or loss. “In addition to the future evolution of the housing prices, interest rates, and other fundamental drivers of asset values, two key forces would influence the net gain or loss on the assets purchased:

• Whether the federal government seeks and is able to succeed in obtaining a fair market price for the assets it purchases and, in particular, whether it can avoid being saddled with the worst credit risks without the purchase price reflecting those risks. Concerns about the government’s overpaying are particularly salient when sellers offer assets with varying underlying characteristics that are complicated to evaluate.  Such problems are attenuated the more that the government focuses on buying part of a given asset from institutions that all own a share of that asset, rather than buying different assets from different institutions. That is, the government is more likely to pay a fair price when multiple institutions are competing to sell identical assets than when it has to assess competing offers for different assets with hard-to-determine values.

• Whether, because of severe market turmoil, market prices are currently lower than the underlying value of the assets. If current prices reflect “fire sale” prices that can result from severe liquidity constraints and the impairment of credit flows, then taxpayers could possibly benefit along with the institutions selling the assets. Under normal circumstances, prices do not long depart from their fundamentals because the incentive to engage in arbitrage and profit from price discrepancies is large. But arbitrage practices work less well when liquidity is restrained, as it is now, and many potential arbitragers cannot get short-term financing. It is therefore at least possible that the prices of some assets are below their fundamental value; in that case, to the extent that the government bought now and held such assets until their market prices recovered to reflect that underlying value, net gains would be possible.”

Nothing in CBO’s testimony should be interpreted as suggesting that the interplay between these two forces would generate a net impact of zero for the transactions alone. Indeed, although the lack of specificity in the bill means that CBO cannot currently quantify its net budgetary impact, and although there is some possibility that the government could realize a net gain on the transactions authorized under the bill, it seems more likely that enacting the bill would result in an increase in the federal deficit. In other words, the net budgetary cost (including administrative costs) is very likely to be substantially smaller than $700 billion, but it seems likely to be greater than zero.

CBO sent a letter today to Senator Conrad estimating the long-term fiscal effect of two personal income tax proposals. The first would index the Alternative Minimum Tax (AMT) for inflation beginning in 2008. The second would, in addition to indexing the AMT for inflation, also permanently extend the personal income tax provisions of the Economic Growth and Tax Relief and Reconciliation Act of 2001 (EGTRRA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) that otherwise would expire in 2010.

Budgetary impacts

1. Compared with the extended-baseline scenario in our long-term budget scenario, indexing the AMT, by itself, would reduce revenues by 2.5 percent of GDP in 2050 and by 2.6 percent in 2082. If those revenue losses were not offset by other changes in policy, the budget deficit would grow to 10 percent of GDP in 2050 and 30 percent of GDP in 2082 (relative to 5 percent and 18 percent, respectively, under the extended baseline scenario).
2. Extending EGTRRA and JGTRRA in addition to indexing the AMT would reduce revenues by about 4 percent of GDP in both 2050 2082. If not offset by other changes in policy, this would result in budget deficits of 15 percent of GDP in 2050 and 39 percent in 2082. Under these policies, federal debt held by the public would increase to 190 percent of GDP in 2050 and to more than 600 percent in 2082 (relative to 50 peercent and 240 percent, respectively, under the extended baseline scenario).

Economic effects

1. To assess the economic effects, CBO compared a scenario with the tax changes financed through deficits with an alternative scenario in which the tax changes were financed fully from the start via changes in other policies. Because the analysis assumes that the tax changes are enacted in either case, the difference between the two scenarios highlights the effects of using deficits to finance them.
2. For example, simulations using one model—a textbook growth model that incorporates the assumption that deficits affect capital investment in the future as they have in the past—indicate that the rising federal budget deficits created by deficit financing of the indexation of the AMT would reduce real GNP per person by 6 percent in 2050 and by about 37 percent in 2080. If both the AMT were indexed and EGTRRA’s and JGTRRA’s personal income tax provisions were extended, and those changes were financed by additional borrowing, the economic costs would be even larger. By CBO’s estimates, real GNP per person would decline by 13 percent in 2050. Beyond 2073, projected deficits under those tax policies would become so large and unsustainable that the model cannot calculate their effects.
3. Despite the substantial economic costs generated by deficits in that model, such estimates may significantly understate the potential loss to economic growth under deficit financing of the tax changes. In particular, the estimates are based on a model in which people do not anticipate future changes in debt; as a result, the model predicts a gradual change in the economy as federal debt rises. In reality, the economic effects of rapidly growing debt would probably be much more disorderly and could occur well before the time frame indicated in the scenario. Simulations using CBO’s other economic models (which are more responsive to changes in tax rates than CBO’s textbook growth model) also show that the outcomes could be worse than the textbook growth model indicates.

CBO is often asked for our most recent estimates of before- and after-tax household income, along with our estimates of effective tax rates. We have therefore just created a special page on our website containing our most recent household tax and income data, to make it easier for people to find those numbers.

Under current law, rising costs for health care and the aging of the population will cause federal spending on Medicare, Medicaid, and Social Security to rise substantially as a share of the economy. At the request of the Ranking Member of the House Budget Committee, CBO released a letter examining the potential economic effects of (1) allowing federal debt to climb as projected under the alternative fiscal scenario presented in CBO’s December 2007 Long-Term Budget Outlook; (2) slowing the growth of deficits and then eliminating them over the next several decades; and (3) using higher income tax rates alone to finance the increases in spending projected under that scenario.

How Would Rising Budget Deficits Affect the Economy? Sustained and rising budget deficits would affect the economy by absorbing funds from the nation’s pool of savings and reducing investment in the domestic capital stock and in foreign assets. As capital investment dwindled, the growth of workers’ productivity and of real (inflation-adjusted) wages would gradually slow and begin to stagnate. As capital became scarce relative to labor, real interest rates would rise. In the near term, foreign investors would probably increase their financing of investment in the United States, but such borrowing would involve costs over time, as foreign investors would claim larger and larger shares of the nation’s output and fewer resources would be available for domestic consumption.

How much would the deficits projected under the alternative fiscal scenario presented in the December 2007 Long Term Budget Outlook affect the economy? For its analysis, CBO used a textbook growth model that can assess how persistent deficits might affect the economy over the long term. According to CBO’s simulations using that model, the rising federal budget deficits under this scenario would cause real gross national product (GNP) per person to stop growing and then to begin to contract in the late 2040s. By 2060, real GNP per person would be about 17 percent below its peak in the late 2040s and would be declining at a rapid pace. Beyond 2060, projected deficits would become so large and unsustainable that the model cannot calculate their effects. Despite the substantial economic costs generated by deficits under this model, such estimates greatly understate the potential loss to economic growth because the effects of rapidly growing debt would probably be much more disorderly and could occur well before the time frame indicated in the scenario.

How Would the Slowing the Growth of Deficits Affect the Economy? The minority staff of the House Budget Committee provided CBO with a target path slows the growth of budget deficits. In evaluating the economic effects of the target path, CBO did not examine how specific policies to achieve that path would affect the economy; instead, CBO limited its attention solely to examining how the deficits produced by the target would affect the economy, assuming that such effects would play out as they have in the past. (CBO has not evaluated either the political feasibility or the economic effects of reducing spending sufficiently to accomplish this path for the deficit. Furthermore, the spending and revenue targets provided by the Committee staff are not the only way to achieve a sustainable budget path. Alternative policies will have different effects on the economy, and changes in taxes and spending can exert influences on the economy other than the effects of reducing budget deficits.)

Under the target path, federal outlays excluding interest (that is, primary spending) would rise from 18 percent of GDP in 2007 to 20 percent in 2030 and then decline to 19 percent in 2050 and 13 percent in 2082. For almost all years, revenues would remain at 18.5 percent of GDP. Under those assumptions, the budget deficit would gradually increase to about 6 percent of GDP in 2040 but then would decline to almost zero in 2075. By 2082, the target path would generate a budget surplus of about 2 percent of GDP. Under this path, real GNP per person would continue to grow over the entire projection period, rising from about $45,000 in 2007 to about $165,000 in 2082 in inflation-adjusted dollars. By 2060 (the last year for which it is possible to simulate the effects of the alternative fiscal policy using the textbook growth model), real GNP per person would be about 85 percent higher under the target path than under the alternative fiscal scenario.

How Would Increasing Income Tax Rates to Finance the Projected Rise in Spending Affect the Economy? How would the economy be affected if the projected rise in primary spending under CBO’s alternative fiscal scenario (from about 18 percent of GDP in 2007 to about 35 percent in 2082) was financed entirely by a proportional across-the-board increase in individual and corporate income tax rates? Answering that question is difficult because the economic models that economists have developed so far would have to be pushed well outside the range for which they were initially developed.

Nonetheless, tax rates would have to be raised by substantial amounts to finance the level of spending projected for 2082 under CBO’s alternative fiscal scenario. Before any economic feedbacks are taken into account, and assuming that raising marginal tax rates was the only mechanism used to balance the budget, tax rates would have to more than double. Such tax rates would significantly reduce economic activity and would create serious problems with tax avoidance and tax evasion. The letter provides more details about possible scenarios. (Raising revenue in ways other than increasing tax rates would have a less marked effect on economic activity.)

Conclusion. The United States faces serious long-run budgetary challenges. If action is not taken to curb the projected growth of budget deficits in coming decades, the economy will eventually suffer serious damage. The issue facing policymakers is not whether to address rising deficits, but when and how to address them. At some point, policymakers will have to increase taxes, reduce spending, or both.

Much of the pressure on the budget stems from the fast growth of federal costs on health care. So constraining that growth seems a key component of reducing deficits over the next several decades. A variety of evidence suggests that opportunities exist to constrain health care costs both in the public programs and in the health care system overall without adverse health consequences, although capturing those opportunities involves many challenges.

For those who haven’t seen it, the Joint Committee on Taxation earlier this week released an interesting report delineating a new approach to analyzing and estimating tax expenditures (that is, targeted tax provisions that reduce revenue through special credits, preferential tax rates, exclusions, exemptions, deductions, etc.). Ed Kleinbard, the chief of staff at the JCT, has made tax expenditure analysis a high priority, and the report released earlier this week is the first of many that JCT will be publishing in coming months.

CBO released a paper today on trends in individual income tax revenue. Such revenue has fluctuated significantly since the early 1990s, increasing by 85 percent between fiscal years 1994 and 2000, then declining by 21 percent between 2000 and 2003, and then increasing by 47 percent between 2003 and 2007.

Income tax revenues generally rise and fall with the economy, but even as a share of gross domestic product (GDP), the recent changes in individual income tax revenue have been dramatic. Between 1994 and 2000, for example, the ratio of income taxes to GDP rose by 2.5 percentage points—from 7.8 percent to just over 10.3 percent, a historic high. In the following four years, that trend reversed, and individual income taxes dropped precipitously, falling to 7.0 percent of GDP by 2004, the lowest level in more than 50 years. Revenues rebounded in the next three years, rising to 8.5 percent of GDP by 2007. The paper explores the causes of these changes in individual income tax revenues relative to the economy. The key factors include:

• A rising and falling income tax base, resulting from growth in wages and capital gains realizations that first exceeded and then lagged behind overall economic growth;
• A rising and falling effective tax rate on adjusted gross income, caused by changes in real (inflation-adjusted) bracket creep (that is, increases in real incomes that shift more taxable income into higher marginal tax brackets) and THE the concentration of income in higher tax brackets
• Tax legislation, which was a major factor in the decline in income taxes relative to GDP from 2000 to 2004, but had little to do with the increase from 1994 to 2000.

CBO released its full analysis of the President’s budget today, following up on a preliminary analysis we issued earlier this month.  The budget estimates are the same as in that preliminary analysis, but today’s report includes a discussion of macroeconomic effects of the President’s budget along with other details.

CBO’s estimates of the economic feedback associated with the President’s proposals may be of most interest—that is, how enacting those proposals might affect the nation’s economy and how those economic impacts, in turn, would affect the federal budget. We used five different economic models that focus on varying aspects of the economy to estimate those feedback effects.  Such estimates depend on a variety of specific assumptions, but under any of the assumptions incorporated into today’s analysis, economic feedback would modify the budgetary effects of the proposals only relatively modestly—and the potential effects could either expand or reduce the proposals’ net budget impact. Between 2009 and 2013, for example, CBO estimated that the President’s proposals would add to deficits or reduce surpluses by a total of $336 billion, without considering any economic effects.  Our analysis indicates that macroeconomic feedback effects could raise the proposals’ cumulative impact on the budget deficit to as much as $410 billion or reduce it to about $185 billion.

The reason that the macroeconomic feedback from President’s proposals is relatively modest is that over the medium to longer run those proposals have both a negative effect on economic growth (that is, by increasing the budget deficit) and a positive effect on economic growth (for example, by reducing marginal tax rates). The net effect of these countervailing forces tends to be small.

As is now widely recognized, the economy is currently experiencing significant short-term weakness. The short-term effects of many budget policies in this type of unusual condition can vary dramatically from their long-term effects —and indeed, the short-term impact can often be opposite in sign from the long-term impact.

Analysts in CBO’s Macroeconomic Analysis and Tax Analysis Divisions prepared the analysis of macroeconomic feedbacks.  Those sections of the report were written by Benjamin Page, and the modeling was performed by Robert Arnold, Paul Burnham, Ufuk Demiroglu, Mark Lasky, Larry Ozanne, Frank Russek, Marika Santoro, Kurt Seibert, and Sven Sinclair. 

Analysts in CBO’s Budget Analysis and Tax Analysis Divisions prepared the baseline estimates and estimated the impact of the President’s proposals in the absence of macroeconomic feedbacks.  (The Joint Committee on taxation prepared most of the estimates of revenue proposals.)  Those sections of the report were written by Barry Blom, Pamela Greene, Robert Arnold, and Amber Marcellino.  

CBO issued a letter today responding to a request from the Chairman of the House Budget Committee. In December 2007, we issued a report on the nation’s 75-year fiscal gap (roughly speaking, the gap between the present value of projected spending and projected revenue, as a share of GDP).

In today’s letter, we provide estimates of the impact on the 75-year fiscal gap from net spending under current law on Medicare Part D (the prescription drug benefit) and possible permanent extension of the individual income tax provisions enacted in 2001, 2003, and 2004 past their scheduled sunset in 2010. In particular:

• The effect of spending for Part D (net of income from premiums) on the 75-year fiscal gap amounts to 0.9 percent of GDP.
• The effect of extending the expiring individual income tax provisions would amount to 0.7 percent of GDP in the absence of further reform to the Alternative Minimum Tax (AMT) and 1.4 percent of GDP if the AMT ’s parameters were indexed to inflation.
• CBO limited its analysis to the estimated effects of extending the individual income tax provisions and did not assess the effects of permanently extending provisions applicable to the estate and gift tax. If the only result of extending the estate and gift tax provisions were to eliminate all revenues from those taxes from CBO’s long-term baseline, the fiscal gap would increase by an additional 0.7 percent of GDP over the next 75 years. Under that assumption and assuming the AMT is indexed to inflation, the combined effect of extending all the tax provisions (including the gift and estate tax ones) on the 75-year fiscal gap would amount to slightly over 2 percent of GDP.

CBO, with contributions from the Joint Committee on Taxation, released an analysis of the President’s budget submission for fiscal year 2009 this morning. (I will be summarizing our analysis at a conference held by the National Association for Business Economists today.) A report that presents the full analysis of the President’s budget, including CBO’s assessment of its macroeconomic effects, will be published on March 19.

CBO’s analysis indicates that:

• If the President’s proposals were enacted, the federal government would record deficits of $396 billion in 2008 and $342 billion in 2009. Those deficits would amount to 2.8 percent and 2.3 percent, respectively, of gross domestic product (GDP). By comparison, the deficit in 2007 totaled 1.2 percent of GDP.

• Under the President’s proposals, the deficit would steadily diminish from 2009 through 2012, at which point the budget would be balanced; it would remain close to balance in most years through 2018. Several key factors contribute to these outcomes, however. In particular, the President’s proposals exclude funding for military operations in Iraq and Afghanistan after 2009, incorporate significant reductions in discretionary spending relative to the size of the economy, and project a substantial expansion of the impact of the alternative minimum tax (AMT).

• The President’s budgetary proposals would result in revenues that were $2.1 trillion below CBO’s baseline projections over the 2009–2018 period, largely because of proposed extensions of various provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). The proposals also would lead to outlays that were below CBO’s baseline projections—by an estimated $1.1 trillion over 10 years—because of a smaller amount of funding for discretionary programs and reductions in mandatory spending, particularly in spending for Medicare.

• CBO’s analysis reflects the recent enactment of the Economic Stimulus Act of 2008. The analysis also takes into account recent revisions to CBO’s economic forecast.

CBO released a report today on the deductibility of state and local taxes on federal income tax returns, which provides an indirect federal subsidy to the state and local governments that levy deductible taxes. The state and local tax deduction reduced federal revenues by an estimated $50 billion in fiscal year 2007.

CBO’s report, which was prepared at the request of the Ranking Member of the Senate Budget Committee, examines the justifications for the state and local tax deduction, how its benefits are distributed among different groups of taxpayers,  interactions between the deduction and the Alternative Minimum Tax (AMT), and options for modifying or eliminating the deduction.

The main points of the report include:

• Whether the deduction is an efficient use of federal resources depends on the nature of the benefits from any services at the state and local level that it subsidizes.
  • To the extent that state and local taxes are payments by residents of those jurisdictions for services that they themselves receive from their state and local governments, the rationale for a federal subsidy is weak.
  • In contrast, if state and local taxes pay for services that have spillover benefits that are regional or national in nature, then a federal subsidy may be desirable to ensure that an adequate volume of such services is produced.
• Some evidence suggests that state and local governments may respond to the taxes-paid deduction not by imposing higher taxes but by simply using deductible taxes in place of some nondeductible taxes.
• In 2004, slightly less than 35 percent of all taxpayers deducted state and local taxes they had paid, but whether a taxpayer claimed the deduction and the value of that deduction varies considerably according to income.   Taxpayers with incomes below $75,000 in 2004 accounted for more than 80 percent of all taxpayers but less than 20 percent of the total tax benefit from the deduction; taxpayers with incomes above $1 million accounted for 0.2 percent of all taxpayers and 16 percent of the total tax benefit from the deduction.
• In 2004, potentially deductible taxes accounted for 17 percent of state revenue and about 40 percent of local government revenue (in both cases excluding revenue received from another government or from government-run entities like utilities).
• Over the next several years, scheduled changes to tax law and the interaction of the regular income tax and AMT will change the number of taxpayers who claim the deduction and the associated loss of federal revenues.  The amount of that loss is projected to diminish through 2010, because a growing number of taxpayers will pay the AMT, which does not allow people to claim the deduction.  The scheduled expiration after 2010 of tax provisions enacted in 2001 and 2003 will boost income tax rates for many taxpayers, raising the value of the taxes-paid deduction for those who claim it and increasing the associated revenue loss for the federal government.
• With assistance from the Joint Committee on Taxation in estimating budgetary effects, CBO analyzed many options for changing the deduction with and without changes to the AMT.   For example, eliminating the deduction and indexing the AMT to inflation would, in combination, raise federal revenue by about $450 billion over the next decade.  Replacing the deduction with a 15 percent credit while indexing the AMT to inflation would reduce revenue by $330 billion from 2008 to 2017.  Other options are discussed and analyzed in the study.

The study was written by Kristy Piccinini of our Tax Analaysis Division. Kristy works in the areas of state and local taxation and tax-exempt bonds. She joined CBO in 2006 after receiving her Ph.D. in economics from the University of California Berkeley. Her dissertation examined how state tax legislation responds to changes in the budget balance.