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The Economic and Budget Outlook: An Update September 1997

The federal budget will come close to balance this year and will move into surplus by 2002, according to the latest estimates of the Congressional Budget Office (CBO). Indeed, the budget is projected to be in virtual balance through 2007, with the deficit or surplus below 1 percent of gross domestic product (GDP) in any year. By contrast, at the beginning of this year, CBO projected that the deficit would be almost 2 percent of GDP by 2002, rising slightly above that by 2007.

The dramatic improvement in the fiscal outlook stems both from a brighter economic outlook and newly enacted legislation that will reduce the growth of federal spending. On July 31, the Congress completed action on two major pieces of legislation--the Taxpayer Relief and Balanced Budget Acts of 1997--which the President signed on August 5. Those two laws will directly reduce the projected federal deficit by $95 billion in 2002 and by $118 billion over the 1998-2002 period. In addition, balancing the budget will help to lower projected interest rates and improve the outlook for future economic growth.

Setting the budget on a course to balance is a significant achievement. Still, some words of caution are required.

First, the economic and other assumptions on which the budget projections are based could prove to be too optimistic. Just as favorable economic developments have caused the deficit outlook to improve rapidly in recent months, unfavorable developments could similarly cause a quick deterioration. In particular, the onset of a recession could push the deficit above current projections by $100 billion or more for several years.

Second, achieving budgetary balance in 2002 depends on adhering to new statutory limits on discretionary spending, which are quite restrictive after 2000. Discretionary spending has been squeezed since 1991, and it may be difficult for the Congress and the President to make the further real (inflation-adjusted) reductions required to live within the limits set by the new caps. In short, the tough decisions on appropriated spending have yet to be made.

Third, severe budgetary problems still await beyond the 10-year horizon, when the baby boomers will begin to retire and the costs of health care continue to escalate. Legislators will need to take substantial further action to set the growth in Social Security and Medicare spending at sustainable levels and to prevent spiraling deficits in the next century. To help address those problems, the Balanced Budget Act establishes a National Bipartisan Commission on the Future of Medicare, which is required to report its recommendations to the Congress and the President in March 1999.
 

The Budget Outlook

As fiscal year 1997 draws to a close, it is clear that the economy has performed better and the deficit has declined much more than CBO and most other forecasters anticipated. CBO now estimates that the deficit for 1997 will be $34 billion, down $81 billion from its deficit projection published in March. This year's deficit will be the lowest since 1974 and will mark the fifth straight year that the deficit has declined. As a percentage of GDP, CBO's estimate of the 1997 deficit matches the 0.4 percent of GDP recorded in 1974.

Unexpectedly large gains in revenue are the major factor pushing down the estimated deficit for 1997. Of the $81 billion drop in the estimate, $71 billion stems from higher revenues and the remaining $10 billion from lower outlays. However, revised data on national income and unanticipated rapid growth in the economy in 1997 explain only about one-third of the unexpected income tax revenues. Several other factors could account for the remaining increase, but available data do not yet permit an exact assessment. The $10 billion decline in outlays largely reflects the pace of spending so far this year. Spending for Medicaid and other mandatory programs is somewhat lower than expected but is slightly offset by higher outlays for defense and transportation. Net interest is also lower, largely as a result of a lower deficit. Those same factors contribute to CBO's lower projections for expected deficits for the fiscal years after 1997.

The budget outlook for 1998 and beyond has been significantly altered as a result of the spending reduc-tions enacted in the Balanced Budget Act of 1997 and the tax reductions contained in the Taxpayer Relief Act of 1997. CBO's baseline economic and budgetary projections contained in this volume incorporate its estimate of the effect of that legislative package as well as the small effects of other legislation enacted since March. The baseline economic projections also have been revised to incorporate new information about the state of the economy since CBO's last forecast.
 

The cost of the tax cuts increases substantially after 2002, but reductions in the growth of spending more than offset it. Because some of the tax cuts will be phased in slowly, and because a few of the revenue- reducing provisions produce short-term gains in revenue, the loss in revenue from the reconciliation legislation is twice as big in the second five years as in the first five. After 2007, when all of the tax provisions will be completely phased in, the tax cut will grow less rapidly than the economy.

Anticipated reductions in future discretionary outlays represent a significant portion of the legislative changes, just as sharply constrained discretionary spending has played a major role in reducing the deficit since 1991. To control the growth of discretionary spending, the Balanced Budget Act of 1997 sets discretionary spending limits for fiscal years 1998 through 2002 and extends the existing enforcement mechanism for that period. For fiscal year 1998, the cap on outlays is $11 billion higher than under previous law. For fiscal years 1999 through 2002, the caps are lower than CBO's March baseline level, which increased the former 1998 cap at the rate of inflation for all years after 1998. Accordingly, the new caps provide savings for those years relative to CBO's March baseline estimates. As Summary Table 1 shows, restraining discretionary spending accounts for $53 billion of the net legislative reduction of $95 billion estimated for 2002. CBO's baseline assumes that the fiscal years after 2002 will show the same level of savings, though increased to reflect inflation.

After rising at less than half the expected rate of inflation between 1997 and 1999, discretionary spending will be limited to the same nominal level in 2002 as in 1999 (see Summary Table 2). That constraint will pare the purchasing power of discretionary spending in 2002 by about 12 percent relative to 1997 outlay levels. The planned reductions in real (inflation-adjusted) discretionary spending are similar to the discretionary cuts contained in the Omnibus Budget Reconciliation Act of 1993. However, continuing to constrain discretionary spending--it has barely increased since 1991 in nominal terms and has declined as a share of GDP--may prove difficult.
 

CBO's March baseline. Shrinking the debt to that level, which has not occurred since 1982, would have a lasting effect on the budget outlook by reducing the cost of interest on previous deficit financing. It would also contribute to the future growth of the economy by increasing the capital stock.
 

The Economic Outlook

The Congressional Budget Office's current forecast dif-fers from its January forecast in several respects. Because of the surprising performance of the economy over the past several quarters and the absence of structural imbalances, CBO has revised upward its near-term forecast for economic growth and interest rates and revised downward its forecast for unemployment and inflation. CBO projects that after calendar year 1998, the economy will ultimately return to its long-run path for gross domestic product and the rate of unemployment. Long-term real growth is assumed to be slightly higher than in the January projections. Inflation is expected to be benign. Real short-term interest rates should drop to their average during the late 1950s and early 1960s, when federal deficits were similar to the levels expected in this baseline.

The performance of the U.S. economy over the past several quarters has been remarkable. Economic growth has picked up, the unemployment rate has dipped to a 24-year low, and inflation has tumbled despite evidence of mounting inflationary pressures. Moreover, CBO expects moderate growth in the second half of this calendar year.

Consumption and investment will continue to fuel near-term growth. Right now, household finances are healthy. In fact, the financial assets of households have been rising faster than their debt. Consequently, overall household spending is supported by stronger net assets. The financial health of business is also sturdy. Firms have greatly reduced their reliance on debt as the stock market has boomed and debt-financed mergers have waned. Interest costs as a share of net cash flow have fallen steadily since the late 1980s and are now at a 20-year low. Only a slight easing in investment is expected.

CBO expects that inflation will climb moderately starting in the second half of the current calendar year and continue to do so through 1998 (see Summary Table 3). Inflationary pressures may lead the Federal Reserve to make modest increases in its target for the federal funds rate. With inflation expected to rise, such a step would help to keep real short-term interest rates from dropping below current levels and keep monetary policy modestly restrictive.
 

Conclusion

CBO projects that the policy changes enacted in the Balanced Budget and Taxpayer Relief Acts of 1997 will produce a balanced federal budget by 2002. Those policy changes do more than merely eliminate the deficit in that year: the reconciliation legislation changes the projected path of the deficit from one of annual increases to one that hovers near zero for the next 10 years. The challenge lies in maintaining the course laid out in the recent reconciliation legislation.

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