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The Economic and Budget Outlook: An Update September 1997

The combination of a strong economy and the enactment of a package of major policy changes has significantly improved the budget outlook. As a result, the Congressional Budget Office (CBO) estimates that in 2002, under current policies, the federal budget will be balanced for the first time since 1969. From a 23-year low of $34 billion this year, the deficit is expected to increase to $57 billion in 1998, decline gradually from 1999 to 2001, and then switch to a surplus of $32 billion in 2002. If current policies remain in place and the economy stays on an even keel, the budget is projected to remain in surplus for the five years through 2007. However, a burst of entitlement spending and a return to budget deficits are likely to be lurking just over the horizon as the baby-boom generation begins to enter retirement age in 2008.

The low deficit in 1997--fueled primarily by a substantial increase in revenues--has been affected very little by policies enacted this year. Boosted by unexpectedly high final payments on 1996 income tax liabilities, as well as income and payroll taxes withheld for 1997, total revenues for the year are expected to increase 8.6 percent from last year. Part of that unexpected growth is attributable to the strength of the economy, but a significant amount stems from other factors such as the timing of payments and more income being taxed at higher tax rates. In addition, the strong economy and various other factors have restrained spending in some income assistance programs, thereby contributing to the steep decline in the 1997 deficit.

Without the changes in policies agreed to by the Congress and the President, however, the budget would probably not reach balance. This year's reconciliation legislation--the Balanced Budget Act of 1997 and the Taxpayer Relief Act of 1997--on balance provides enough savings in mandatory spending and restraints in discretionary spending to bring projected deficits down by $118 billion (net of tax cuts) through 2002. Net policy changes of $95 billion in that year provide the final shove from deficit to surplus.

Relatively low deficits for the next few years and small surpluses in the beginning of the 21st century would cause the federal government to draw substantially less from private credit markets than it has in recent years. Debt held by the public relative to the size of the economy would drop from its current level of nearly 50 percent of gross domestic product (GDP) to 30 percent by 2007, a level unseen since the early 1980s. As a result, interest payments and interest rates should drop, thereby making more resources available for private investment and enhancing productivity and economic growth.

There is no guarantee that deficits will disappear, however. Extending pay-as-you-go constraints on new direct (mandatory) spending and revenue legislation and the enforceable limits on discretionary spending through 2002 will reduce the likelihood that future legislation will undo the promised deficit reduction (see Appendix C, "Sequestration Update Report for Fiscal Year 1998," for more information on budget enforcement procedures). Nevertheless, an economy that is weaker than anticipated or entitlement spending that grows more rapidly than expected could push deficits up. In addition, maintaining the fiscal discipline necessary to adhere to the discretionary caps may be difficult in the face of a near-freeze on such spending for another five years and pressures to increase spending on such items as transportation infrastructure, education, and the replacement of aging military equipment. In any case, deficits or surpluses that differ by $100 billion from current projections are entirely possible. Chapter 3 of CBO's The Economic and Budget Outlook: Fiscal Years 1998-2007 (January 1997) reviews the inherent uncertainty in budget projections.

This chapter presents CBO's outlook for the federal budget under the economic forecast described in Chapter 1 and the policies currently in place. It summarizes the effect of the two reconciliation acts and other changes that have occurred since CBO's March baseline was published. The chapter concludes with the budget estimates displayed in the framework of the national income and product accounts, which economists use to analyze the government's activities.
 

The Deficit Outlook

CBO estimates that the total deficit this year will fall to $34 billion, a decline of $73 billion from the 1996 level (see Table 7). That deficit figure represents just 0.4 percent of GDP, which is a substantially smaller share than the 4.7 percent recorded just five years ago.
 

After 2002, modest budget surpluses are projected to continue. Although CBO expects the surplus to decline to $13 billion in 2003, under current policies it could rise to $86 billion in 2007. The good news is likely to be fleeting, however. In 2008, the first of the baby boomers will turn 62 years old and thus become eligible to claim early retirement under Social Security. Three years later marks the start of their participation in Medicare, the major health program for the elderly. Without further action to restrain the growth of those entitlement programs, a deficit is likely to reappear sometime thereafter. See Long-Term Budgetary Pressures and Policy Options (March 1997) for more information on CBO's view of the long-term budget outlook.

Another measure of the deficit that is sometimes used is the on-budget deficit, which excludes the transactions of the Social Security trust funds (Old-Age and Survivors Insurance and Disability Insurance) and the Postal Service. That measure of the deficit has little utility from an economic perspective; although designated as off-budget, the trust fund and postal transactions affect the economy as much as other governmental spending and receipts. Because it excludes the Social Security funds, which continue to run large surpluses, the on-budget deficit declines to $88 billion in 2002 rather than balancing. Similar deficits remain from 2003 through 2007.

Those trust fund surpluses will diminish rapidly once the baby boomers enter retirement. As benefit payments begin to outstrip receipts, the trust funds will have smaller surpluses, and the on-budget deficit will more closely resemble the total deficit.
 

Revenue and Spending Projections

Federal revenues are expected to be $1,578 billion in 1997, an increase of $125 billion over 1996 (see Table 8). As a share of GDP, revenues will total 19.8 percent this year, the highest level since the end of World War II. That percentage is expected to dwindle over the next few years. Revenues are projected to equal 19.0 per-cent of GDP in 2003 and remain at that level through 2007.
 

Federal revenues tend to grow in tandem with the economy, as measured by nominal GDP (see Figure 13). However, temporary factors, such as changes in tax law or in the growth of taxable income relative to that of GDP, often cause growth of revenues and the economy to diverge from that pattern. Over the past four years (including 1997), such temporary factors have caused revenue growth to exceed that of GDP. For the next few years, though, that trend is expected to reverse. By 2002, growth of revenues is projected to be close to that of GDP as the temporary factors fade. Box 3 explains the deviations between revenue and GDP growth rates.
 

Figure 13.   Growth of Federal Revenues and GDP

SOURCE: Congressional Budget Office.

Spending for entitlements and other mandatory programs, by far the largest spending category, will reach $900 billion this year and is growing faster than the economy. Fueling that growth are expenditures for Social Security, Medicare, and Medicaid, which together account for roughly three-quarters of all mandatory outlays (see Table 9). Total mandatory spending is projected to grow from 11.3 percent of GDP in 1997 to 12.5 percent in 2007.
 

Changes Resulting from the Reconciliation Legislation

The Congress enacted two reconciliation bills in Au-gust--the Balanced Budget Act of 1997 and the Tax-payer Relief Act of 1997. CBO estimates that those acts will reduce the deficit by a cumulative $118 bil-lion from 1997 through 2002 compared with its March 1997 baseline estimates. Outlay savings of $198 bil-lion will be partly offset by $80 billion of revenue decreases over that period. Through the following five years--2003 through 2007--the legislation will lead to additional net budget savings of about $475 billion, assuming that discretionary spending grows at the rate of inflation after 2002. The President's use of his newly granted line-item veto powers will have very little effect on those cumulative savings even if the vetoes are upheld. See Box 5 for a description of the provisions excised by the President.
 

Box 5. Exercise of Line-Item Veto Authority On August 11, the President for the first time exercised new authority granted last year by the Line Item Veto Act.  As allowed by that act, he canceled one "item of direct spending" (a provision that would increase direct, or mandatory, spending) in the Balanced Budget Act of 1997 and two provisions providing a "limited tax benefit" (a revenue-losing provision affecting 100 or fewer beneficiaries or a provision providing transitional relief for 10 or fewer beneficiaries) in the Taxpayer Relief Act of 1997.  Those provisions would:  Waive the application to the state of New York of certain tax provisions for Medicaid providers and deem certain taxes currently under review to be in compliance with restrictions on providers' taxes.  That waiver would prevent the federal government from attempting to recover about $1.5 billion in disputed Medicaid payments to New York.  Because the recovery of the disputed payments is uncertain even if the waiver is not in effect, the Congressional Budget Office (CBO) estimates that the cost of the waiver is the $150 million expected value of the recovery effort, all recorded in 1998.  Defer gains from sales of stock in firms that process or refine farm products to farm cooperatives that supply the firm with raw farm products, thereby reducing revenues by a total of $84 million over the 1998-2002 period. o Allow multinational financial services firms to defer taxes on their foreign earnings during 1998, reducing revenues by a total of $94 million in 1998 through 2000.  Under the Line Item Veto Act, the Congress has 30 "calendar days of session" (those days when both the House and Senate are in session) to pass a bill that would disapprove any or all of the cancellations specified by the President.  If the President vetoes that bill, it can be enacted only by a vote of two-thirds of the Members in the House and in the Senate to override the veto.  In addition, the President's cancellations face an almost certain challenge in court on the grounds that the Line Item Veto Act is unconstitutional.  The estimates of the Balanced Budget Act and the Taxpayer Relief Act discussed in this report, and CBO's baseline projections of spending and revenues, do not reflect the effects of the proposed cancellations.  Under the Line Item Veto Act, cancellations of provisions in direct spending and revenue bills do not reduce the pay-as-you-go estimates of those bills that are required by the Balanced Budget and Emergency Deficit Control Act of 1985; the cancellations therefore will not make room for additional spending or further tax cuts.  In any case, the Balanced Budget Act provides that none of its deficit effects or those of the Taxpayer Relief Act shall be included on the pay-as-you-go scorecard.

 
Revenues

The Joint Committee on Taxation estimates that the tax provisions in the two reconciliation acts will reduce revenues below the levels projected under prior law by about $80 billion through 2002 and $242 billion through 2007 (see Table 10). In any given year, those changes represent a net decrease of slightly more than 1 percent of revenues (less than 0.3 percent of GDP). In addition, changes to the tax code will increase refundable tax credits, which are recorded as outlays, by nearly $30 billion over 10 years. Total revenue reductions through 2002 amount to $141 billion, over half of which result from a new child tax credit. Offsetting those reductions are more than $60 billion in revenue increases, around 55 percent of which come from extending and modifying airline excise taxes. The reconciliation acts also contain several provisions that merely shift the payment of taxes from one fiscal year to another--increasing revenues in 1999 and 2002 and lowering revenues in other years, especially 1998.
 

Child Tax Credit. The child credit results in the largest tax reduction, decreasing revenues by $73 billion through 2002 and $155 billion over 10 years. It will also increase outlays for the earned income tax credit (EITC), since some beneficiaries will be eligible to claim the child credit. The credit is $400 for 1998 and $500 as of 1999 for each child under the age of 17. It is phased out beginning at $110,000 of adjusted gross income (AGI) for couples filing joint returns and $75,000 for individuals. The length of the phaseout is variable, depending on the number of eligible children.

The total cost of the credit declines over time because neither the amount of the credit nor the phaseout is indexed for inflation. Over time, a greater share of families will receive lower credits as they move into the phaseout range or become ineligible. In addition, the credit is not applied against the alternative minimum tax. The AMT will affect a greater number of taxpayers over time, so fewer will benefit from the credit.

Education Incentives. Tax incentives for education will reduce revenues by nearly $100 billion through 2007, with over 75 percent of the reduction stemming from the new HOPE and Lifetime Learning tax credits. The HOPE credit equals 100 percent of the first $1,000 and 50 percent of the next $1,000 of tuition and fees paid for the first two years of postsecondary education. Subsequent postsecondary studies qualify for the Lifetime Learning credit, which equals 20 percent of up to $5,000 of education costs ($10,000 after 2002). Both credits are nonrefundable and phase out for joint filers with income between $80,000 and $100,000 and for other taxpayers with income between $40,000 and $50,000, indexed for inflation after 2001. Taxpayers may claim one HOPE credit for each qualifying student, but the cap on the Lifetime Learning credit applies to the total expenses for all eligible students in the family. Only students enrolled at least half-time in a degree program qualify for the HOPE credit. In contrast, the Lifetime Learning credit may be claimed for students in degree programs or taking courses to acquire or improve job skills. In a given year, a taxpayer may claim the HOPE credit for some students and the Lifetime Learning credit for others, but both credits may not be claimed for the same student in one year.

The Taxpayer Relief Act also establishes new individual retirement accounts for education, reducing revenues by $14 billion over the next decade. Taxpayers may contribute up to $500 annually for each beneficiary, and subsequent withdrawals to pay educational costs are not taxable. The maximum contribution phases down to zero for joint filers with income between $150,000 and $160,000 and other taxpayers with income between $95,000 and $110,000.

Other incentives allow penalty-free withdrawals from IRAs for education expenses, expand the tax advantages of state-sponsored prepaid tuition programs, permit some interest on student loans to be deducted, and reinstate the exclusion of employer-provided assistance for undergraduate education.

Estate and Gift Tax Provisions. The reconciliation legislation raises the unified credit against the estate and gift tax and then indexes the exemption for inflation. Those changes reduce revenues by just $6 billion through 2002 but by $34 billion over the 10-year period. The current credit, which has not changed since 1987, is equivalent to an exclusion of the first $600,000 of transfers. The legislation raises the credit in steps to an exclusion of $1 million in 2006. After that, the credit amount (and hence the effective exclusion), the annual limits on gifts, and the limit on current-use valuation for family businesses will all be adjusted for inflation. Since the largest increases in the unified credit occur in 2004 and 2005, the revenue loss from the change grows rapidly in the last three years of the projection period.

Reductions in the Capital Gains Tax Rate. Prior law imposed a ceiling of 28 percent on the rate at which capital gains income was taxed for people whose rate on other income was 31 percent, 36 percent, or 39.6 percent. The ceiling applied to gains on assets held for one year or more.

The new law provides lower tax rates for capital gains realized after May 6, 1997. The new rates are 10 percent for people otherwise in the 15 percent tax bracket and 20 percent for those in higher brackets. As of July 28, 1997, those rates apply to gains on assets held for more than 18 months. Prior law applies to gains on assets held for shorter periods. Thus, gains on assets held between 12 and 18 months will continue to have a maximum tax rate of 28 percent, and gains from assets held less than 12 months will continue to be taxed at the same rates as other income. Lower rates of 8 percent and 18 percent will eventually apply to assets held for more than five years. The 8 percent rate will apply to long-held assets sold in 2001 or later by taxpayers in the lowest income bracket. The top rate will drop to 18 percent for assets purchased after 2001 and held for at least five years. In 2001, taxpayers have the option of paying tax on their accumulated gains on an asset to take advantage of the lower rates on subsequent gains if the assets are held for an additional five years.

The legislation also allows homeowners filing jointly to exclude $500,000 ($250,000 for other taxpayers) of capital gains on each home sale, provided they have lived in their home for at least two of the past five years and have not claimed the exclusion for a sale in the past two years. Taxpayers will no longer be able to roll over gains from one home to the next.

After an initial burst of realizations over the next two years, the lower rates are estimated to reduce revenues in each year. The revenue loss is lower in 2002 because taxpayers who realize gains in 2001 in order to acquire assets eligible for lower future rates will pay higher taxes in April 2002. The total revenue loss through 2007 is estimated to be $21 billion.

IRA Expansions. The Taxpayer Relief Act makes two significant changes to the tax treatment of individual retirement accounts. The current deductible IRAs will be made available to taxpayers with higher income, and a new type of account, known as a Roth IRA, will be introduced.

Currently, couples in which either spouse is eligible for employer-sponsored pension coverage can deduct the full amount of an IRA contribution from their taxable income only if their AGI is below $40,000, and none of the IRA is deductible if their income exceeds $50,000. The deductible amount of the IRA for individuals covered by a pension is phased out between $25,000 and $35,000. Those income levels will gradually rise until they reach $80,000 and $100,000 for couples and $50,000 and $60,000 for individuals.

Contributions to Roth IRAs will not be deductible, but the investment earnings in those accounts will be completely tax-free when withdrawn at the qualifying age or for qualifying purposes, which include a first-time home purchase. The income phaseouts for Roth IRAs begin at $150,000 for joint filers and $95,000 for single filers. The combined annual contribution to both types of IRAs is limited to $2,000 per person.

The effect of the IRA provisions grows over time for three main reasons. First, the increased income limits for deductible IRAs are phased in. Second, to the extent that Roth IRAs replace assets that would have been taxed, the revenue loss from those accounts increases as the balances grow (although there is no initial revenue loss since contributions are not deductible). Third, in the first few years, revenues receive a temporary boost because the law allows the penalty-free shifting of assets from deductible IRAs to Roth IRAs. Taxpayers who shift to Roth IRAs to make their future earnings tax-exempt will have to pay income taxes, but not penalties for early withdrawal, on the amount shifted. By 2007, the annual revenue loss from the IRA provisions is projected to reach $5 billion.

Tax Reductions for Corporations and Small Businesses. Among other relief for businesses, the legislation provides substantial relief to corporations from the alternative minimum tax. First, for investment assets put in place after December 31, 1998, corporations will be able to calculate depreciation for purposes of the AMT using the same asset lifetimes they use for regular tax purposes, although firms will still be required to use a less accelerated method of calculating depreciation for AMT purposes. The previous requirement to use longer lifetimes for the AMT accounted for the bulk of AMT revenue. Second, corporations with business receipts averaging less than $5 million annually over a recent period will be exempt from the AMT. In addition, the legislation allows farmers to use the installment method of accounting for AMT purposes. The annual revenue losses estimated for the three provisions decline after 2004 because AMT payments largely represent an earlier payment of regular taxes that would eventually be paid anyway. The estimated loss in revenue through 2007 is about $20 billion.

The legislation also clarifies the definition of a principal place of business (allowing a greater number of self-employed people to deduct certain business- related housing expenses from their business income), increases the percentage of health insurance expenses that self-employed people are permitted to deduct, and extends the research and experimentation credit for 13 months.

Increases in Excise Taxes. Much of the revenue raised by the reconciliation acts comes from extending existing excise taxes or increasing their rates. Almost $33 billion results through 2002 from extending and modifying the excise taxes related to the Airport and Airway Trust Fund, which were previously scheduled to expire on September 30, 1997. The 10 percent tax on air passenger tickets has been extended but substantially modified. In 2002, when all the changes will have been phased in, the rate will be 7.5 percent of the purchase price of the ticket, with an additional tax of $3 for each segment of a domestic flight. The international departure fee has been increased from $6 to $12 and now applies to both departures and arrivals. A new 7.5 percent tax will be imposed on cash payments by credit card companies to airlines for the right to award airline tickets to their customers. The other Airport and Airway Trust Fund taxes have been extended without modification. The 4.3 cents per gallon tax on aviation fuel, now dedicated to the general fund, will be deposited in the trust fund. The $33 billion in revenue generated by the provisions through 2002 is approximately $4 billion greater than the amount an extension of prior law would have produced.

The current excise tax rate on cigarettes is 24 cents per pack of 20. Under the new law, the rate will rise by 10 cents per pack on January 1, 2000. An additional increase of 5 cents per pack on January 1, 2002, will bring the total increase to 15 cents per pack. The rates on other tobacco products, such as pipe tobacco and cigars, will increase by the same amounts. Those changes will generate additional revenues of $17 billion through 2007.

Increase in Federal Unemployment Tax. The Federal Unemployment Tax Act (FUTA) effectively imposes a 0.8 percent tax on the first $7,000 of wages paid to each covered employee. Those revenues are deposited into accounts designated for administrative costs, the federal portion of extended unemployment benefits, and loans to states. Federal law limits the size of those funds; excess funds are distributed to state accounts.

The 0.8 percent tax includes a temporary 0.2 percent surtax that was set to expire at the end of 1998. The legislation extends that surtax through 2007 and adjusts the cap on one of the federal accounts so that the additional revenues can be retained. No increase in revenues is projected for later years, since the limit on the federal accounts will still be reached in 2003.

Increased Taxes on Businesses. The new law also targets certain businesses for tax increases. Among other provisions, it expands the limitations on the deductibility of premiums and interest for corporate- owned life insurance policies. It also restricts the use of certain tax-motivated methods for selling corporate assets--for example, by requiring that certain dividends and distributions of controlled corporate stock be treated as capital gains. The new law also limits the use of losses by allowing businesses to carry losses back (and thereby receive refunds of previous taxes paid) generally for only two years rather than the three years allowed under prior law, but businesses can now carry losses forward for 20 years rather than 15. The two changes in the use of losses raise revenue on net, but in the long term, the gain represents predominantly the timing of tax payments, not their level.

Timing Changes. The reconciliation legislation includes four provisions that change payment dates from one fiscal year to another but do not change tax liabilities. In three cases, payments are delayed from the end of one fiscal year into the beginning of the next. Remittals of airline ticket taxes will be moved from the end of fiscal year 1997 into 1998 and will be delayed again one year later. Excise taxes on fuels will be postponed from the end of fiscal year 1998 into 1999. The Universal Service Fund will receive payments at the beginning of fiscal year 2002 instead of at the end of 2001. The rule that determines how much individuals must pay in withholding and estimated taxes during the tax year will first be liberalized and then made tighter than under prior law. Those changes reduce revenue in 1998 and 2003 and increase it in 1999 and 2002.

Discretionary Spending

New limits on discretionary spending through 2002 included in the Balanced Budget Act of 1997 will reduce estimated discretionary spending by $89 billion relative to CBO's March baseline. There are now three separate caps--for defense spending, the Violent Crime Reduction Trust Fund (VCRTF), and other nondefense, noncrime spending--for 1998 and 1999. In 2000, the number of caps narrows to two (VCRTF and other); in 2001 and 2002, a single cap covers all discretionary spending. After the cap expires in 2002, the baseline assumes that discretionary spending grows at the rate of inflation.

Complying with the caps in 1998 does not appear to be a major problem. Appropriation bills already passed by the House and Senate (no bills have yet been agreed to by both Houses) are consistent with the allowed amounts, which are just a few billion dollars below the level of appropriations enacted for 1997 adjusted for inflation. The revised cap for 1998 is also $11 billion higher than the cap in place at the start of 1997 (see Table 11). By 2002, however, discretionary spending under the new single cap is projected to be $53 billion lower than under CBO's previous baseline and would be only $11 billion higher than in 1997. In real terms, such spending would be 12 percent lower than this year's outlay level, and the difficult decisions about how to accomplish such a reduction are yet to be made.
 

Mandatory Spending

Changes in mandatory spending in the reconciliation bills provide a net reduction in the deficit of $52 billion in 2002 and $107 billion for the five-year period (see Table 11). Increases in spending for some welfare programs and funding for a new block grant to states to provide health care for uninsured children partially offset reductions in outlays for other programs, particularly Medicare and Medicaid. Increased receipts from auctioning the right to use portions of the electromagnetic spectrum also help reduce the deficit, especially in 2002.

Medicare Savings. Medicare accounts for the overwhelming majority of cuts in mandatory spending included in the reconciliation package. CBO estimates that between 1998 and 2002, benefit payments will be reduced by nearly $99 billion. Increased premiums from beneficiaries will save another $13 billion. Those modifications will slow projected annual growth in the program from 8.5 percent to about 6 percent through 2002. Over the 10-year period, changes to the Medicare program are expected to save $385 billion.

Most of the savings in Medicare benefits stem from reductions in payments to providers in Medicare's fee-for-service sector. The act cuts the growth of payment rates for almost every category of services, including inpatient and outpatient hospital services, physicians' services, skilled nursing facilities, therapy services, home health services, laboratory services, and durable medical equipment. Slowing the growth of fee-for-service spending also slows the growth of rates paid to capitated plans, whose payment rates are linked to those in the fee-for-service sector. (Capitation refers to a health insurance payment mechanism in which a fixed amount is paid per person to cover services.)

The Balanced Budget Act also alters Medicare in ways intended to encourage more plans and more enrollment in its capitated sector, called Medicare+ Choice. Although the Medicare+Choice provisions produce little immediate budgetary savings, they help build an infrastructure for Medicare capitation and set the stage for further changes to deal with Medicare's long-term financial problems. As the next step toward solving those problems, the act establishes a National Bipartisan Commission on the Future of Medicare, which will issue its recommendations to the Congress and the President in March 1999.

Medicare+Choice will make available to beneficiaries a broader range of plans beyond the currently available health maintenance organizations (HMOs). For the first time, beneficiaries will be given uniform, comprehensive, and timely comparative information about the options available to them. Greater choice of health plans and increases in payment rates will help expand Medicare's capitated sector in rural areas. Other provisions of the act, however, will tend to reduce enrollment in capitated plans. In particular, Medicare's payment rates will grow more slowly than costs in the fee-for-service sector for several years, potentially eroding the additional benefits that many of the capitated plans now provide.

In addition to slowing the growth of benefits and increasing premiums, the Balanced Budget Act also undertakes some new initiatives in Medicare. Expanded coverage of clinical preventive services will increase Medicare spending by $4.0 billion over the 1998-2002 period. Increased payments to rural hospitals and coverage of telephone consultations in certain rural areas will cost $0.4 billion. And states will receive $1.5 billion to help pay Medicare premiums for Medicaid beneficiaries who do not now qualify for such assistance.

The new law also reassigns the costs of certain home health services from the Hospital Insurance Trust Fund to the Supplementary Medical Insurance Trust Fund. That change has no effect on the bottom line of the budget, but it helps postpone the depletion of the Hospital Insurance Trust Fund from 2001 to 2007.

Other Net Savings in Mandatory Spending. Estimated Medicaid savings from the Balanced Budget Act total $7 billion over the next five years and $37 billion over the next 10 years. The largest savings come from instituting limits on state allotments for payments to hospitals that serve a disproportionate share of patients in poverty. Additional savings from giving states flexibility in paying providers are offset by higher spending for other purposes.

The Federal Communications Commission (FCC) has been instructed to conduct more auctions of the right to use portions of the electromagnetic spectrum for commercial purposes. Those additional auctions are expected to raise $21 billion over the 1998-2002 period, with slightly more than half of that amount to be recorded in 2002. Estimates of auction receipts are very uncertain because market conditions may change rapidly and because the FCC has considerable discretion in how it conducts future auctions and licensing. CBO assumes that future spectrum auctions will yield, on average, lower prices than those achieved in recent auctions, because of two factors: the increased supply of licenses that will result, and the development of new technologies that increase the information-carrying capacity of the spectrum.

Veterans' programs are scheduled to be reduced by nearly $4 billion from 1998 through 2002. Most of the savings come from extending expiring provisions regarding payments for Medicaid-eligible veterans in nursing homes, recovering the costs of medical care, and housing. Some of those savings are offset by higher Medicaid payments.

Among other provisions of the reconciliation laws, additional agency contributions for federal employee retirement programs will raise over $0.5 billion a year through 2002. Federal employees will also contribute more for their retirement, thereby increasing revenues by nearly $2 billion over the 1998-2002 period. Changes to federal housing and student loan programs each save roughly $2 billion over the five-year period.

Increases in Mandatory Spending. The Balanced Budget Act creates a new capped entitlement to provide health care coverage for children. States will be given approximately $20 billion over the next five years to expand coverage for uninsured low-income children. States may use their grant to purchase health coverage from group plans or to expand their Medicaid programs. They may also arrange for health care services directly through providers or through other means approved by the Secretary of Health and Human Services.

CBO estimates that the new State Children's Health Insurance Program, together with changes in Medicaid, will extend health care coverage to 2 million children who would otherwise have been uninsured. Not all of the new federal funds and required state matching funds will yield greater coverage, however. States will use some of the funds to offset reductions in Medicaid payments for disproportionate share hospitals, to provide services directly, or to replace spending on other state health programs and administrative activities. In addition, the new program will cover 1.4 million children who would have had health insurance coverage anyway.

Changes to Supplemental Security Income (SSI), the Food Stamp program, and Temporary Assistance to Needy Families (TANF) were included to ameliorate some of the effects of the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (also known as welfare reform). That law denied SSI benefits to legal immigrants. The reconciliation act restores eligibility to legal immigrants who were in the United States when the welfare reform law was passed. That provision is estimated to cost about $2 billion a year through 2002. Increased spending on the Food Stamp program and welfare-to-work grants provided under the TANF block grant to states will cost another $4 billion through 2002.

Increased outlays for the earned income tax credit primarily reflect the child tax credit enacted as part of the Taxpayer Relief Act of 1997. The child credit will reduce the tax liabilities of families receiving the EITC and increase the portion of the EITC that is refundable. About one-third of the spending is the result of making the child credit refundable for families with three or more children. The combined effect will raise outlays by an estimated $2.4 billion in 1999 and $3.6 billion in 2007.

Unfunded Liabilities of the District of Columbia's Pension Plan. Under the Balanced Budget Act, the federal government will assume responsibility for the existing pension plans that the District of Columbia provides to its law enforcement officers, firefighters, teachers, and judges. The District will close out those plans and transfer to the federal government approximately $3.2 billion in assets and $9 billion in liabilities. Although the federal government will assume unfunded liabilities of approximately $5.8 billion, this change will initially have no net effect on the deficit. The cash received by the federal government from investing and selling the transferred assets will offset the outlays for payments to beneficiaries until such payments exhaust the assets in or near fiscal year 2006. At that time, the federal government will begin to pay the remaining pension benefits out of general revenues--about $0.3 billion in 2006 and $0.7 billion in 2007. Payments will continue until the middle of the next century, increasing to roughly as much as $1 billion a year before gradually dropping off.

Timing Shifts. If the first day of a month falls on a weekend or federal holiday, payments for veterans' benefits, SSI, and Medicare HMOs are normally pushed back into the preceding month. When that happens to payments due on October 1--the beginning of the federal government's fiscal year--billions of dollars can be shifted to the preceding year. The Balanced Budget Act of 1997, however, reverses the shift from 2001 to 2000 that would have occurred in those programs. The act also shifts into 2001 nearly $5 billion in HMO payments that would otherwise have been made in 2002.
 

Other Changes in the Budget Outlook Since March

CBO last presented its baseline budget projections in March 1997 in conjunction with its analysis of President Clinton's budgetary proposals. The budget estimates have changed since then, partly because of the reconciliation laws but also because of revisions in CBO's economic forecast and technical assumptions about revenues and spending (see Table 12).
 

CBO categorizes the reestimates that result from legislation enacted since the previous baseline as policy changes. Most of those changes stem from the reconciliation package and were discussed in the previous section. The only other change of budgetary note that affects outlays is supplemental funding for disaster relief and other activities, totaling nearly $1 billion in 1997. Those outlays are offset by increased revenues of close to $3 billion from temporarily reinstating the airline ticket taxes that had expired at the end of December 1996.

Economic and Technical Changes

Since CBO's last forecast, the economic news has been almost entirely upbeat. Strong economic growth has been coupled with low inflation, low unemployment, and stable interest rates. Those favorable conditions have contributed to a revised economic forecast that improves the budget outlook. Other changes in estimates that are not attributable to legislation or revisions in the economic forecast are known as technical reesti-mates, which, in this outlook, also reduce the deficit projections.

Revenues. As discussed above, changes in tax laws included in the reconciliation package enacted this year will reduce revenues through 2007. Those reductions, however, are more than offset in CBO's new baseline by increases in projected revenues--$427 billion through 2002 and more than $1 trillion through 2007-- that result from other factors. The most important of those factors are:
 

• An increase in taxable income. That increase is the result of higher-than-expected income in recent quarters, as measured by the national income and product accounts (NIPAs), and an increase in the projected growth rate. Those revisions result in annual revenue increases that grow throughout the projection period.
•  An increase in 1997 revenues that exceeds the amount that would have been expected just from the increase in taxable income reported in the NIPA data. That increase cannot be fully explained by currently available data, and CBO assumes that only part of the increase is carried forward into future years.

CBO's current projection of revenues for 1997 is $71 billion higher than was anticipated in March. Legislation (primarily a bill that temporarily reinstated the airline ticket tax) accounts for only $3 billion of the increase. As Table 12 shows, about one-third--$23 billion--of the total increase is attributable to current data that indicate the economy grew faster and taxable income was higher in 1996 and 1997 than CBO had forecast last January (the economic forecast was not updated for the March baseline). The improved outlook for economic growth in 1998 and beyond generates even larger increases in projected revenues in those years--growing from $41 billion in 1998 to $124 billion in 2007.

The remaining $46 billion increase in revenues in 1997 cannot be explained with any precision until the NIPA data are revised and income and liability data based on tax returns for 1996 and 1997 become available, but several factors that may have contributed to that increase were discussed in Box 3.

To the extent that the $46 billion increase in 1997 is the result of a permanent change in the tax base, similar increases in revenues might be expected in future years. However, if most of that amount is the result of shifts in the timing of tax payments or other temporary factors, revenues in later years may not rise. Because information is not currently available to indicate how much of the increase is attributable to which factor, CBO assumes that approximately one-third of the unexplained increase carries over into future years, generating about $15 billion a year in additional revenues in the long run.

Outlays. Reestimates of outlays for economic reasons primarily affect interest on the debt and programs that are subject to yearly cost-of-living increases. Other, technical factors that can cause changes in spending range from deviations in the timing of payments to administrative actions that decrease spending for entitlement benefits.

CBO's current forecast of interest rates is slightly higher than its previous one for 1997 and up to 0.5 percentage points higher for 1998. From 1999 on, though, the effect of the government's diminished participation in the credit market contributes to a reduction of 0.2 percentage points in short-term rates and 0.5 percentage points in long-term rates compared with CBO's previous forecast. Those changes increase net interest payments by $6 billion in 1998; however, by 2007, net interest payments are down by $19 billion for economic reasons (plus another $51 billion as a result of lower debt-service costs).

The cost-of-living adjustment for Social Security and a number of other entitlement programs in 1998 is projected to be 0.6 percentage points lower than previously expected. The projected unemployment rate through 2001 is also lower. The combination of those two changes reduces outlays by $5 billion in 1998 and similar amounts annually thereafter.

The bulk of the technical changes in outlays reflect debt-service savings on technical reestimates of revenues and outlays. Those savings grow to $26 billion by 2007. Technical changes in outlays other than net interest reduce the deficit by $7 billion, on balance, in 1997 and by similar amounts in future years.

In 1997, defense spending is expected to be $3 billion higher as a result of faster spending on operation and maintenance, procurement, and research and development. A delay in a planned reestimate of subsidy costs for student loans pushes outlays up by almost $3 billion, and transportation spending is about $1 billion higher than previously projected. Those increases are offset by reductions in other areas such as Medicaid ($3 billion), family support ($3 billion), unemployment insurance ($1 billion), SSI ($1 billion), deposit insurance ($1 billion), disability insurance ($1 billion), and general government programs ($1 billion).
 

The Federal Sector of the National Income and Product Accounts

The projections summarized so far in this chapter draw on the usual labels--revenues by source, outlays by category--that are familiar to policymakers. Economists, though, often use another approach for measuring the government's activities. The federal sector of the national income and product accounts divides the government's spending and receipts into categories that are conventionally used to analyze domestic production and income. That categorization allows economists to track the relationship between the government and other sectors of the economy.

Just a few major differences distinguish the NIPA versions of federal receipts and expenditures from their counterparts in the budget. Netting and grossing adjustments move some collections, mainly those labeled offsetting receipts in the budget, from the spending to the receipts side of the NIPAs (see Table 13 on page 46). Most collections are recorded in the budget as negative outlays because they do not result from the government's taxing power. Shifting them to the receipts side of the NIPA ledger gives users a fuller picture of government receipts, regardless of source, and does not affect the total deficit.
 

The NIPAs and the unified budget also differ in their treatment of investment and capital consumption. The unified budget includes all federal government expenditures, including purchases such as buildings and aircraft carriers, that could be considered investments. The NIPA version shows the current, or operating, account for the federal government; consequently, government investment is left out, and the government's consumption of fixed capital (depreciation) is included.

The NIPA federal sector generally portrays receipts according to their sources and expenditures according to their purpose and destination (see Table 14). Receipts are split into four large categories--per-sonal tax and nontax receipts, corporate profits tax accruals, indirect business tax and nontax accruals, and contributions for social insurance--whose labels summarize the nature of the collection and the identity of the payer. The term "nontax" indicates that NIPA receipts include some charges, such as fees and premiums, that are not generally treated as revenues in the budget.
 

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