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The Budget and Economic Outlook: Fiscal Years 2004-2013 January 2003 |
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The baseline projections in Chapters 1 and 2 represent the most likely of the possible outcomes for the budget and the economy, on the basis of current trends and the assumption that tax and spending policies now in place do not change. But considerable uncertainty surrounds those projections for two reasons. First, future legislation is likely to alter the paths of federal revenues and spending. The Congressional Budget Office does not predict future legislation--indeed, any attempt to incorporate future legislative changes in its baseline would undermine the usefulness of those numbers as a base against which to measure the effects of legislation. Second, the U.S. economy and the federal budget are highly complex and are affected by many economic and other changes that are difficult to predict. As a result, actual budgetary outcomes will almost certainly differ from CBO's baseline projections, even after adjustments for new legislation. This chapter explores how the accuracy of the economic and technical assumptions that CBO incorporates in its baseline can affect the accuracy of its budget projections. Looking back, the chapter describes CBO's record of projections and shows how reliable CBO's current and future projections might be if they are as accurate as those of the past. Looking forward, it uses several scenarios to describe how the budget might differ from CBO's baseline projections. The outlook for the budget (given current law and policies) can best
be described not as the single row of numbers presented in CBO's tables
but as a large spread, or fan, of possible outcomes around those numbers
that widens as the projections extend. The fan in Figure
5-1 is based on CBO's record of accuracy in its five-year budget
projections. The baseline budget projections presented in Chapter
1 fall in the middle of the highest probabilities--shown in the darkest
part of the figure. But nearby projections--other paths in the darkest
part of the figure--have nearly the same probability of occurring as do
the baseline projections. Moreover, projections that are quite different
from the baseline also have a significant probability of coming to pass.
On the basis of the historical record, the budget surplus or deficit would,
in the absence of new legislation, fall within the fan around CBO's projections
about 90 percent of the time.
Figure 5-1 cannot be precisely accurate because the probabilities are themselves estimates; as such, they may misstate the true uncertainty of current projections. The record on which the fan chart is based is short, and it may not represent future uncertainty. Historically, CBO's projections have been least accurate around cyclical turning points (times when the economy moves from expansion to recession, or vice versa), which economists are generally unable to predict reliably. However, from 1981 (the earliest year for which complete data suitable for this analysis are available) until 2002, the economy experienced just three recessions (in 1981 and 1982, 1990 and 1991, and 2001) and two long expansions. Thus, CBO has limited information on the accuracy of its projections around turning points. In addition to the uncertainty about cyclical turning points, the economic and budget trends that underlie the 10-year outlook are not clear. For example, measuring and forecasting the potential growth of the economy--an important part of the 10-year projections--are very difficult and involve assumptions about many factors that affect the growth of capital, labor supply, and total factor productivity (which reflects the output from both capital and labor combined). Much uncertainty surrounds factors such as the enduring effect of the investment boom of the late 1990s, the pace of future technological improvements in IT (information technology) equipment, the impact of changes in the educational status of the labor force, developments in the world economy, and work and retirement patterns--including the full implications of the impending retirement of the baby-boom generation. Even small inaccuracies in the projected growth rate of potential output can have significant budgetary implications over the course of 10 years. Another way to show the uncertainty of projections is to calculate the effects of specific sets of alternative assumptions on the outlook for the economy and the budget. To illustrate the possible implications of alternative cyclical and trend assumptions, CBO has chosen several scenarios. Two cyclical scenarios explore the possibilities of either a faster recovery than the one now shown in the baseline projections or, alternatively, another downturn--the second part of a double-dip recession. Other short-term scenarios focus on various possibilities of a war with Iraq. Two additional scenarios concentrate on differing assumptions about longer-term trends in productivity growth, effective tax rates on income, and medical costs. The first assumes that growth of labor productivity is higher than in the baseline, resembling that of the late 1990s, and that other budgetary trends (aside from legislation) also follow favorable paths, as they did in the same period. The second assumes slower growth in labor productivity, more like that of the 1973-1995 period, and less favorable budgetary trends. The projections that result from those various scenarios suggest a very wide range of possible outcomes for the budget. Like the fan chart, the various scenarios illustrate how the range of
uncertainty of budget projections expands as they are extended. The range
is very large for the 10-year projections: for instance, choosing relatively
optimistic or pessimistic, but still reasonable, assumptions about economic
and budgetary trends could increase or decrease the projected cumulative
10-year budget surplus by several trillions of dollars. About three-quarters
of the uncertainty in 10-year budget projections occurs in the last five
years of the projection period. Looking forward a decade allows the Congress
to consider the longer-term budgetary implications of specific policy changes,
but it also increases the likelihood that budgetary decisions will be made
on the basis of projections that later turn out to have been far wrong.
The Accuracy of CBO's Past Budget ProjectionsBaseline budget projections are bound to deviate from actual outcomes, but assessing the accuracy of previous projections is not a simple matter. Baseline projections are meant to serve as a neutral reference point for evaluating policy changes, so they make no assumptions about future legislation that might alter current budget policies. Of course, new legislation is likely to affect revenues and spending, but the purpose of baseline estimates is not to forecast legislation. Consequently, this chapter focuses on inaccuracies in projecting that stem from economic and technical factors and excludes the estimated effects of new legislation. To assess the accuracy of its past annual projections, CBO compared
those projections with actual budgetary outcomes and attempted to determine
the sources of differences, after adjusting for the estimated effects of
policy changes (see Box 5-1). The comparisons
included 21 sets of projections for the ongoing fiscal year (the one in
which the projections were made), 20 sets for the following fiscal year
(referred to as the budget year), and 16 sets of projections that extend
four more years into the future.(1)
CBO used only the first five years of projections because its record is
not long enough to draw conclusions from 10-year projections. On average,
the absolute difference (without regard to whether the difference was
positive or negative) between CBO's estimate of the federal surplus or
deficit and the actual result was 0.5 percent of gross domestic product
for the ongoing fiscal year and 1.2 percent for the budget year; by the
fourth year beyond the budget year, CBO's estimate (adjusted for the effects
of subsequent legislation) rose to 3.2 percent (see Table
5-1). If those averages were applied to CBO's current baseline,
the actual surplus or deficit could be expected to differ in one direction
or the other from the corresponding projection by roughly $55 billion in
2003, $135 billion in 2004, and $450 billion in 2008, aside from the effects
of legislative changes.
Misestimates of revenues have generally been larger than misestimates of outlays, reflecting the greater sensitivity of revenues to economic developments. In absolute terms, revenue projections have differed from actual outcomes by an average of about 1.9 percent for the current year, 4.6 percent for the budget year, and 11.5 percent for the fourth year beyond the budget year. Inaccuracies in outlay projections were about a third smaller than those in revenue projections for the current year and about half as large for the budget year and subsequent years. The misestimates of the budget's bottom line went in both directions: sometimes the projections were too high and at other times too low. On average, CBO's projection of the surplus or deficit has tended to be slightly pessimistic--that is, CBO overestimated deficits--for the current and budget years and slightly optimistic for the third and fourth years beyond the budget year. However, the averages of the underestimates and overestimates for the six years have not been statistically significant, so in the calculations underlying Figure 5-1, the average inaccuracy was assumed to be zero. Similar conclusions can be drawn from looking at the history of CBO's
estimates of the primary surplus--the total budget surplus excluding net
interest--for each of the 16 full (six-year) baseline projections in the
sample period.(2) In each
case in Figure 5-2, the shaded cone corresponds
to an area similar to that shown by the fan in Figure
5-1, which is likely to capture a misestimate about 90 percent of the
time. Both figures reflect a statistical analysis of CBO's past misestimates
of revenues and outlays.(3) Misestimates above the center of the cones represent instances in which
CBO underestimated the primary surplus, while misestimates that lie below
the center of the cones are times when CBO overestimated the primary surplus--in
all cases, apart from the effects of subsequent legislation.
As the graphs in Figure 5-2 show, CBO's baseline projections have sometimes been very close to the mark, especially in the short run. While the five-year budget projections made between 1993 and 1997 tended to be too pessimistic, those made earlier tended to be too optimistic. Finally, projections made around the times of large changes in taxes generally would not have been improved if those projections had incorporated larger "feedback effects" on the budget from anticipated responses of capital and labor supply. For example, adding revenues to the 1983 baseline projection of the primary surplus to reflect larger supply-side effects of the Economic Recovery Tax Act of 1981 and the Tax Equity and Fiscal Responsibility Act of 1982 than the amount assumed in that baseline would have increased rather than reduced the inaccuracies in that projection.(4) Similarly, assuming larger supply-side effects of the Omnibus Budget Reconciliation Act of 1993 than those incorporated in the 1994 baseline would have reduced the projected level of revenues and magnified the inaccuracies in projecting the budget balance. Inaccuracies in some years of the 1991 baseline, which followed the Omnibus Budget Reconciliation Act of 1990, would have been increased by assuming larger negative feedbacks from the tax increase. Sources of Past Inaccuracies in Projecting Revenues
The unexpected shortfall in receipts in 2001 and 2002 was very likely due to some unwinding of the same factors that pushed receipts above expectations in the 1995-2000 period. Capital gains realizations fell substantially in 2001; other causes (as yet unidentified) reduced effective tax rates on income besides capital gains. The causes of the shortfall will not be fully known until all of the data from tax returns for 2001 and 2002 are tabulated over the next year and a half. Sources of Past Inaccuracies in Projecting Mandatory Outlays
Misestimates of those broad economic trends, however, accounted for
only part of the inaccuracies in past projections of mandatory outlays.
The remainder came from inaccurate assumptions about such factors as what
proportion of eligible individuals and families would participate in benefit
programs, how sound financial institutions would be, and how health care
providers would behave--factors that can be extremely difficult to predict.
For example, the deposit insurance crisis of the 1980s was not fully anticipated,
and the year-by-year costs for its cleanup were highly variable and hard
to estimate. CBO also did not fully anticipate either the expansion between
the late 1980s and the late 1990s of states' use of creative financing
mechanisms to obtain federal Medicaid funds or the temporary slowing of
the growth of Medicare costs in the late 1990s.
Alternative Economic and Budget ScenariosAnother way of looking at the uncertainty of today's projections is to consider how different scenarios could affect the budgetary outcome. Those alternative scenarios can provide a qualitative understanding of how budget projections can miss the mark, although assigning probabilities to the various outcomes is generally not possible. Short-Term Economic Uncertainty
In addition, much uncertainty exists in the short term about the amount of tax receipts. In recent years, tax receipts have swung by more than would be expected if the economic cycle was the only thing at work--first rising even more than income in the economic boom of the late 1990s, and then falling more than income during the past two years. CBO has constructed two scenarios to illustrate the range of possibilities in the short run, both for the economic outlook and for tax receipts. Double-Dip Recession.
The economy could turn rapidly worse in
2003 if the imbalances that precipitated the last recession have not been
fully worked out. The areas to watch include the response of consumers
to their loss of wealth in the stock market's decline, and the willingness
of businesses to invest in the face of excess capacity and the prospect
of no more than modest growth in consumer demand. The economy could tip
into recession if consumers slow the growth of their spending to much below
the growth of their income. Some forecasters are also concerned that with
a weak economy might come more widespread deflation, which currently exists
in the goods market, although CBO's scenario does not assume falling prices
economywide (see Box 5-2).
The recession scenario that CBO has constructed assumes weaker growth across the board in spending by consumers, businesses, state and local governments, and foreigners (see Table 5-2). In the scenario, the Federal Reserve does not fully anticipate the slowing demand, and the downturn proceeds too rapidly for monetary policy to stop it or for the Administration and the Congress to respond with timely legislation. With three quarters of negative growth in 2003, the growth of real GDP is 1.9 percentage points below the baseline this year and remains lower in 2004. Corporate profits and dividends fall more than proportionately in response to GDP, contributing to a more-than-proportionate decline in the major tax bases (wages and salaries, plus corporate profits). Unemployment rates are over 1 percentage point higher in 2004. The scenario also assumes that tax receipts are even lower than the weaker economic activity suggests. Consequently, the budget deficit would worsen by $55 billion this fiscal year and $61 billion in 2004. Rapid Expansion. A more optimistic interpretation of recent events is also possible. Stock market prices suggest that investors are discounting the current weakness in corporate earnings and looking forward to substantial improvements. The recent strength of consumer spending may demonstrate that the loss of wealth since 1999 does not affect consumers' spending plans very much. If people still feel wealthy--the wealth-to-income ratio has not fallen below the trend it followed before 1995--consumption may continue with vigor. The Federal Reserve has, in the process of lowering interest rates, sharply expanded the money supply, providing the wherewithal for a burst in demand. Moreover, businesses may have finished cutting costs and revising their plans and now may be ready to invest more strongly than expected. The scenario that CBO has constructed assumes that the growth of consumption is significantly stronger in 2003 and that this additional spending stimulates business investment. The growth of exports also picks up, possibly because of faster growth abroad. The stronger growth means that state and local governments have more revenues than they expected and therefore are able to balance their budgets with smaller cuts in purchases and other spending. Consequently, the growth of real GDP is more than a percentage point higher in 2003 than it is in the baseline, and remains higher in 2004. The scenario also assumes that tax receipts are even higher than the increase in economic activity suggests. As a result of those assumptions, the budget deficit would narrow by $54 billion in 2003 and by $68 billion in 2004, compared with CBO's baseline. War with Iraq
A war's effect on the economy, including its impact on oil prices and on the confidence of consumers and businesses, obviously depends on its outcome. In order to assess the possible effects of war on the U.S. economy, CBO has turned to a recent analysis by Macroeconomic Advisers (MA).(6) That analysis considers three scenarios. In the most benign scenario, victory is quick and decisive, with hostilities ending in four to six weeks and without serious political repercussions for other states in the region. With little damage to wells and ports, oil production quickly resumes and--because the war is over--oil prices no longer include a risk premium and may even fall. In an intermediate scenario, fighting extends six to 12 weeks, and tensions persist even after the main fighting is over. With some damage to oil facilities, production is down. In the worst scenario, fighting lasts between three and six months, produces major casualties, and severely damages Iraq's infrastructure. In this scenario, the United States faces major geopolitical problems, including widespread resentment in Arab countries, that undermine the confidence of U.S. consumers and businesses even after fighting has ended. In MA's analysis, the most benign scenario, with a quick finish to the war, could provide a short-term lift to the economy that comes from lower oil prices and the removal of uncertainty about the nature of the war (see Table 5-3). In the other two scenarios, the economic effects are serious enough to produce either a pause in growth or a double-dip recession. (Conflict with Iraq is unlikely to provide much immediate direct economic stimulus from government spending, because it is likely to be fought using equipment and munitions that have already been purchased.) By MA's calculations, the war would increase the federal budget deficit by amounts ranging from $20 billion to $64 billion in 2003 and from $14 billion to $120 billion in 2004. (CBO has no estimates of the overall budgetary costs of a war, although Box 1-3 provides estimates of monthly costs and the costs of some activities. MA used those estimates in its budget calculations.)
Those scenarios are obviously only examples. MA's calculations include attempts to put numbers on several imponderables: how the war might turn out and how consumers and businesses might react to the potential increase in risk. Moreover, while MA provided probability estimates for the various scenarios, CBO prefers not to assess odds; the scenarios stand simply as examples of the kinds of things that might happen. Trends in Productivity, Effective Tax Rates, and Medical Costs
The scenarios illustrate a wide range of possible budgetary outcomes. Over the 10 years from 2004 through 2013, the optimistic scenario implies $3.2 trillion more in total surpluses than CBO's baseline does. The pessimistic scenario implies cumulative deficits that increase the government's debt by nearly $3.2 trillion over the amount in CBO's baseline. In each case, 75 percent of the difference occurs in the last five years, emphasizing that budget projections for the 2009-2013 period are even more uncertain than those for the earlier years. Scenario Based on Optimistic Trends. In CBO's optimistic 10-year scenario, the favorable trends for the budget that existed between 1996 and 2000 continue more or less unabated after the economy recovers from the 2001 recession. Average growth of labor productivity from 2002 to 2013 matches that from 1996 through 2000 and so is 0.4 percentage points higher than that assumed in the baseline (see Table 5-4). As a result, real GDP grows at a rate that is 0.4 percentage points higher than in the baseline. In addition, the scenario assumes that the effective tax rate on taxable personal income grows faster than it does in the baseline projection and is about 2 percentage points above the baseline by 2013. (The effective rate rose by a couple of percentage points--excluding the more predictable effects of real bracket creep--over the 1995-2000 period and then fell by a similar amount in the past two years.) On the outlay side of the budget, the optimistic scenario assumes that spending for Medicare and Medicaid will grow at an annual rate that is 2 percentage points lower than the rate in the baseline. The budget outlook would improve dramatically under the assumptions of the scenario based on optimistic trends. Over the decade, if there was no other action to cut taxes or increase spending, the cumulative surplus would reach $4.5 trillion (about three times the surplus projected in the baseline). With a surplus of that magnitude, the government's holdings of assets (uncommitted funds) would exceed federal debt held by the public by more than $400 billion at the end of 2013.(7) Scenario Based on Pessimistic Trends.
CBO's pessimistic 10-year
scenario reverses most of the assumptions of the optimistic scenario and
assumes that the economy reverts in many respects to its situation before
1996. In this scenario, trends in the economy are generally unfavorable
to the budget. The scenario assumes that the recent burst of productivity
proves temporary, so future growth of productivity averages only the 1.4
percent rate seen from 1974 through 1995 (cyclically adjusted), implying
correspondingly lower growth of GDP. Productivity growth might slow for
a number of reasons: for example, if businesses have learned how to step
up to a higher level of productivity by improving their use of computers,
the growth of productivity will slow when most businesses have achieved
that efficiency. Any slowing in the rate of improvement of the skills of
the workforce might also diminish the growth of productivity (see Box 5-3). In addition to those economic factors, the scenario assumes that the effective tax rate on taxable personal income rises more slowly than in the baseline projections and is about 2 percentage points lower
by 2013. Similarly, the scenario assumes that Medicare and Medicaid spending
grows 2 percentage points faster each year than it does in the baseline.
In this scenario based on pessimistic trends, the budget balance remains
in overall deficit throughout the projection period. Debt held by the public
would rise to more than $5.5 trillion by the end of 2013, compared with
less than $2.6 trillion under assumptions for the baseline.
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