Congressional Budget Office
Director’s Blog

In preparing its economic forecast published in September 2008, CBO estimated that 40 percent of the tax rebates issued in the spring and summer under the Economic Stimulus Act of 2008 would be spent within six months––raising the growth of consumption in the second and third quarters of 2008 by 2.3 percent and 0.2 percent, respectively, and reducing it by 1.0 percent in the fourth quarter, when the distribution of the rebates was expected to end. However, analysts disagree about the economic impact of tax rebates. One study of the 2001 rebates suggests that as much as two-thirds of those rebates was spent within six months. For the 2008 rebates, some analysts have put the figure as low as 10 percent to 20 percent––in contrast to CBO’s estimate of 40 percent. There is, however, disagreement among analysts about the economic impact of tax rebates. Today CBO released a brief that examines the issue in light of the evidence currently available.

Studies of tax rebates fall into three groups depending on the type of data employed: those based on detailed data about spending by individual households; those based on qualitative answers to surveys in which people were asked what they intended to do or had already done with their rebate check; and those based on national data on income and spending for the country as a whole. By itself, simple observation of aggregate  consumption over time may not detect the effect of rebates; no spike in spending corresponds to the spike in income. For that reason, CBO places more confidence in studies of the first two types, which rely on differences in spending by people who benefit from the tax rebates and those who do not.

The figure below illustrates why careful studies, not casual observation, are necessary.  It shows a counterfactual path for monthly consumption spending, constructed by subtracting from actual spending CBO’s estimate of the effect of the rebates. That estimate (based on an assumption that 40 percent of the rebates was spent) implies that the rebates raised the growth of consumption in the second and third quarters by 2.3 percent and 0.2 percent, respectively, but reduced it by 1.0 percent in the fourth quarter, when the distribution of the rebates ended. However, someone comparing the monthly course of consumption with that of income would be unlikely to detect any effect.

Note: The cumulative area between lines showing consumption with and without the effects of rebates is 40 percent of the area between the lines showing income with and without the rebates. In the figure, it is assumed that the 40 percent of rebates is spent over six months according to this pattern: 15 percentage points in the first month and 5 percentage points in each subsequent month. On the basis of those assumptions, CBO estimates that the rebates added 2.3 percent (at an annual rate) to the growth of consumption in the second quarter of 2008 and 0.2 percent in the third quarter but––because of those effects––reduced the growth of consumption by 1.0 percent in the fourth quarter.

Long viewed as an integral component of higher education, athletic programs in many universities have become highly commercialized and, in some cases, are very rewarding financially: The National Collegiate Athletic Association (NCAA) men’s basketball tournament alone garnered about $143 million in revenue for athletic departments in 2008, and college football bowl games generated a similar amount. 

A new CBO study released today assesses the degree of commercialization of athletic departments by comparing their share of revenue from commercial sources with that of the rest of their schools’ activities. In the case of NCAA Division IA schools, 60 percent to 80 percent of athletic departments’ revenue comes from activities that can be described as commercial—seven to eight times that for the rest of the schools’ activities and programs. For schools in the rest of Division I, revenue from commercial activities accounts for a much smaller share of athletic departments’ revenue, about 20 percent to 30 percent.

The high share of commercial revenue for some sports programs raises the questions of whether those programs have become side businesses for schools and, if they have, whether the same preferential tax preferences should apply to them as to schools in general. The Congress could change the tax treatment of sports programs in several ways, such as limiting the deduction for contributions, limiting the use of tax-exempt bonds, or limiting the exemption from income taxation. As long as athletic departments remain a part of larger nonprofit or public universities, however, schools would have considerable opportunity to shift revenue, costs, or both between their taxed and untaxed sectors, rendering efforts to limit the tax preferences for athletic departments alone largely ineffective. In contrast, changing the tax treatment of income from certain sources, such as corporate sponsorship income or royalties from sales of branded merchandise, would create less opportunity for shifting revenue or costs, and it would have larger effects on the most commercial sports programs.

The report was written by Kristy Piccinini. Kristy has been at CBO for three years and holds a PhD from UC Berkeley. She has also traveled halfway across the country just to get a taste of March Madness in person (for research purposes, of course).

Last week CBO’s Deputy Director Robert Sunshine testified about the financing of the federal government’s aviation programs (basically operations of the Federal Aviation Administration) before the House Ways and Means Committee. Reauthorization of the aviation programs raises a number of significant policy questions:

• How much do we need to spend on those activities, especially to ensure that we have a safe, efficient, and effective air traffic control system?
• How much of those costs should be borne directly by users of the system, and how much by the general public?
• Of those costs borne by users, how should they be allocated among different types of users—or among users at differing times or differing places?

How much to spend. Before the current economic downturn, congestion and delays in the U.S. had risen to record levels.  According to the FAA, in 2007 and 2008 about ¼ of all commercial flights in this country arrived at their destination at least 15 minutes after the scheduled time.  In 2007, about 680 million passengers boarded nearly 10 million domestic revenue flights.  That’s 26 percent more flights than in the year 2000, for about 14 percent more passengers.  Both of those figures have declined somewhat from their peak, but demand for travel is likely to increase again when the economy starts to recover, hopefully later this year. 

The system is clearly under stress, and implementing the next generation air traffic control system will require a significant investment of resources by both the government and the private sector over many years.  CBO has not done any analysis regarding the potential costs of that system, but it seems likely that at least several hundred million dollars a year will be needed for that purpose.

Who should bear those costs?  Most of the benefits of federal aviation programs accrue to users of the aviation system—though the general public also benefits from the use of the system by the military and other government agencies, and from the flow of commerce that the system facilitates.  Historically, a combination of general taxpayers and users of the system have paid for its costs—the users through a set of aviation taxes that flow through the Airport and Airway Trust Fund.  Economists generally believe that a good way to foster efficient use of any system is to charge users for the cost they impose on that system.  In recent years, receipts to the trust fund have covered more than 3/4 of the cost of the government’s aviation programs. 

How should costs be allocated?  It is important to determine not only how much users should pay, but also how to apportion those costs among the various users.  Almost 70% of the trust fund revenues come from the passenger taxes.  Another 20% comes from the international arrival and departure tax.  Fuel and cargo taxes account for the rest.  It’s not clear, however, that this system of taxes encourages efficient use of the system. 

Most of the taxes are linked closely to the number of passengers and the fares they pay—not to the number of aircraft operations.  But the cost of the air traffic control system and the amount of congestion in the system is driven largely by the number, timing, and location of aircraft operations.  For example, over the past several years, the number of aircraft departures has grown much more rapidly than the number of passengers—because air carriers have tended to substitute higher frequency service with smaller aircraft for less frequent service with larger aircraft. 

Finding a way to allocate costs that accurately reflects the impact that various kinds of users have on the aviation system is a real analytical and political challenge, but a better alignment of taxes with costs could help reduce congestion and delays.

Today CBO released an update to its estimates of effective federal tax rates, which now incorporate data for the 2006 calendar year.  Those data, the most current available, reflect tax returns filed in 2007 and became available for analysis in 2008.  The effective tax rates in 2006 differed only slightly from those in 2005.  CBO’s analysis indicates that:

• The overall effective federal tax rate (the ratio of federal taxes to household income) was 20.7 percent in 2006. Individual income taxes, the largest component, were 9.1 percent of household income. Payroll taxes were the next largest source, with an effective tax rate of 7.5 percent. Corporate income taxes and excise taxes were smaller, with effective tax rates of 3.4 percent and 0.7 percent.
• The overall federal tax system is progressive—that is, effective tax rates generally rise with income. Households in the bottom fifth of the income distribution paid 4.3 percent of their income in federal taxes, while the middle quintile paid 14.2 percent, and the highest quintile paid 25.8 percent. Average rates continued to rise within the top quintile, with the top 1 percent facing an effective rate of 31.2 percent.
• Higher-income groups pay a disproportionate share of federal taxes because they earn a disproportionate share of pretax income and because effective tax rates rise with income. In 2006, the highest quintile earned 55.7 percent of pretax income and paid 69.3 percent of federal taxes, while the top 1 percent of households earned 18.8 percent of income and paid 28.3 percent of taxes. In all other quintiles, the share of federal taxes was less than the income share. The bottom quintile earned 3.9 percent of income and paid 0.8 percent of taxes, while the middle quintile earned 13.2 percent of income and paid 9.1 percent of taxes.
• Effective tax rates in 2006 changed only slightly compared with their levels in 2005. There were no significant changes in the tax law between those years, and changes in the income distribution were not enough to cause large movements in effective rates. The overall effective rate was 0.1 percentage point higher in 2006 than in 2005. And the effective tax rate for each of the four taxes was within 0.1 percentage point of its 2005 level. Similarly, no income quintile saw its total effective tax rate change by more than 0.1 percentage point, though in some cases the rate for specific taxes differed by 0.2 points. On average, the top 1 percent of households saw their effective tax rate decline by 0.4 percentage point (from 31.6 percent to 31.2 percent), primarily because of a drop in the average rate for their individual income taxes.

Special thanks to Ed Harris of our Tax Analysis Division for preparing these estimates.

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.