Congressional Budget Office
Director’s Blog

Yesterday I gave a lecture in the introductory economics course at Harvard University.  I was the head sectionleader of this course—known as “Ec 10”—when I was an assistant professor at Harvard about 20 years ago.  The full professor in charge of the course at that time was Martin Feldstein, who had been the chairman of the Council of Economic Advisers under President Reagan (and was one of my dissertation advisers).  The professor in charge of the course today is Greg Mankiw, who was chairman of the CEA under President George W. Bush (and also was one of my dissertation advisers).  I was honored by Greg’s invitation to talk to the class today and appreciated the attentiveness and questions of the students.

My topic was the outlook for the federal government’s budget over the next 10 years and the next 75 years.  You can read the slides.

In discussing the next 10 years, I began with the observation that CBO’s baseline projection of the budget deficit for 2010 through 2019 (that is, the deficit we project under current laws and policies) was more than $4 trillion.  Then I explained that, compared with current law, President Obama’s budget would both cut taxes and raise outlays considerably over the next 10 years.  In rounded figures, we estimate the President’s budget proposals would produce:

• Revenue reduction: $2.1 trillion.
  – Extend elements of 2001-2003 tax cuts (which are scheduled to expire in 2010 under current law and are treated as such in the baseline):  $1.9 trillion.
  – Index the Alternative Minimum Tax (which is not indexed to inflation under current law and is treated as such in the baseline): $450 billion.
  – Other proposals: $250 billion increase.
• Programmatic outlay increase: $1.7 trillion.
  – Refundable tax credits: $500 billion.
  – Adjust Medicare physician payments (which are scheduled under current law to be reduced by 21 percent in 2010 and more in subsequent years, and are treated as such in the baseline): $300 billion.
  – Defense discretionary (which is assumed in the baseline to keep pace with inflation) $150 billion.
  – Other (about half nondefense discretionary, which is assumed in the baseline to keep pace with inflation): $800 billion.
• Resulting increase in net interest on the debt: $1.0 trillion.

The resulting budget deficit for 2010 through 2019 would be more than $9 trillion according to our projections.

I also told the students that, while these proposals would require legislation, many would would continue policies already in place (for example, holding steady tax rates set in the 2001-2003 legislation) or maintain historical relationships (for example, preventing nondefense discretionary spending from falling to nearly the smallest share of GDP in my lifetime, as would occur under the baseline projection). 

The aspect of the budget that is anomalous by the standards of the past several decades—under both the baseline and the President’s budget—is outlays for Social Security, Medicare, and Medicaid.  Specifically, under CBO’s estimate of the President’s budget for 2019:

• Revenues would be close to their pre-recession share of GDP and historical average share of GDP.
• Spending on all programs except Social Security, Medicare, and Medicaid would be below their pre-recession share of GDP and historical average share of GDP.
• While at the same time, spending on Social Security, Medicare, and Medicaid would be a record share of GDP.  The result is large and growing budget deficits.

Looking beyond the next 10 years, federal outlays under current law for Medicare and Medicaid, in particular, will substantially outpace GDP growth.  CBO is now in the process of updating its long-term budget projections and will release these projections when they are completed.  However, the key message of these long-term projections is not in doubt:  U.S. fiscal policy is on an unsustainable course.

CBO has a panel of health advisers consisting of widely recognized experts in health policy. Members of the panel have a variety of backgrounds, areas of knowledge, and experience. We host periodic meetings of the advisers at our office and solicit their views between meetings via e-mail exchanges and conference calls. Through these interactions, we benefit from the advisers’ understanding of cutting-edge research and the latest developments in health care delivery and financing. As a result, the quality of CBO’s analysis of health policy is greatly enhanced. (The agency also has a panel of economic advisers, which I will discuss in an upcoming blog entry.) The health advisers for 2009 and 2010 are:

We appreciate these advisers’ contribution to our work.  We look forward to continuing to benefit from their knowledge and experience as we undertake very complex analyses of proposals for major changes in the nation’s health care system.

The Troubled Asset Relief Program (TARP) gives the Department of the Treasury authority to purchase or insure up to $700 billion of outstanding assets at any one time.  Under the Emergency Economic Stabilization Act of 2008, which provided that authority, the federal budget is supposed to reflect an estimate of the ultimate net cost of the transactions for the TARP as opposed to recording the gross cash disbursements under the program (and later recording cash receipts for any earnings or purchase redemptions). Broadly speaking, the estimated net cost is the purchase cost minus the present value—calculated using an appropriate discount factor that reflects the riskiness of the assets—of any estimated future earnings from holding the assets and the proceeds from their eventual sale.

CBO currently estimates that the net cost of using the TARP’s full $700 billion in purchase authority will total $356 billion—$336 billion to be recorded in 2009 and $20 billion to be recorded in 2010. That estimate amounts to a roughly 50 percent net subsidy—that is, roughly one-half of the gross purchase authority. CBO’s most recent estimate of the TARP’s cost is higher than what we presented in January:  by $152 billion for this year and $15 billion for next year (at that time, our estimated net subsidy was approximately 27 percent of the $700 billion purchase authority).  The revisions stem from three factors:  changes in financial market conditions, new transactions, and a small shift in the anticipated timing of disbursements.

By the beginning of March, when CBO’s most recent estimate was completed, market yields on securities issued by the firms that had received TARP funds were higher than they were a few months earlier.  We use those yields in the present-value calculations to reflect the riskiness of the government’s loans and investments.  Because those yields have risen, the estimated subsidy cost of the Treasury’s purchases of preferred stock, asset guarantees, and loans to automakers has also increased. Also, during that period, the Treasury announced additional deals with Bank of America and American International Group (AIG), as well as participation of up to $50 billion in the Administration’s foreclosure mitigation plan, all of which involve higher expected subsidy rates than the 27 percent average subsidy in our January projections. Finally, CBO now assumes that more transactions would occur after October 1, which pushes the recognition of more of the subsidy cost into fiscal year 2010.

Because the ultimate cost of the TARP depends directly on market value of the financial assets involved, that net cost is very uncertain.  The eventual cost may well be significantly different than CBO’s current estimate, and could be either higher or lower than the roughly 50 percent subsidy embodied in our most recent projections.

Over the past several years, spurred by both rising gasoline prices and long-standing subsidies for producing ethanol, the use of ethanol as a motor fuel in the United States has grown at an annual average rate of nearly 25 percent.  U.S. consumption of ethanol last year exceeded 9 billion gallons–a record high.  CBO released a paper today that discusses the relationship between ethanol, greenhouse-gas emissions, food prices, and federal spending on nutrition programs.

Most ethanol in the United States is produced from domestically grown corn, and the rapid rise in the fuel’s production and usage means that roughly one-quarter of all corn grown in the U.S. (nearly 3 billion bushels) is now used to produce ethanol. The demand for corn for ethanol production has exerted upward pressure on corn prices and on food prices in general. CBO estimates that the increased use of ethanol accounted for about 10 percent to 15 percent of the rise in food prices between April 2007 and April 2008.

In turn, increases in food prices will boost federal spending for mandatory nutrition programs such as the Supplemental Nutrition Assistance Program (SNAP, formerly known as Food Stamps) and the school lunch program by an estimated $600 million to $900 million in fiscal year 2009. The Special Supplemental Assistance Program for Women, Infants, and Children—better known as WIC—is a discretionary program that provides a specific basket of goods to recipients rather than a set cash benefit, so changes in food prices in 2008 had an immediate impact on costs for the program.  Under the assumption that the effects are much the same, increased production of ethanol would have added less than $75 million in fiscal year 2008 to the cost of serving the same number of WIC participants as in 2007.

Last year the use of ethanol reduced gasoline usage in the United States by about 4 percent and greenhouse-gas emissions from the transportation sector by less than 1 percent. The future impact of ethanol on greenhouse-gas emissions is unclear. Research suggests that in the short run, the production, distribution, and consumption of ethanol will create about 20 percent fewer greenhouse gas emissions than the equivalent processes for gasoline. In the long run, if increases in the production of ethanol led to a large amount of forests or grasslands being converted into new cropland, those changes in land use could more than offset any reduction in greenhouse-gas emissions—because forests and grasslands naturally absorb more carbon from the atmosphere than cropland absorbs. In the future, the use of cellulosic ethanol, which is made from wood, grasses, and agricultural plant wastes rather than corn, might reduce greenhouse-gas emissions more substantially, but current technologies for producing cellulosic ethanol are not yet commercially viable.

Today CBO released the latest Monthly Budget Review, reflecting an analysis of budget data through the end of March 2009. CBO estimates that the Treasury Department will report a deficit of about $953 billion for the first six months of fiscal year 2009, $640 billion more than the deficit recorded through March 2008.

Budget accounting issues are clouding the deficit forecasts for this year. The above estimate of this year’s deficit to date includes outlays of about $290 billion for the Troubled Asset Relief Program (TARP). Although the Treasury has been recording most spending for the TARP on a cash basis, CBO believes that the budget should record the program’s activities on a net present-value basis adjusted for market risk. Using that approach, CBO estimates that outlays of $140 billion should be recorded for the TARP through March. That approach would yield an estimated deficit of $803 billion for the first half of the year.

March receipts were estimated to be about 30 percent lower than receipts in March 2008. More than half of the decline reflects a drop in net corporate income tax receipts, which fell by 90 percent from March of last year, in part because firms may be applying current-year losses to obtain refunds of taxes paid in previous years.

Federal outlays were $89 billion (or 39 percent) more than those last March, by CBO’s estimates. About half of the increase in spending comes from $46 billion in cash infusions to Fannie Mae and Freddie Mac (now taken over by the government); another $10 billion was lent to credit unions by an arm of the Treasury, and Medicaid spending rose by $10 billion, of which $8.5 billion was due to provisions in the economic stimulus legislation. Outlays for unemployment benefits increased by $7 billion, defense spending by $5 billion, and Social Security benefits by $4 billion.

In March, CBO issued new estimates for the budget outlook for fiscal year 2009. We project that the deficit for 2009 will be $1.7 trillion under current laws and policies and $1.8 trillion if the President’s proposals for the current fiscal year are enacted. (Click here to link to A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and Economic Outlook).

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.

This morning I testified before the House Ways and Means Committee about the ways to reduce the economic cost of a cap-and-trade program for greenhouse-gas emissions by increasing firms’ flexibility in the timing of their emission reductions. Accumulating evidence about the pace and potential extent of global warming has heightened the interest of policymakers in cost-effective ways to achieve substantial reductions in emissions. Many analysts agree that that putting a price on carbon emissions—rather than dictating specific technologies or changes in behavior—would lead households and firms to reduce emissions where and how it was least costly to do so.

Allowing flexibility about when emissions were reduced would further lower costs, because changes in weather and fuel markets lead the cost of emissions reduction to vary from year-to-year. This flexibility in timing can be achieved without lowering the benefits of emissions reductions because climate change depends not on the amount of greenhouse gases released in a given year but on their buildup in the atmosphere over decades. Analysts have developed a number of options for increasing timing flexibility; this morning I made five key points about these options:

• First, permitting firms to “bank” allowances—to save allowances for use in the future—has helped lower compliance costs in existing cap-and-trade programs. However, existing cap-and-trade programs that use banking have still experienced substantial volatility in allowance prices.
• Second, permitting firms to borrow future allowances as well as to bank them could further lower compliance costs. Existing cap-and-trade programs typically preclude borrowing, in part because of concerns that firms that borrow allowances might be unable to pay them back later.
• Third, permitting firms to purchase allowances from a public “reserve pool”– composed of allowances that were borrowed from future years or that supplemented the initial supply—could partially substitute for borrowing by individual firms.  The effectiveness of the reserve pool in realizing cost savings would depend on the size of the pool and the threshold price at which firms could purchase the reserve allowances.
• Fourth, setting a floor and ceiling for the price of allowances would also lower firms’ compliance costs, but it would not ensure a particular level of emissions in the end.
• Finally, a “managed-price” approach would allow for substantial cost savings by eliminating short-term volatility in the price of allowances while accommodating longer-term shifts in prices that would be necessary to keep emissions within a long-term cap. In a managed-price arrangement, firms could purchase allowances from the government each year at a price specified by regulators; in this respect, the policy would be similar to a tax. However, the policy is like a cap-and-trade program in other key respects: Policymakers could choose to distribute some allowances to firms for free; they could allow firms to comply by purchasing “offsets,” or credits for emission reductions made in sectors not covered by the cap; and cumulative emissions over a period of several decades would be capped. To implement this approach, regulators would establish a path of rising prices for allowances with the goal of complying with the cumulative cap that legislators had set; that path would be adjusted periodically based on new information about emissions and future compliance costs.

In short: timing flexibility can be a useful tool in meeting emissions targets as efficiently as possible. The more flexibility that is granted regarding the timing of emissions reductions, the less short-term volatility in the price of emissions and the lower the cost of meeting any given emissions target.

The CBO’s budget projections released last Friday are based in part on our economic forecast. In this blog entry, I want to discuss how our projection of real (that is, inflation-adjusted) GDP, one of the most important economic factors in the budget projections, compares with two other forecasts—the Blue Chip forecast (an average of about 50 private-sector forecasters), and the Administration’s forecast.

Often, it is useful to focus on growth rates, as we did in our report here. However, the effect of GDP projections on the budget—and especially on tax revenue—can be seen more clearly by comparing levels of projected GDP. As the figure below shows:

• CBO’s projection of real GDP is lower than that of the Administration throughout the next 10 years, and,
• CBO’s projection is stronger than the Blue Chip consensus of private forecasters in 2010 and beyond (although slightly weaker in 2009). A difference remains even though CBO’s projection of growth slows a bit after 2015 (the slope of the line flattens slightly), while the Blue Chip’s projection does not.

Comparison of CBO, Administration, and Blue Chip Medium-Term Projections: Levels of Real GDP, 2005 to 2019 (Billions of 2000 dollars)

Sources: Congressional Budget Office; Office of Management and Budget; Department of Commerce, Bureau of Economic Analysis; and Aspen Publishers, Inc., Blue Chip Economic Indicators (March 10, 2009).

For the differences in 2009, much of the story is behind us: real GDP fell at an annual rate of 6.2 percent in the fourth quarter of 2008 and now seems likely to be falling at a similar rate in the first quarter of this year. CBO’s forecast was completed a month and a half after the Administration’s forecast and a few weeks after the March Blue Chip survey. Economic news during that time—weaker employment, exports, and orders for manufacturers, and downward revisions to GDP growth in the fourth quarter of 2008 and to employment growth in December and January—caused many economists to sharply reduce their estimates for the level of economic activity in the first part of this year.

But, like the Blue Chip consensus, CBO projects the beginning of an upturn late this year (as shown in the figure below), reflecting in part the effects of the recent economic stimulus legislation (the American Recovery and Reinvestment Act) and very aggressive actions by the Fed and the Treasury.

The Gap Between Actual and Potential Output (Percentage of potential GDP)

Note: The gap is the difference between real (inflation-adjusted) gross domestic product and its estimated potential level (which corresponds to a high level of resource—labor and capital—use).

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

For the next few years, CBO projects faster growth than the Blue Chip, as the economy grows back toward CBO’s estimate of potential GDP (which corresponds to a high level of use of labor and capital resources). Still, the CBO forecast assumes that the gap between actual and potential output closes more slowly than in previous recoveries because of a persistent drag from financial markets, households’ loss of wealth, the overhang of vacant houses, and weak economic growth overseas. Therefore, CBO projects that the economy does not return to its potential level until 2014.

In the 2015-2019 period, the projected rate of real GDP growth averages 2.4 percent.  That rate is lower than during the period from 2010 to 2014, largely because there is no longer any gap to close between actual and potential GDP.

Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation.  Over the postwar period, the labor force grew at an average annual rate of 1.6 percent; by contrast, we project it to grow only 0.4 percent per year in the period from 2015 through 2019.  As a result, potential GDP grew 3.4 percent per year on average in the postwar period, but CBO expects that it will grow by only 2.4 percent annually (allowing for a tad more productivity growth) in the 2015-2019 period.  That demographic trend is reflected also in the Social Security Administration’s projections of the labor force, available here. CBO published its own analysis of demographic trends; while the numbers have changed a little with new information since then, the general story remains the same.

To be sure, all economic forecasts are subject to considerable uncertainty, as we emphasized in our report.  But I hope that this discussion of the logic behind the latest CBO forecast is helpful to readers of that report.

We have just released our latest projections for the budget and economic outlook, updating the projections published in early January 2009. In addition, we have reviewed the President’s budgetary proposals contained in the February publication A New Era of Responsibility: Renewing America’s Promise, and our report summarizes our preliminary analysis of that budget plan.  For a detailed discussion of the economic forecast underlying the report click here.

Our updated budget projections indicate that:

• Largely as a result of the enactment of recent legislation and the continuing turmoil in financial markets, CBO’s baseline projections of the deficit have risen by more than $400 billion in both 2009 and 2010 and by smaller amounts thereafter. Those projections assume that current laws and policies remain in place. Under that assumption, CBO now estimates that the deficit will total almost $1.7 trillion (12 percent of GDP) this year and $1.1 trillion (8 percent of GDP) next year—the largest deficits as a share of GDP since 1945. Deficits would shrink to about 2 percent of GDP by 2012 and remain in that vicinity through 2019.
• Under current laws and policies, outlays are projected to decline from 27.4 percent of GDP in 2009 to about 22 percent in 2012 and subsequent years, as spending related to the current recession phases out, problems in the financial markets fade, and discretionary spending–under the assumptions of the baseline–declines as a share of GDP.
• At the same time, under current laws and policies, revenues are estimated to rise from 15.5 percent of GDP in 2009 to about 20 percent in 2012 and subsequent years. Much of that projected increase in revenues results from the growing impact of the alternative minimum tax (AMT) and, even more significant, the scheduled expiration in December 2010 of provisions enacted in the recent economic stimulus legislation and tax legislation in 2001 and 2003.

Our analysis of the President’s budget proposals indicates that:

• As estimated by CBO and the Joint Committee on Taxation, the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010–2019 period. CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.
• The cumulative deficit from 2010 to 2019 under the President’s proposals would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41 percent of GDP in 2008 to 57 percent in 2009 and then to 82 percent of GDP by 2019 (compared with 56 percent of GDP in that year under baseline assumptions).
• Proposed changes in tax policy would reduce revenues by an estimated $2.1 trillion over the next 10 years. Proposed changes in spending programs would add $1.7 trillion (excluding debt service) to outlays over the next 10 years. Interest costs associated with greater borrowing would add another $1.0 trillion to deficits over the 2010–2019 period.
• Our estimates of deficits under the President’s budget exceed those anticipated by the Administration by $2.3 trillion over the 2010-2019 period. The differences arise largely because of differing projections of baseline revenues and outlays. CBO’s projection of baseline deficits exceeds the Administration’s estimate (prepared on a comparable basis) by $1.6 trillion.

Our current assessment of economic developments indicates that:

• Although the economy is likely to continue to deteriorate for some time, the enactment of the American Recovery and Reinvestment Act and very aggressive actions by the Federal Reserve and the Treasury are projected to help end the recession in the fall of 2009. In CBO’s forecast, on a fourth-quarter-to-fourth-quarter basis, real (inflation-adjusted) GDP falls by 1.5 percent in 2009 before growing by 4.1 percent in both 2010 and 2011.
• For the next two years, CBO anticipates that economic output will average about 7 percent below its potential—the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer—making the current recession the most severe since World War II. In this forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years.

CBO released a cost estimate yesterday for H.R. 1256, the Family Smoking and Tobacco Control Act. This bill would authorize the Food and Drug Administration (FDA) to regulate tobacco products and require the agency to assess fees on manufacturers and importers of tobacco products to cover the cost of these new regulatory activities.

The effect of these activities on the use of tobacco products is uncertain, in part because ongoing initiatives to reduce the use of tobacco products are expected to continue under current law. In particular, public health efforts by federal, state, and local governments and by private entities have contributed to a substantial reduction in underage smoking in recent years. For example, the recent increase in the federal excise tax on cigarettes, from $0.39 to $1.01 per pack, as a result of the Children’s Health Insurance Program Reauthorization Act is likely to contribute to a continuing decline in smoking. 

H.R. 1256 would affect the use of tobacco products through a combination of regulatory and economic factors. The regulatory changes with the largest potential to reduce smoking include: restricting access to tobacco by youths, requiring an increase in the size of warning labels on certain tobacco packaging (and authorizing the Secretary of HHS to mandate further changes to enhance warning labels), limiting certain marketing and advertising activities (especially those that target youths), and requiring FDA’s permission before manufacturers can market tobacco products that suggest reduced health risks or exposure to particular substances. In addition, tobacco consumption would decline because the assessment of new fees on manufacturers and importers of tobacco products would probably result in higher prices for tobacco products. CBO expects that consumption of tobacco products in the United States would further decline as a result of enacting H. R. 1256.  By 2019, CBO projects a decline of 11 percent among underage tobacco users and about 2 percent among adult users, as a result of this legislation.

CBO anticipates that FDA’s regulation of tobacco products would lead to a decline in smoking among pregnant women, which would slightly decrease federal spending for Medicaid.  A decline in smoking could affect health care spending for many other medical conditions, and CBO continues to examine the impact of smoking-related legislation on public and private payers. Counterintuitively, a reduction in smoking might add to the government’s costs in many cases by enabling some people to live longer and to incur health care costs over longer periods. In those cases, government spending for Social Security, Medicare, and other retirement and mandatory spending programs, would increase.