The nation's fiscal situation has not changed much since the Congressional Budget Office (CBO) issued its previous baseline budget projections in March. Although the deficit for fiscal year 2004 is anticipated to be $56 billion lower than CBO estimated then, the deficits projected for 2006 and beyond have grown.

In the absence of further legislation, the federal government will record a total budget deficit of $422 billion in 2004. That deficit would represent a record level in dollar terms, but at 3.6 percent of the nation's gross domestic product (GDP), it would be smaller than the deficits of the mid-1980s and early 1990s relative to the size of the economy (during which time deficits frequently exceeded 4 percent of GDP).

Under the laws and policies currently in place, the deficit is projected to decline to $348 billion, or 2.8 percent of GDP, in 2005, and outlays are estimated to continue to exceed revenues through 2014 (see Summary Table 1). Consequently, in CBO's projections, the cumulative deficit for 2005 through 2014 totals $2.3 trillion, or 1.5 percent of total GDP. That outlook is substantially the same as it was in CBO's previous baseline projections, which cited a cumulative deficit of 1.3 percent of GDP.

By statute, CBO's baseline projections must estimate the future paths of federal revenues and spending under current laws and policies. The baseline is therefore not intended to be a prediction of future budgetary outcomes; instead, it is meant to serve as a neutral benchmark that lawmakers can use to measure the effects of proposed changes to taxes and spending.

CBO expects solid growth in overall economic output during the next two years. Demand is now growing fast enough to spur producers to expand their capacity by investing in new capital (equipment and structures) and by hiring more workers. Led by large gains in business investment, GDP will expand by 4.5 percent in calendar year 2004, CBO forecasts, and by 4.1 percent in 2005; from 2006 through 2014, annual growth of GDP will average 2.8 percent, according to CBO's projections. The average growth rate over the entire 2004-2014 period is 0.1 percentage point higher than in CBO's previous economic projections, published in January 2004.

Even if the economy grows more rapidly than projected, significant long-term strains on the budget will start to intensify within the next decade as the baby-boom generation begins to reach retirement age. By CBO's estimates, a growing elderly population and rapidly rising health care costs will cause total federal spending for Social Security, Medicare, and Medicaid to increase from more than 8 percent of GDP in 2004 to between 12 percent and 17 percent in 2030 and to between 13 percent and 28 percent in 2050 (depending on assumptions about federal spending and revenues in the future). Thus, over the long term, growing resource demands for those major entitlement programs will exert pressure on the budget that economic growth alone is unlikely to alleviate.
 

The Budget Outlook

Assuming that current laws and policies remain unchanged, CBO projects that federal deficits will begin to decline after this year. In CBO's baseline, deficits drop as a percentage of GDP, from 3.6 percent in 2004 to 2.8 percent in 2005 and to 1.9 percent in 2010. After 2011--if the tax cuts enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) expired as scheduled, discretionary spending continued to grow no faster than the rate of inflation, and other policies stayed the same--the budget would be relatively close to balance.

Total outlays are projected to remain steady at roughly 20 percent of GDP over the next 10 years. In CBO's baseline, mandatory spending grows approximately 1 percentage point faster than nominal GDP does, but discretionary spending is assumed to increase at the rate of inflation and thus at about half the growth rate of GDP.

Net interest spending is projected to increase--because of continued deficits and rising interest rates--from 1.4 percent of GDP in 2004 to 2.1 percent in 2010. After that, as projected deficits shrink and debt held by the public declines as a share of the economy, net interest spending diminishes slightly as a percentage of GDP, reaching 1.9 percent by the end of the projection period.

The path of federal revenues over the next 10 years is shaped by the scheduled expiration of numerous tax provisions enacted between 2001 and 2003. Revenues are projected to rise sharply as a percentage of GDP over the next two years--from 16.2 percent this year to 17.0 percent in 2005 and 17.7 percent in 2006--largely because several major tax cuts will expire on December 31, 2004. Revenues are estimated to then increase gradually as a share of GDP, reaching 18.2 percent in 2010. If the remaining EGTRRA tax cuts expire in 2011, as scheduled, revenues will rise sharply again, reaching 19.8 percent of GDP in 2014, the highest level since 2001. The expiration of those tax cuts accounts for about 2.1 percentage points of the projected increase of 3.6 percentage points in revenues as a share of GDP over the next decade.

In CBO's baseline, individual income taxes are responsible for almost all of the rise in revenues as a percentage of GDP over the next 10 years. Revenues from corporate income taxes increase relative to GDP in 2005 and 2006 but then fall back during the rest of the projection period. Other sources of revenues--the largest of which is social insurance taxes--remain relatively stable as a share of GDP.

In the six months since CBO's previous baseline was published, the outlook in terms of the deficits in 2004 and 2005 has improved, but the projection of the cumulative deficit over the 2005-2014 period has worsened. In March, CBO estimated that the deficit for 2004 would reach $477 billion, the deficit for 2005 would decline to $363 billion, and the cumulative 10-year deficit would be $2.0 trillion. In its current baseline, CBO has lowered its estimate for this year's deficit by $56 billion and for next year's deficit by $15 billion. However, CBO has increased its projection for the 10-year deficit by $281 billion (see Summary Table 2).

Projected outlays have decreased slightly for 2004 but have grown by a total of $603 billion (including debt-service costs) for the following 10 years. Most of that increase ($492 billion) stems from newly enacted legislation--principally from extrapolating throughout the 10-year period the recent $28 billion in supplemental appropriations for 2004 and the Department of Defense's appropriations for 2005. Changes in CBO's economic outlook have increased the estimate of 10-year outlays by another $188 billion, primarily for spending sensitive to changes in inflation (such as discretionary spending and cost-of-living adjustments for Social Security). Technical estimating changes partially offset the legislative and economic changes, lowering the spending estimate for the 10-year period by $77 billion.

Projected revenues have increased by $54 billion for 2004 and by $322 billion for the 2005-2014 period. The economic revisions have boosted revenues in that period by a total of $361 billion, whereas legislation enacted since March and technical changes together have decreased those revenues by $39 billion.
 

The Economic Outlook

In CBO's estimation, the economy has entered a phase of investment-led growth, in which the number of jobs is rising and real (inflation-adjusted) GDP is expanding faster than its trend rate. Indeed, CBO expects real GDP to grow strongly enough that the current excess capacity in the economy will be eliminated by the end of calendar year 2005 (largely depending, however, on how lasting the recent surge in productivity turns out to be). The current assessment of the economy is similar to the one that CBO published in January--the only significant change to the two-year forecast being the likelihood of somewhat higher inflation.

CBO does not attempt to forecast business cycles more than two years into the future. Instead, its medium-term economic projections (through 2014) reflect a likely average for GDP over future cycles. As a result, CBO's projection of the growth of GDP keeps pace roughly with the agency's estimate of the trend growth of the economy--that is, potential GDP.⁽¹⁾ In CBO's estimates, real GDP growth averages 3.0 percent from 2006 to 2009 and 2.6 percent from 2010 to 2014 (see Summary Table 3). The slower growth projected for the latter half of the period stems primarily from a slowdown in the expansion of the labor force as the baby boomers begin to retire.

Summary Table 3.

The rate of unemployment in CBO's two-year forecast and medium-term projections is related to the agency's estimate of the gap between GDP and potential GDP. As that gap is eliminated over the next two years, CBO expects the unemployment rate to fall to 5.6 percent in 2004 and 5.2 percent in 2005 and then average 5.2 percent from 2006 through 2014.

According to CBO's forecast, inflation (as measured by the consumer price index) will be higher in 2004 (2.6 percent) than in 2003 (2.3 percent) as a result of more-rapid growth early this year in core prices, which exclude those for food and energy. Inflation will ease somewhat in 2005, declining to a rate of 2.0 percent. From 2006 through 2014, consumer prices will increase at an average annual rate of 2.2 percent, CBO projects. Altogether, price increases remain low by post-World War II standards.

Interest rates, especially short-term interest rates, are expected to rise as the economy continues to grow, but they too are likely to remain low by historical standards. The interest rate on three-month Treasury bills is forecast to increase from an average of just 1.0 percent in 2003 to 1.3 percent in 2004 and 2.6 percent in 2005; it is then expected to average 4.5 percent through 2014. Yields on 10-year Treasury notes are anticipated to rise by a smaller cumulative amount, from an average of 4.0 percent last year to 4.6 percent this year, 5.4 percent in 2005, and an average of 5.5 percent from 2006 through 2014.