The nation's fiscal outlook has not changed substantially since March, when the Congressional Budget Office (CBO) issued its previous baseline budget projections.⁽¹⁾ The deficits estimated for fiscal years 2004 and 2005 have shrunk somewhat, but the deficits projected for later years have grown.

In the absence of further legislation, the federal government will record a total budget deficit of $422 billion in 2004, CBO anticipates--about $56 billion less than it estimated six months ago. 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 (see Figure 1-1). Thereafter, if current laws and policies do not change, annual deficits will decline to 2.8 percent of GDP ($348 billion) in 2005 and to 0.4 percent of GDP ($65 billion) by 2014, for a cumulative 10-year deficit of $2.3 trillion, CBO projects (see Table 1-1). That cumulative deficit equals 1.5 percent of projected GDP over the 10-year period--up slightly from the 1.3 percent figure in CBO's March baseline.

Figure 1-1.

Source: Congressional Budget Office.

Federal debt held by the public will equal 37.5 percent of GDP at the end of this fiscal year, CBO estimates. In its baseline, such debt increases slowly in relation to the size of the economy, peaking at more than 40 percent of GDP in 2010. After that year--when recent tax cuts are scheduled to expire--lower projected deficits slow the growth in the government's need to borrow, and debt held by the public shrinks as a share of GDP.

CBO's baseline projections are constructed according to rules set forth in law (mainly in the Balanced Budget and Emergency Deficit Control Act of 1985 and the Congressional Budget and Impoundment Control Act of 1974). Because they assume that current laws and policies do not change, they are not intended to be a prediction of future budgetary outcomes; instead, CBO's baseline is meant to serve as a neutral benchmark that lawmakers can use to measure the effects of proposed changes to taxes and spending. Actual budget totals will almost certainly differ from the baseline projections.

For revenues and mandatory spending, the assumption that present laws continue without change means that CBO's baseline assumes that the tax cuts enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) will expire as scheduled.

For discretionary spending, which is governed by annual appropriation acts, the Deficit Control Act specifies that if appropriations for the coming budget year have not yet been enacted, discretionary spending should be projected by adjusting the current year's budget authority to reflect inflation and other factors. Normally, appropriations for the budget year have not been enacted when CBO prepares its summer baseline, so projections for discretionary programs are based on current-year appropriations. In this case, however, the Department of Defense Appropriations Act, 2005 was enacted on August 5. Consequently, the levels of budget authority for 2005 included in that law have been incorporated into CBO's current baseline and projected through 2014.

The newly enacted defense appropriations do not include any budget authority specifically for 2005 for military and reconstruction activities in Iraq and Afghanistan. Funding for such activities in 2004 was provided through supplemental appropriations, which totaled $115 billion.⁽²⁾ The baseline reflects that funding for the current year and extrapolates it through the projection period.

Although CBO's baseline projections cannot incorporate possible policy changes, this report shows the budgetary implications over the next 10 years of some alternative policy assumptions. For example, the assumption that current funding for activities in Iraq and Afghanistan does not continue after 2004 shrinks the projected 10-year deficit from $2.3 trillion to $0.9 trillion. Debt held by the public at the end of 2014 drops from 36.6 percent of GDP to 28.9 percent.

Similarly, as noted above, the baseline must follow the assumption that all of the tax provisions set to expire over the next 10 years actually do so. However, if all of those provisions (except the higher personal exemptions for the alternative minimum tax) were extended, the projected deficit for 2014 would grow from 0.4 percent of GDP to 2.9 percent of GDP. The 10-year deficit would total 3.0 percent of GDP ($4.5 trillion) instead of 1.5 percent ($2.3 trillion), and debt held by the public at the end of 2014 would climb to 48.8 percent of GDP from 36.6 percent.⁽³⁾

Since March, revisions to CBO's baseline have reduced the deficit projected for this year by $56 billion. Virtually all of that improvement is attributable to higher-than-expected revenues collected so far this year. In contrast, for the 2005-2014 period, revisions to the baseline have added $281 billion to the cumulative deficit. Legislation enacted since March (primarily the 2005 defense appropriation act, which included additional supplemental funding for 2004) accounts for the biggest change to the 10-year deficit, increasing it by $497 billion. Revisions stemming from changes in CBO's economic forecast partially offset that increase. CBO has raised its forecast for real (inflation-adjusted) economic growth slightly; the effect of that change on projected revenues, coupled with the impact of other economic revisions, reduces the projected 10-year deficit by $173 billion. Finally, technical revisions to the baseline shrink that deficit by another $43 billion.

Over the longer term, the federal budget will face significant strains, which will begin during the current 10-year projection period and intensify as more of the baby-boom generation reaches retirement age. In the next 30 years, the number of people age 65 or older will double, while the number of adults under age 65 will rise by less than 15 percent. In addition to those demographic changes, costs per enrollee in federal health care programs are likely to continue growing faster than inflation.

CBO projects that those pressures will cause federal spending for Social Security, Medicare, and Medicaid combined to increase from more than 8 percent of GDP this year to between 12 percent and 17 percent in 2030 and between 13 percent and 28 percent in 2050 (depending on assumptions about federal spending and revenues in the future). 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; left unchecked, such demands could pose an obstacle to higher standards of living.
 

A Look at 2004

The total federal budget deficit will grow from $375 billion (3.5 percent of GDP) in 2003 to $422 billion (3.6 percent of GDP) in 2004, CBO anticipates (see Table 1-2). Although revenues are projected to rise by 5.0 percent this year, spending is expected to grow faster, by 6.3 percent.

Outlays

CBO expects total outlays to increase by $136 billion in 2004, with that growth divided almost evenly between discretionary and mandatory programs. Outlays for discretionary programs (the part of the budget whose spending levels are set anew each year in appropriation acts) are projected to rise by $63 billion, or 7.6 percent. Outlays for entitlements and other mandatory programs (whose spending is usually governed by eligibility rules and benefit levels set forth in existing laws) are projected to increase by $67 billion, or 5.7 percent. Net interest (the government's interest payments on debt held by the public, offset by interest income and earnings that it receives) is expected to rise by $5 billion, or 3.6 percent, this year.

Discretionary Spending. Defense programs remain the fastest growing component of discretionary spending. Their overall budget authority increased by 7 percent ($31 billion) in 2004, after rising by 26 percent ($94 billion) last year and 9 percent ($29 billion) in 2002. Some of those increases stem from supplemental appropriations for defense--mainly to fund operations in Iraq and Afghanistan--which grew from $62 billion in 2003 to a total of $92 billion in 2004. Budget authority for defense activities not directly associated with Iraq and Afghanistan has also grown. In 2001, defense appropriations totaled $318 billion excluding funds made available in response to the September 11 terrorist attacks; by 2004, defense funding totaled $394 billion excluding supplemental appropriations. As a result of the recent increases in budget authority, outlays for national defense will total $452 billion in 2004, CBO estimates, almost 12 percent more than last year. (The most recently enacted supplemental appropriations, which contain $27 billion in budget authority for defense, are not expected to have a significant impact on outlays in 2004.)

Although most major components of defense spending continue to increase at double-digit rates, an exception is spending for military personnel. CBO expects that such spending will grow by 6.1 percent this year, far smaller than the adjusted growth rate of 13.6 percent seen last year with the onset of the war in Iraq.⁽⁴⁾ With spending on pay and benefits for military personnel excluded, defense outlays would rise by about 14 percent (rather than 12 percent) this year, CBO estimates--roughly the same rate as in 2002 and 2003.

Funding provided for nondefense discretionary programs--which includes budget authority for discretionary activities other than defense as well as obligation limitations for certain transportation programs--rose by 6 percent in 2004, up from a growth rate of 4.9 percent the previous year. However, both of those rates are significantly lower than the double-digit growth rates experienced in 2001 and 2002.

Outlays for nondefense discretionary programs will increase by 3.6 percent ($15 billion) in 2004--far slower than the 9.3 percent growth rate in 2003--and will total $436 billion, CBO estimates. That projected slowdown in growth is attributable to several factors. In general, it reflects the diminishing effect of the large funding increases that occurred in 2001 and 2002. In addition, outlays for border and transportation security activities of the Department of Homeland Security are likely to be about $5 billion lower in 2004 than they were last year, when they included one-time payments for security-screening equipment at airports and $2.3 billion for assistance to airlines. Outlays for disaster relief--which were much higher than usual in the aftermath of the attacks of September 11, 2001--are expected to drop by about $2 billion from last year's level.⁽⁵⁾ Moreover, outlays for education are expected to grow by about 8 percent this year, compared with 18 percent in 2003, because appropriations in the past two years have not increased as rapidly as in previous years. (Budget authority for discretionary education programs rose at an average rate of nearly 20 percent a year during the 1999-2002 period; in 2003 and 2004, it grew by about 7 percent and 5 percent, respectively.)

Outlays for reconstruction activities in Iraq are expected to total $2.7 billion in 2004. Although that amount is a significant increase from last year's level, it represents less than 15 percent of the funding made available in 2004 for that purpose. Continuing security challenges in Iraq have impeded the obligation and expenditure of money on reconstruction projects.

Mandatory Spending. Mandatory outlays (net of offsetting receipts) are projected to rise by 5.7 percent this year, less than the 6.6 percent growth recorded in 2003. However, the three largest mandatory programs will grow faster in 2004 than they did last year, CBO estimates--Social Security by 4.5 percent (versus 4.1 percent in 2003), Medicare by 8.1 percent (compared with 7.9 percent in 2003), and Medicaid by 9.4 percent (versus 8.9 percent last year). In the case of Medicaid, that rise stems from a temporary increase in the federal government's share of the program's costs. The higher share ended on June 30.

Among other mandatory programs, spending for the September 11th Victim Compensation Fund is expected to rise from less than $1 billion in 2003 to more than $6 billion in 2004. In addition, in 2004 the Federal Housing Administration's Mutual Mortgage Insurance program recorded a large reestimate of the costs of its mortgage guarantees made in previous years, which raised its outlays from $1.5 billion in 2003 to $7 billion this year.

Despite those increases, total mandatory spending is expected to grow more slowly in 2004 than in 2003 mainly because of a significant decrease in spending related to unemployment insurance. Last year, a temporary emergency unemployment compensation program gave long-term unemployed people 13 additional weeks of benefits. Those extended benefits were phased out at the beginning of 2004, which, combined with a decline in the unemployment rate, has decreased projected outlays for unemployment compensation this year by $11.5 billion, or 21 percent. In addition, spending for farm price- and income-support programs will drop by 38 percent (to $9.5 billion) in 2004, CBO estimates, because higher prices for agricultural commodities have lessened the need for government assistance.

Net Interest. CBO expects net interest costs to rise by about $5 billion this year. That growth reflects an increase in the outstanding amount of federal debt held by the public, higher compensation for inflation on Treasury inflation-protected securities (TIPS), and other factors.

Revenues

After three years of decline, revenues are projected to increase by $89 billion, or about 5 percent, in 2004. However, because that increase is slower than the growth of nominal GDP, revenues will continue to fall as a share of GDP: from 16.4 percent in 2003 to 16.2 percent this year.

Revenues from individual income taxes and social insurance (or payroll) taxes, which are tied to personal income, are expected to rise much more slowly this year than revenues from corporate income taxes, which depend on corporate profitability. CBO's projected growth rates are 2.2 percent ($17 billion) for individual income tax receipts and 2.7 percent ($19 billion) for social insurance receipts, compared with 38 percent ($50 billion) for corporate income tax receipts. Other tax sources, which account for less than 10 percent of revenues, are projected to increase by 2 percent ($3 billion).

Individual Income and Social Insurance Tax Receipts. A large share of this year's growth in individual income and payroll taxes has occurred in withholding from employees' paychecks. CBO expects combined withholding for those taxes to rise by 2.3 percent (about $32 billion) in 2004.⁽⁶⁾ Withholding typically follows the same pattern as total wage and salary income in the economy, which CBO projects will rise by 4.8 percent this year. However, receipts from withholding are growing more slowly than wage and salary income because of the cuts in individual income taxes enacted in EGTRRA and accelerated by JGTRRA. Those cuts included reductions in tax rates and the expansion of certain tax brackets. If the effects of those tax cuts were excluded, withholding would increase more than twice as fast this year--by about 5 percent--CBO estimates.

In addition to withholding, unemployment insurance receipts (a component of social insurance tax receipts) are projected to grow by just over 20 percent, or about $7 billion, in 2004. States have raised their unemployment insurance taxes to replenish the trust funds they use to pay unemployment insurance benefits, which were depleted during the most recent recession. (State employment taxes are remitted to the federal government and recorded as receipts in the federal budget.)

Nonwithheld payments of individual income and social insurance taxes (net of refunds) have been relatively stable in 2004, and CBO expects them to decline by only about $2 billion. Gross payments of income and payroll taxes--consisting both of quarterly estimated payments for taxes in the current year and final payments for the prior year's taxes (usually made in April)--are projected to fall by $6 billion, or about 2 percent. Refunds of individual income taxes are expected to decline by about $4 billion, also about 2 percent. (The change in refunds this year would have been an increase of about $10 billion, or 5 percent, had refunds in 2003 not been expanded by payments of legislated advance rebates last summer.)

CBO and other analysts had expected individual income tax refunds to grow sharply this year because of the tax provisions enacted in JGTRRA. They anticipated that taxpayers filing returns for 2003 would receive large one-time refunds because that law's cuts in tax rates and other changes were made effective on January 1, 2003, whereas the changes in withholding rates did not take effect until after late May (when the law was enacted). CBO still estimates that JGTRRA's tax changes substantially increased refunds in 2004, but it appears that other factors--which will remain unclear until individual income tax returns for 2003 are fully processed next year--held down refunds.

Corporate Income Tax Receipts. Corporations' before-tax profits--so-called book profits--are expected to increase by about 20 percent this year, exceeding last year's strong growth rate of 17 percent. The rise in the growth of profits has boosted corporate tax receipts in 2004. Another contributor to this year's increase in net corporate tax receipts is reduced refunds of corporate taxes paid in previous years. Companies can obtain such "carryback refunds" if they incur a loss in the current year and paid taxes in either of the two prior years. Many firms that were unprofitable last year and received refunds may now be profitable and paying taxes.
 

Baseline Budget Projections for 2005 Through 2014

CBO projects that if current laws and policies remain the same, the annual budget deficit will drop to 2.8 percent of GDP in 2005 and gradually decrease thereafter, reaching 1.9 percent in 2010 (see Table 1-2). After that, primarily because of increased revenues from the scheduled expiration of the tax cuts enacted in EGTRRA, the baseline deficit drops considerably, reaching a low of 0.4 percent of GDP in 2012 and continuing at that level through 2014.

Outlays

Under current laws and policies, 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.

Discretionary Spending. According to the Deficit Control Act, CBO's baseline must assume that discretionary spending will continue at the level of the most recent appropriations, with annual increases based on two projected rates of inflation: the GDP deflator and the employment cost index for wages and salaries. For most discretionary accounts, the most recent appropriations were made for 2004. However, appropriations for Department of Defense activities and for certain programs funded in the defense appropriation act have already been enacted for 2005; CBO has incorporated those appropriations in this baseline.

Besides the 13 regular appropriation acts that provide funding, two appropriation acts contained supplemental budget authority for 2004, primarily for operations in Iraq and other activities associated with the global war on terrorism. Both the $87 billion in budget authority provided in November 2003 and the $28 billion provided in August 2004 have been included in the total for 2004 that is extrapolated through 2014, in accordance with baseline rules.

With all of those components of current discretionary appropriations taken into account, outlays are projected to increase from $888 billion this year to nearly $1.2 trillion in 2014 (see Table 1-3). Over the 2005-2014 period, discretionary outlays grow at an average annual rate of 3.1 percent in CBO's baseline. (The budgetary effects of alternative assumptions about the growth of discretionary spending are discussed later in this chapter.)

Because of the nation's continuing concern about homeland security, the Administration has identified the spending that it considers related to such activities, and CBO follows the Administration's classification. Net discretionary budget authority for homeland security is estimated to total about $36 billion this year--$9 billion for defense and $27 billion for nondefense programs. The discretionary outlays resulting from that budget authority will total $31 billion this year, CBO estimates. (In addition, roughly $1 billion a year in net outlays for homeland security are classified as mandatory spending.) Over the next 10 years, discretionary outlays for homeland security will average slightly less than 0.3 percent of GDP, under CBO's baseline assumptions. Those outlays reflect $5.6 billion in appropriations already provided for Project BioShield, an initiative to develop drugs and vaccines to counter attacks by biological and chemical weapons--$885 million for 2004, $2.5 billion for 2005, and $2.2 billion for 2009.

Mandatory Spending. Outlays for mandatory programs are generally determined by eligibility rules and benefit levels set in law rather than through the annual appropriation process. CBO estimates that under current law, those outlays (excluding offsetting receipts) will grow at an average rate of 5.8 percent a year through 2014. That growth is fueled by spending for Social Security, Medicare, and Medicaid, which together account for more than three-quarters of mandatory outlays (see Table 1-4).

Ten-year averages, however, do not fully reveal the long-term trends propelling the growth of outlays for those programs. As baby boomers begin to qualify for Social Security and Medicare in the second half of this decade, the underlying growth of spending for those programs will accelerate. For example, outlays for Social Security are projected to increase by about 4.2 percent in 2006; however, by 2014, that growth rate will rise to 6.4 percent. In the case of Medicare, the introduction of a prescription drug benefit in 2006 is projected to help boost that program's federal outlays by a total of 30.6 percent between 2005 and 2007.⁽⁷⁾ Over the following seven years, the growth of Medicare spending will continue at a robust rate of 7.6 percent a year, CBO projects, driven by increases in participation and in utilization of medical services.

The annual growth rate of Medicaid spending, which was roughly 9 percent in 2003 and 2004, is projected to dip to just under 4 percent in 2005 and 2006 because of recent legislation. In 2006, Medicaid will begin to realize substantial savings as Medicare assumes the cost of prescription drugs for people who are eligible for both programs. However, Medicaid's growth rate is projected to head back up toward the previous level beginning in 2007 and to average 8.8 percent annually during the last seven years of the projection period.

Overall, CBO projects that under current law, mandatory spending (excluding offsetting receipts) will equal 11.5 percent of GDP in 2005 and increase thereafter, reaching 13.0 percent in 2014. Spending for Social Security, Medicare, and Medicaid combined is projected to grow from 8.3 percent of GDP in 2005 to 10.3 percent in 2014, at which point those three programs would account for more than half of all federal spending (under current law). Other mandatory programs are projected to decline as a share of GDP.

Net Interest. Interest costs--mainly on accumulated federal debt--will account for almost 10 percent of total outlays over the 2005-2014 period, CBO estimates. Those costs reached a nadir in 2003, but they are projected to grow steadily during the projection period: from $178 billion in 2005 to $348 billion in 2014 (see Table 1-5). That rise reflects projected increases both in interest rates and in federal borrowing. Under CBO's baseline assumptions, net interest will peak relative to GDP at 2.1 percent in 2010 and then decline through 2014. (The baseline assumes that the statutory limit on federal borrowing is raised as necessary to cover projected deficits. For more information about that limit, see Box 1-1.)

Revenues

Under current law, the path of federal revenues over the next 10 years is shaped by the scheduled expiration of numerous tax provisions. 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 tax cuts will expire on December 31, 2004. Over the following four years, revenues will increase gradually as a share of GDP, reaching 18.2 percent in 2010, CBO projects. After the EGTRRA tax cuts expire at the end of calendar year 2010, revenues will rise sharply again, reaching 19.8 percent of GDP in 2014, the highest level since 2001. Out of the projected increase of 3.6 percentage points in revenues as a share of GDP between 2004 and 2014, about 2.1 percentage points result from the expiration of the tax cuts enacted during the 2001-2003 period.

Individual income taxes are responsible for almost all of the projected rise in revenues as a percentage of GDP over the next 10 years. Receipts 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 revenue, the largest of which is social insurance taxes, remain relatively stable as a share of GDP.

Individual Income Tax Receipts. Relative to the size of the economy, revenues from individual income taxes are expected to be at their lowest level this year since 1951--7.0 percent of GDP. In CBO's baseline, receipts increase in just 10 years from that low to a new high of 10.6 percent of GDP in 2014 (exceeding the previous peak in 2000). That rapid rise results mainly from the expiration of recently enacted tax cuts and several inherent characteristics of the tax structure that increase effective tax rates over time.⁽⁸⁾

Four cuts in individual income taxes are scheduled to expire at the end of calendar year 2004: the expanded 10 percent tax bracket, the higher child tax credit, the expanded 15 percent bracket and standard deduction (intended to provide relief from the so-called marriage penalty), and the increased exemption for the alternative minimum tax (AMT). Those expirations, combined with the cessation of the one-time refunds occurring in 2004 as a result of the tax cuts, explain most of the projected increase in individual income tax receipts as a share of GDP in the next two years.

Over the longer term, however, all of those provisions except the AMT exemption are currently scheduled to phase back in fully by 2010, reducing receipts. In addition, provisions first enacted in 1990 that increase taxes on high-income taxpayers by restricting their itemized deductions and personal exemptions are scheduled to phase out over the 2006-2010 period. At the same time, reduced tax rates on capital gains and dividends that were enacted last year expire at the end of 2008, and all remaining tax cuts (including those phased back in) expire at the end of 2010, boosting receipts in the later years of the projection period.

Furthermore, the effective tax rate on personal income is projected to increase steadily over the next decade because of three factors unrelated to recent changes in tax law.⁽⁹⁾ The first factor is the phenomenon known as "real bracket creep": the dollar amounts that define tax brackets, standard deductions, and personal exemptions are indexed to increase with inflation each year, but when income grows faster than inflation, more income is pushed into higher tax brackets (raising receipts by a total of about 0.7 percent of GDP over the 2005-2014 period).

Second, the parameters of the AMT--a parallel income tax system that has fewer exemptions, deductions, and rates than the regular income tax--are not indexed for inflation. Consequently, over time, a rapidly growing number of taxpayers must pay the AMT and thus pay a higher share of their income in taxes (which increases receipts by more than 0.2 percent of GDP over 10 years).

Third, taxable distributions from tax-deferred retirement accounts--such as 401(k) plans and individual retirement accounts--will increase quickly as a rising number of workers retire from the labor force with, on average, larger balances in their retirement accounts than their predecessors had (raising receipts by about 0.3 percent of GDP).

Corporate Income Tax Receipts. Revenues from corporate income taxes are projected to grow from 1.6 percent of GDP this year to 1.9 percent by 2006 and then gradually decline to 1.5 percent by 2014. Both the expiration of corporate tax cuts and the projection of corporate profits relative to GDP contribute to that pattern.

Tax law enacted in 2002 gave businesses an additional first-year depreciation deduction of 30 percent for investments in equipment that year; legislation enacted in 2003 increased the deduction to 50 percent. Because those partial-expensing provisions permit greater up-front deductions for depreciation but do not increase the total amount that can be deducted over the life of the equipment, they only delay tax liability. The provisions benefit both corporate and noncorporate businesses and expire for investments made after 2004. Corporate tax revenues are expected to increase sharply in 2005 and 2006 (and to a lesser degree in the following few years) both because firms will no longer get the additional deductions for new investment and because they will get fewer deductions in those years from previous investments that qualified for the investment incentive.

The relationship between GDP and underlying corporate profits--measured without the effects of the partial-expensing provisions--also influences the projected relationship between corporate tax revenues and GDP. Underlying profits, often referred to as economic profits, have risen much more rapidly than GDP in recent quarters and are expected to remain high through 2005. Thereafter, they are projected to decline as a percentage of GDP because of a larger share of GDP going to labor compensation (as wage growth begins to reflect past productivity gains and higher depreciation associated with strong investment growth). The projected decrease in profits contributes to the outlook for declining corporate receipts as a percentage of GDP beyond 2006.

Social Insurance and Other Tax Receipts. Social insurance receipts and other tax receipts are expected to grow at about the same rate as GDP over the next 10 years. Social insurance receipts are largely tied to economywide wages and salaries, which are expected to grow only slightly faster than GDP. Those receipts are projected to increase from 6.3 percent of GDP this year to 6.4 percent in 2005 and 6.5 percent in 2006 and then remain between 6.4 percent and 6.5 percent of GDP through 2014.

As a whole, other revenue sources are projected to stay relatively stable at 1.2 percent to 1.3 percent of GDP over the next decade. Among those sources, excise taxes are expected to decrease from 0.6 percent to 0.5 percent of GDP. Most of those taxes are assessed on the quantity of production or consumption rather than on its price; they therefore grow more slowly than GDP, which includes price increases. Estate and gift taxes are projected to decline from 0.2 percent of GDP now to about 0.1 percent in 2010 and 2011 as the estate tax is phased out under the provisions of EGTRRA. After that, however, estate and gift tax receipts are projected to rebound to 0.3 percent of GDP with the expiration of the tax cuts--and hence the return of the estate tax--after 2010. Earnings of the Federal Reserve System, which are largely generated from its portfolio of Treasury securities, are expected to rise from 0.2 percent of GDP to 0.3 percent over the projection period, mainly because of projected increases in the interest rates on short-term Treasury securities.
 

Uncertainty and Baseline Projections

Actual budgetary outcomes are highly sensitive to the performance of the economy and to the myriad variables through which tax and spending policies affect overall economic performance. Uncertainty about the future of those factors translates into uncertainty about the outlook for the budget. Because of that uncertainty, it is informative to characterize the budget outlook not as a single row of numbers but as a range of possible outcomes centered around those numbers.

Using the difference between past CBO baselines and actual budgetary results as a guide, Figure 1-2 displays a range of possible outcomes for the total deficit or surplus under current law. The current baseline projection of the deficit falls in the middle of the highest-probability area, shown as 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 the baseline projection does. Projections that are increasingly different from the baseline are shown in lighter areas, but they also have a significant probability of coming to pass. For example, CBO projects a deficit of 2.1 percent of GDP for 2009. However, under current law, there is roughly a 10 percent chance that the actual outcome that year will be a deficit greater than 6 percent of GDP, as well as about a 25 percent chance that the budget will be in balance or in surplus.

Figure 1-2.

Source: Congressional Budget Office.

Note: This figure, calculated on the basis of CBO's forecasting track record, shows the estimated likelihood of alternative projections of the budget deficit or surplus under current policies. The baseline projections described in this chapter fall in the middle of the darkest area of the figure. Under the assumption that tax and spending policies will not change, the probability is 10 percent that actual deficits or surpluses will fall in the darkest area and 90 percent that they will fall within the whole shaded area.

Actual deficits or surpluses will be affected by legislation enacted in future years, including decisions about discretionary spending. The effects of future legislation are not reflected in this figure.

For an explanation of how CBO typically calculates the probability distribution underlying figures such as this one, see Congressional Budget Office, The Uncertainty of Budget Projections: A Discussion of Data and Methods (April 2004).

Budget Projections Under Alternative Scenarios

CBO's baseline projections--which are founded on current law in order to provide a neutral benchmark for measuring the effects of policy proposals--are likely to be altered in the future by legislative actions. To illustrate the potential effects of different fiscal policies on the baseline, CBO has estimated the budgetary impact of some broad alternative scenarios (see Table 1-6). Although the discussion below focuses on the direct effects of those scenarios on revenues and outlays, their full impact would include their effect on debt-service costs (changes in projected interest payments resulting from changes in the government's projected borrowing needs), which is shown separately in Table 1-6.

The future path of discretionary spending has a sizable impact on the budget outlook, but because appropriations are set one year at a time, current policy with regard to future appropriations is undefined. CBO's baseline inflates budget authority for discretionary programs--including supplemental appropriations--from the most recently enacted level and thus projects total discretionary outlays of $10.8 trillion for the 2005-2014 period. Different assumptions about spending for operations in Iraq and Afghanistan (which have largely been funded through supplemental appropriations thus far) or about the growth rate of regular discretionary appropriations would produce a different total.

If the $115 billion in supplemental appropriations enacted for 2004 (nearly all for activities in Iraq and Afghanistan) was excluded from the amount extrapolated for future years, discretionary outlays over the next 10 years would be $1.1 trillion lower than shown in the baseline. Alternatively, activities in Iraq and Afghanistan could be assumed to slow gradually instead of continuing over the next 10 years at the level funded for 2004. Such a slowdown might involve keeping U.S. force levels related to operations in Iraq and the global war on terrorism at their current levels (about 180,000 active-duty and reserve personnel deployed overseas) through fiscal year 2006 but, over the longer term, reducing U.S. military personnel in Iraq to about 55,000, scaling back operations in Afghanistan to a level comparable with the peacekeeping missions in Bosnia and Kosovo, and decreasing domestic military operations for homeland security. Such a scenario would cost about $315 billion over the 2005-2014 period--or $827 billion less in discretionary outlays than shown in the baseline.⁽¹⁰⁾

Besides scenarios dealing with spending for operations in Iraq and Afghanistan, alternative assumptions about other discretionary spending are possible. For example, if current appropriations (excluding supplementals) were assumed to grow at the same rate as nominal GDP through 2014 instead of at the rate of inflation, total projected discretionary spending would be $1.2 trillion higher. In the other direction, if appropriations (including supplementals) were frozen at their current level through 2014, with no adjustment for inflation, cumulative discretionary outlays would be $1.1 trillion lower.

For revenues, CBO's baseline projections rest on the assumption that current tax laws do not change.⁽¹¹⁾ For example, the baseline envisions that major provisions of EGTRRA--such as the introduction of the 10 percent tax bracket, decreases in previously existing tax rates for individuals, increases in the child tax credit, and the repeal of the estate tax--will expire as scheduled at the end of 2010. On balance, the tax provisions that are set to expire during the projection period reduce revenues; thus, if they were assumed to be extended, projected revenues would be lower than the level in the baseline.⁽¹²⁾ For example, if all expiring tax provisions (except those related to the exemption amount for the AMT) were extended, total revenues over the 2005-2014 period would be nearly $1.9 trillion lower.

Another policy change that could affect revenues involves modifying the alternative minimum tax, which many observers believe cannot be maintained in its current form. As noted above, the AMT's exemption amount and brackets are not indexed for inflation, which means that its impact will grow in coming years as more taxpayers become subject to the tax (many of whom were not the intended target of the AMT when it was enacted). If the AMT was indexed for inflation after 2004, federal revenues would be $340 billion lower over the next 10 years, according to CBO and the Joint Committee on Taxation.
 

Changes to the Budget Outlook Since March 2004

In the six months since CBO's previous baseline was published, the outlook for the deficit in 2004 and 2005 has improved, but the outlook for the cumulative deficit over the 2005-2014 period has worsened. In March, CBO estimated that this year's deficit would reach $477 billion, the deficit for 2005 would decline to $363 billion, and the 10-year deficit would total $2.0 trillion. In the 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, the total deficit projected for the 2005-2014 period has increased by $281 billion (see Table 1-7).

When CBO revises its baseline projections, it divides the changes into three categories according to their cause: recently enacted legislation, changes to CBO's outlook for the economy, and other, so-called technical factors that affect the budget. Legislative changes to revenues and outlays have worsened the budget's bottom line for the 10-year projection period by $497 billion. Together, economic and technical changes have partially offset that effect, improving the projected bottom line by $216 billion for the same period.⁽¹³⁾

CBO's revenue projections have increased by $54 billion for 2004 and by $322 billion for the 2005-2014 period. Economic revisions have increased revenues over that period by a total of $361 billion, whereas legislation enacted since March and technical changes have together lowered projected revenues by $39 billion.

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 the $28 billion in recent supplemental appropriations for 2004 and the Department of Defense's appropriations for 2005. Changes in CBO's economic assumptions add another $188 billion to projected 10-year outlays, primarily for components that are sensitive to changes in inflation (such as projections of discretionary spending and of Social Security's cost-of-living adjustments). Technical changes partially offset the legislative and economic changes, lowering projected spending for the 10-year period by $77 billion.

The Effects of Recent Legislation

Laws enacted in the past six months have decreased this year's deficit by $3 billion but worsened the budgetary picture for the 2005-2014 period by $497 billion. Virtually all of that 10-year change comes from revisions to the projections of outlays.

Discretionary Spending. The Department of Defense Appropriations Act, 2005 (Public Law 108-287) accounts for all of the legislative changes to projected discretionary outlays. The law provides $391 billion in budget authority for defense for 2005--$9 billion more than CBO's March baseline had assumed by adjusting enacted 2004 budget authority for inflation. That increase in budget authority causes projected outlays for 2005 to rise by $7 billion. Extended over the 2005-2014 period, it adds $97 billion to the baseline for discretionary outlays.

P.L. 108-287 also provides $28 billion in supplemental budget authority for 2004, nearly $27 billion of which is designated for costs directly associated with operations in Iraq and Afghanistan. Although that funding was made available upon enactment and thus is counted as 2004 budget authority, the Administration will not disburse most of the funds until 2005. As a result, the new funding has a negligible effect on 2004 outlays but increases estimated 2005 outlays by $19 billion. Extrapolating that additional supplemental funding boosts projected discretionary defense spending over the 2005-2014 period by another $270 billion.

For nondefense programs, P.L. 108-287 provides authority to fund highway projects as well as $1 billion in supplemental 2004 budget authority for a variety of programs, primarily in the Departments of State and Agriculture. Extrapolating those changes to nondefense programs increases outlays by $2 billion for 2005 and by a total of $20 billion through 2014.

Mandatory Spending. Legislation enacted since March has had little budgetary effect on mandatory programs, increasing their projected spending by just $1 billion over 10 years.

Revenues. Changes in law in the past six months have played only a minor role in revisions to the revenue projections. (As described below, economic changes have had a far greater impact.) CBO and the Joint Committee on Taxation estimate that laws enacted since March will increase receipts this year by $3 billion and reduce them over the 2005-2014 period by about $5 billion.

The Pension Funding Equity Act of 2003 (P.L. 108-218) has had the largest legislative impact. It allows firms to use higher interest rates through 2005 to calculate their pension liabilities, resulting in smaller tax-deductible pension contributions and an estimated $10 billion in additional revenues over the 2004-2006 period. Revenues are expected to decline by a similar amount from 2007 through 2014 when employers increase their contributions to compensate for the lower ones they made in 2004 and 2005.

Recently enacted trade legislation has reduced the revenues projected for the 2005-2014 period by an estimated $1.4 billion. Lawmakers have enacted free-trade agreements with Australia and Morocco, further liberalized trade with sub-Saharan Africa, and renewed for one year the ban on trade with Burma, all of which act to reduce customs duties.

Net Interest. In all, the legislation enacted in the past six months will increase the cumulative deficit for the 2005-2014 period by $393 billion, CBO estimates. That increase adds $104 billion to projected debt-service costs over those 10 years (for the total legislative impact of $497 billion).

The Effects of Economic Changes

Changes in the outlook for the economy since January--when CBO last updated its economic projections--reduce this year's projected deficit by $14 billion, almost entirely on the revenue side of the budget. For the 2005-2014 period, economic revisions increase projected revenues by $361 billion and projected outlays by $188 billion relative to CBO's March baseline, thus reducing the cumulative deficit by $173 billion. The major economic changes causing those revisions are slightly higher projected levels of GDP and wages and higher projected inflation in the near term. (CBO's new economic forecast and projections are described in Chapter 2.)

Discretionary Spending. As noted above, CBO is required to project discretionary budget authority using two measures of inflation: the GDP deflator (which covers the changes in price of all goods and services contributing to GDP) and the employment cost index for wages and salaries. CBO's forecast for both measures over the 2004-2006 period has increased, but its projection for the GDP deflator from 2007 through 2014 has declined slightly. Despite that slower growth after 2006, the projected level of the GDP deflator remains above the level anticipated in January because of more-rapid growth in 2004 and 2005. Overall, those changes raise projected discretionary outlays over the 2005-2014 period by a total of $79 billion.

Mandatory Spending. The effect of economic changes has been much greater on mandatory spending. Updates to CBO's economic forecast since January have added $165 billion to projected mandatory outlays for the 2005-2014 period.

Social Security and Medicaid are the two mandatory programs most affected by the revised economic forecast. Higher projected inflation in 2004 boosts the upcoming cost-of-living adjustment for Social Security beneficiaries by 1.2 percentage points, which will raise projected Social Security payments each year. In addition, higher projected wage growth increases future benefit payments. In all, such economic changes increase the outlay projections for Social Security by $104 billion through 2014. Higher projected inflation in health care costs has a similar effect on Medicaid over the decade, raising projected outlays for that program by a total of $46 billion from the level in the March baseline.

Revenues. Except in 2004, most of the change since March in CBO's revenue projections comes from changes in the economic outlook. Economic reestimates add about $14 billion to revenues this year and $361 billion--about 1.3 percent--for the 2005-2014 period.

CBO has increased its projection of nominal GDP, mainly because of higher expected inflation in 2004 and 2005 and slightly higher expected real growth beyond 2005. That revised outlook has caused CBO to raise its projection of payments for wages and salaries, the type of income subject to the highest marginal tax rate. As a result, CBO has increased its projections for both individual income and social insurance taxes, accounting for nearly all of the upward revision to revenues for the 2005-2014 period.

In recent quarters, corporate profits have been stronger than CBO expected in January. The resulting changes in CBO's outlook for profits contribute to the upward re-estimate to revenues for the next two years. Beyond 2006, CBO has not revised its projections of book or economic profits significantly, although reductions in the share of those profits earned domestically reduce tax receipts and offset the upward reestimate in the near term.

Net Interest. Economic revisions to projected net interest spending have two components: the effects of changes in interest rates and inflation and the effects of additional (or reduced) debt service. Recent increases in inflation have raised interest costs on TIPS by more than $2 billion this year. In the other direction, a lower forecast for short-term interest rates in 2005 and 2006 helps reduce projected spending on net interest over the 2005-2014 period by $3 billion. (CBO has lowered its estimate of the interest rate on three-month Treasury bills by 0.32 percentage points for 2005 and by 0.5 percentage points for the first quarter of fiscal year 2006.) In addition, CBO projects that the debt-service savings associated with economic changes total about $53 billion through 2014.

The Effects of Technical Changes

Technical changes represent all other revisions to the baseline not directly related to recent laws or to changes in the economic outlook. For 2004, technical changes decrease the projected deficit by $39 billion--almost entirely because of upward revisions to revenue estimates. For the 2005-2014 period, technical changes lower the cumulative deficit by $43 billion.

Discretionary Spending. Technical reestimates reduce projected discretionary outlays in 2004 by $8 billion; those changes chiefly reflect new information about spending so far this year. For the following 10 years, a variety of technical adjustments lower projected discretionary spending by a total of $3 billion.

Although those technical revisions affect nearly all areas of the budget, the largest involve the Iraq Relief and Reconstruction Fund. CBO has reduced its estimate of outlays from that fund by $2.4 billion for 2004 and $2.3 billion for 2005 to reflect the unexpectedly slow rate of spending thus far. In addition, CBO's estimate of transportation spending this year has declined by $1.0 billion, and its estimate of outlays for grants for elementary and secondary education has dropped by $1.5 billion.

Mandatory Spending. Technical adjustments increase CBO's projection of mandatory spending for 2004 by $4 billion relative to the previous baseline. For the 2005-2014 period, such adjustments reduce projected mandatory spending by $33 billion, with most of that decline resulting from relatively small revisions to projections of Social Security benefits.

The bulk of CBO's technical reestimates for Social Security stem from adopting new assumptions about population projections. In the Social Security trustees' 2004 report, historical population figures were revised, and the projected population of the "Social Security area" (which includes the United States, Puerto Rico, and overseas military personnel) was lowered by between 3 million and 4 million each year. Roughly one-fifth of that net revision reflects the population age 62 and older. As a result, CBO has lowered its estimates of Social Security benefits by amounts that grow to $7 billion in 2014.

Projected spending for farm price-support and income-support payments by the Commodity Credit Corporation over the 2005-2014 period has declined by $8 billion since the March baseline. Most of that reduction affects the first few years of the projection period; it stems from new information about the number of producers receiving program benefits and the current high prices for many agricultural commodities.

CBO's estimate for Medicaid spending this year has grown by $2 billion on the basis of spending through July. Technical changes have little effect, however, on the longer-term projections for Medicaid outlays.

Estimated 2004 outlays from the September 11th Victim Compensation Fund have increased by $3 billion, primarily because CBO now expects the remaining payments from the fund to be made in 2004 rather than spread over 2005 and 2006. In addition, the average payment per recipient for cases involving a death is projected to increase slightly from what CBO estimated in March. The fund has also paid more disability claims than CBO anticipated.

Other technical changes to mandatory programs include an increase of $4.3 billion for student loans in 2004 because of a higher-than-expected volume of loan consolidations. In addition, CBO has reduced its projections of spending for unemployment benefits by $1.0 billion for 2004, $1.6 billion for 2005, and $1.3 billion for 2006. Those changes reflect a lower-than-expected number of claims this year, partly offset by a longer-than-anticipated average duration of benefits.

Revenues. CBO has increased its revenue projections by $37 billion for 2004 and $10 billion for 2005 and decreased them by a total of $44 billion for the rest of the projection period for reasons other than changes in the economic projections or legislation enacted since March. Three factors explain most of those technical reestimates: recent information about tax collections, new data on the effects of the partial-expensing provisions enacted in 2002 and 2003, and new modeling of the effects of corporate losses on future tax receipts.

First, collections of individual and corporate income taxes have been higher this year than CBO projected in March. Stronger-than-expected incomes (as currently measured in the national income and product accounts) and recent legislation explain only part of that strength. The other causes will become more apparent once individual and corporate income tax returns for 2003 and 2004 are available for study.

In the meantime, CBO must infer the reasons for the additional tax revenues and project their likely path. On the basis of its experience with such deviations and the cyclical nature of several of the possible causes, CBO assumes that the unexplained increase in revenues in 2004 will gradually dissipate in the next several years--more quickly for corporate receipts, which are highly cyclical, than for individual income tax receipts. In CBO's baseline, most of the unexplained receipts are phased out by 2007. In all, CBO has raised its revenue projections by almost $70 billion for 2004 through 2009 because of those factors.

Second, data from corporate income tax returns for 2002 indicate that firms utilized the new partial-expensing provisions by about 30 percent less than CBO had anticipated. CBO now estimates that those provisions will reduce revenues by about $10 billion less over the 2004-2005 period than previously expected and increase revenues by about $30 billion less thereafter.

Third, CBO has adjusted its modeling of corporations' losses, which are especially important following the decline in profits in 2001 and the large increases that year in the amount of losses by unprofitable firms. Companies can use losses from unprofitable years to reduce taxable profits up to 20 years later. CBO now anticipates that more losses will be generated and used in future years than it previously expected, reducing projected receipts over the 2004-2014 period by more than $50 billion.

One technical change to revenue projections results only in a reallocation of 2004 revenues between social insurance and individual income taxes, without changing overall receipts. CBO has reduced its projection of social insurance receipts by about $17 billion and increased estimated individual income taxes by the same amount to reflect official data as reported in the Monthly Treasury Statement. When employers remit taxes withheld from paychecks to the Internal Revenue Service, they do not specify how much represents individual income taxes and how much represents payroll taxes for the Hospital Insurance and the Old-Age, Survivors, and Disability Insurance programs. The Treasury Department estimates those components and then corrects its earlier estimates in later years once data from tax returns become available. The corrections in 2004 have been larger than usual. However, they do not affect CBO's projections beyond this year.

Net Interest. Technical reestimates lower projected outlays for net interest (other than debt service) over the 2005-2014 period by $20 billion. In particular, CBO has revised its assumptions about the future composition of debt held by the public, assuming that more TIPS and fewer bills and notes will be issued than it estimated in March. That assumption reflects the change in the Treasury's auction calendar that introduced 20-year and five-year TIPS.

Overall, technical changes to the baseline reduce revenues by $34 billion and outlays by $56 billion over the projection period. The resulting decline in the cumulative deficit decreases projected debt-service costs through 2014 by $21 billion.