The Effects of Automatic Stabilizers on the Federal Budget

Report
April 21, 2011

In March 2011, the Congressional Budget Office (CBO) released its most recent baseline projections of federal revenues, outlays, and budget balances for the next 10 years. For those projections, CBO assumed the continuation of current laws and policies that affect taxes and mandatory spending programs and extrapolated the growth of discretionary spending by using projected rates of inflation. CBO estimated in March that the baseline budget deficit will rise from $1.3 trillion in fiscal year 2010 to $1.4 trillion in 2011 and then will average $692 billion over the next five years. At 9.3 percent of gross domestic product (GDP) in 2011, the deficit in those terms will be the second largest in more than half a century (behind only the 2009 deficit, which was 10.0 percent of GDP). By comparison, CBO projects that the deficit will average 4.1 percent of GDP during the five years from 2012 through 2016 if current laws remain in place.

CBO's projections of the budget deficit are affected by legislation that governs taxation and spending and by the automatic responses of revenues and outlays to developments in the economy and other factors. This report focuses on a component of the latter group—the automatic stabilizers—that reflect cyclical movements in real (inflation-adjusted) output and unemployment. During recessions, GDP falls relative to potential GDP (the quantity of output that corresponds to a high rate of use of labor and capital), and revenue declines automatically. In addition, some outlays—for example, to pay unemployment insurance claims or to provide federal nutrition benefits—automatically increase. Those automatic reductions in revenues and increases in outlays when GDP is falling relative to potential GDP and unemployment is correspondingly rising help bolster economic activity, but they also temporarily increase the budget deficit. As GDP moves up closer to potential GDP, revenues automatically begin to rise, outlays automatically begin to fall, and the automatic stabilizers offer a smaller boost to output. (For a discussion of the measurement of automatic stabilizers, see the appendix.)

CBO estimates that automatic stabilizers are adding significantly to the budget deficit now but that their contribution will steadily fade over the next few years. In 2010, CBO estimates, automatic stabilizers added the equivalent of 2.4 percent of potential GDP to the deficit, an amount somewhat greater than the 2.1 percent added in 2009. According to CBO's baseline projections, the contribution of automatic stabilizers to the budget deficit will decrease as a share of potential GDP—to 2.1 percent in 2011, 1.7 percent in 2012, and 1.5 percent in 2013 (see Table 1 and Table 2). That contribution will then continue to fall—to 1.0 percent in 2014, 0.5 percent in 2015, and 0.1 percent in 2016—consistent with CBO's projection for output to come back up near potential output by 2016.

The budget balance without automatic stabilizers is an estimate of what the surplus or deficit would be if GDP was at its potential, the unemployment rate was at a corresponding level, and all other factors were unchanged. That budget measure has several applications. For example, some analysts use it to discern underlying trends in government saving or dissaving (that is, trends in surpluses or deficits). Others use it to approximate whether the short-run influence of the budget on aggregate demand and on the growth of real output is positive or negative. More generally, the measure helps analysts estimate the extent to which changes in the budget balance are caused by cyclical developments in the economy and thus are likely to prove temporary rather than long lasting.

Under CBO's baseline assumptions, the budget deficit without automatic stabilizers would constitute 6.7 percent of potential GDP in 2011, up from 6.0 percent in 2010. That increase is primarily due to a rise in mandatory spending from sources other than the automatic stabilizers that amounts to 0.6 percent of potential GDP. Discretionary outlays, which have no automatic response to the business cycle, are projected to decline by 0.2 percent of potential GDP, and interest payments, which are assumed to have no automatic response, are projected to rise slightly. Revenues without automatic stabilizers are projected to decrease by 0.2 percent of potential GDP in 2011.

According to CBO's baseline projections, the budget deficit without automatic stabilizers falls significantly over the next three years, from 6.7 percent of potential GDP in fiscal year 2011 to 4.9 percent in 2012, 2.6 percent in 2013, and 1.9 percent in 2014 (see Figure 1). The drop in 2012 is due mostly to an increase in revenues without automatic stabilizers (from 15.8 percent of potential GDP to 17.1 percent)—largely attributable to the ending of the temporary reduction in payroll taxes for 2011, which was part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (referred to in this report as the 2010 tax act, Public Law 111-312)—and to a lower amount of depreciation deductions for investment in business equipment resulting from provisions of the 2010 tax act and other recent acts. Outlays without automatic stabilizers fall by 0.5 percent of potential GDP in 2012, reflecting declines in both mandatory and discretionary outlays that are partly offset by an increase in interest payments. In 2013, the decline in the deficit without automatic stabilizers is almost entirely the result of a rise in revenues, which in turn is due to the delayed effects of the scheduled expiration at the end of 2011 of the temporary patch for the alternative minimum tax and, to a greater extent, to the expiration at the end of 2012 of other tax provisions extended or newly implemented in the 2010 tax act, including extensions of the individual income tax reductions enacted in 2001 and 2003. Moreover, some high-income taxpayers will be subject to additional taxes that are scheduled to take effect in calendar year 2013 under provisions of the Patient Protection and Affordable Care Act of 2010 (P.L. 111-148) and the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152). Some of the impacts of those tax changes become larger in 2014, the first full fiscal year the provisions are in effect.

In 2015, the federal deficit without automatic stabilizers reverses course, rising to 2.5 percent of potential GDP in that year and to 3.3 percent in 2016. Those increases stem mainly from a rise in mandatory outlays (largely Social Security, Medicare, and Medicaid) that is not attributable to automatic stabilizers. Revenues without automatic stabilizers fall slightly in those years relative to potential GDP, mostly because of legislation that shifts the timing of corporate income tax payments out of 2016 and into prior years. An uptick in interest costs is roughly offset by a decline in discretionary spending.