Calculating the Fiscal Gap

June 26, 2009

Yesterday CBO released the Long-Term Budget Outlook. Under current law, the federal budget is on an unsustainable pathmeaning that federal debt will continue to grow much faster than the economy over the long run.

How much would policies have to change to avoid unsustainable increases in government debt? A useful answer comes from looking at the so-called fiscal gap. The gap represents the extent to which the government would need to immediately and permanently raise tax revenues, cut spending, or undertake some mix of both to make the governments debt the same size (relative to the size of the economy) at the end of a given period as prevailed at the beginning of the period.

The fiscal gap is a present-value measure of the nations fiscal imbalance. A present-value calculation adjusts future payments for the time value of money to make them comparable with payments today. CBO calculates the present value of a stream of future revenues by taking the revenues for each year, discounting each value to 2009 dollars, and then summing the resulting series. The same method is applied to the projected stream of outlays. CBO also computes a present value for future gross domestic product (GDP) so it can calculate the present value of outlays and revenues as a share of the present value of GDP.

CBO performed such calculations for two different scenarios that represent, in different ways, a continuation of current policies. The extended-baseline scenario adheres most closely to current law and assumes that many policy adjustments that lawmakers have routinely made in the past will not occur. The alternative fiscal scenario represents another interpretation of what it would mean to continue todays underlying fiscal policy; it incorporates some policy changes that are widely expected to occur and that policymakers have regularly made in the past. For example, under the latter scenario, the changes in tax rates enacted in 2001 and 2003, now scheduled to expire in December 2010, would be extended and the alternative minimum tax would be indexed to inflation.

Under the extended-baseline scenario, the fiscal gap would amount to 2.1 percent of GDP over the next 25 years and 3.2 percent of GDP over the next 75 years. In other words, under that scenario (ignoring the effects of debt on economic growth), an immediate and permanent reduction in spending or an immediate and permanent increase in revenues equal to 3.2 percent of GDP would be needed to create a sustainable fiscal path for the next three-quarters of a century. (That amount would come to about $450 billion in 2009.) If the policy change was not immediate, the required percentage would be greater.

Under the alternative fiscal scenario, the fiscal gap is greater: 5.4 percent of GDP over the next 25 years (equivalent to about $750 billion in 2009) and 8.1 percent over the next 75 years.