The Macroeconomic and Budgetary Effects of an Illustrative Policy for Reducing the Federal Budget Deficit

July 14, 2011

Adopting a deficit reduction plan would have three kinds of effects on the budget. One would be the direct effect of the plan’s changes to spending and revenues. A second effect would be a reduction in interest payments by the government, as smaller deficits would result in lower federal debt. A third effect would result from the fact that smaller deficits would affect the economy in various ways, in turn leading to further changes in federal spending and revenues.

At the request of the Chairman and Ranking Member of the Senate Budget Committee, CBO has estimated the magnitude of that third effect, using as an example an “illustrative policy” that would reduce budget deficits by $2.0 trillion over the next 10 years. That analysis is intended to help policymakers assess the broad economic and budgetary consequences of potential policies, beyond the standard budget estimates.

The illustrative policy that CBO analyzed does not incorporate any assumptions about the particular mix of spending or revenue changes, is not meant to correspond to any specific legislative proposal, and does not represent a recommendation by CBO as to the desirable amount of deficit reduction.

What is the “illustrative policy” that CBO analyzed?

The illustrative policy would reduce primary deficits by a cumulative $2.0 trillion between 2012 and 2021 relative to CBO’s baseline projections, before taking account of any economic effects of the policy. (The primary deficit is the total budget deficit excluding net interest payments.) CBO assumed that the deficit reductions, excluding economic effects and interest savings, would start at $100 billion in 2012 and increase gradually until they reached $300 billion in 2021.

How would a reduction of $2.0 trillion in primary deficits affect total deficits before taking into account the macroeconomic effects of the policy?

A $2.0 trillion reduction in future deficits would result in lower federal debt than is currently projected, thus reducing the government’s interest costs. Taking into account those savings in interest, CBO estimates that the illustrative policy would lower deficits by a total of $2.4 trillion over the 2012–2021 period, under an assumption that those budgetary changes would have no effect on the economy. A policy that reduced primary deficits by the same amount but with different timing than assumed in CBO’s analysis would result in different interest savings.

How would the illustrative policy affect the economy?

Budgetary changes would affect the economy—in differing ways in the short term and over the medium term and long term. In the short term, while the economy is relatively weak and economic growth is restrained primarily by a shortfall in demand for goods and services, the policy would decrease the demand for goods and services even further and thus reduce economic output and income. Long-term interest rates would be lower than if the deficit reduction did not occur.

Over the medium term and long term, a reduction in primary budget deficits would induce greater national saving and investment, thereby boosting economic output and income. Long-term interest rates would be lower than they would be without such deficit reduction.

Because considerable uncertainty surrounds many of the economic relationships that are fundamental to this analysis, CBO used a range of assumptions about the short-term effects on output of changes in federal spending and taxes and about the effects on national saving and investment of changes in deficits. CBO varied those assumptions so that effects on output were smaller, medium-sized, or larger.

CBO estimated the effects of the illustrative policy relative to the current-law assumptions underlying CBO’s baseline projections, finding the following:

  • Lower demand resulting from the illustrative policy would decrease real (inflation-adjusted) gross national product (GNP) in 2012, 2013, and 2014 by amounts ranging from roughly 0.1 percent to 0.6 percent depending on the year and the assumptions used.  In addition, long-term interest rates would be reduced by about 0.1 to 0.4 percentage points during those years. 
  • Beyond 2014, the illustrative policy would lead to gains in GNP that increased over time. 
  • Near the end of the decade, from 2019 through 2021, GNP would increase by roughly 0.5 percent to 1.4 percent, again depending on the year and the assumptions used. Long-term interest rates would be reduced by about 0.1 to 0.2 percentage points.

What would be the resulting effects on the budget?

The changes in the economy would in turn affect the federal budget. CBO estimated the budgetary implications of the illustrative policy’s macroeconomic effects using an approach that takes into account changes in GNP, interest rates, and other factors. Specifically, CBO’s analysis indicates the following:

  • Effects on Primary Deficits: The macroeconomic effects of the illustrative policy would increase primary deficits by small amounts in the first part of the coming decade and reduce them by small amounts in the latter part of the decade. Because the gains in GNP generated by the policy would increase further beyond the decade, the reduction in primary deficits would continue to grow as well. 
  • Effects on Interest Costs: The macroeconomic effects would reduce federal interest payments—over and above the reduction attributable to the lower levels of debt that would result from the policy—because the policy would lead to lower interest rates (relative to those underlying CBO’s baseline projections) in every year. Those savings would be much larger than the net savings arising from the changes in primary deficits induced by the macroeconomic effects of the policy, and would also continue to grow beyond the end of the decade.
  • Total Budgetary Effects: Under the set of assumptions that imply medium-sized effects of the illustrative policy on output, the macroeconomic effects of the policy would reduce deficits by about $185 billion over and above the $2.4 trillion reduction in primary deficits and interest costs estimated before accounting for the macroeconomic effects. Therefore, the illustrative $2.0 trillion reduction in primary deficits (relative to CBO’s baseline projections) would yield a total reduction in deficits of about $2.6 trillion from 2012 through 2021.

Cumulative Reduction in Deficits Under an Illustrative Policy, With and Without Its Macroeconomic Effects (Billions of dollars)

How did CBO account for uncertainty in the estimates?

CBO used a range of assumptions about the effects on output and investment. Even so, the macroeconomic impact of a reduction in primary budget deficits of $2.0 trillion could lie outside the range of estimates reported here, depending on the specific policies chosen, the future state of the economy, and numerous other factors. The magnitude of the impact of future deficit reduction on interest rates is especially uncertain.

Would alternative scenarios for deficit reduction generate different macroeconomic effects and resulting budgetary effects?

Alternative scenarios for deficit reduction would generate different macroeconomic effects and resulting budgetary effects. For example, a policy that had a different amount of cumulative reduction in primary deficits but that reduced deficits on the same gradual time path as the policy analyzed here would have macroeconomic and budgetary effects that would differ by roughly the same percentage as did the cumulative amount of deficit reduction. Thus, for example, a reduction in primary deficits that followed the same gradual time path but was twice as large would produce macroeconomic effects that were roughly twice as large as those shown here.

A different policy that had the same amount of cumulative reduction in primary deficits but that reduced deficits more slowly than the policy analyzed here would have more favorable macroeconomic effects in the next few years but less favorable ones later in the decade. The total budgetary impact of slower deficit reduction would be smaller, for two reasons. First, the policy’s impact on interest rates would be smaller. Second, because the reduction in debt would occur more slowly, the resulting savings in interest costs would have less time to compound. 

How would the estimates be different if they were calculated relative to a scenario other than CBO’s baseline?

Applying the illustrative deficit reduction policy to a scenario in which deficits were assumed to be larger or smaller than those in CBO’s current-law baseline would yield somewhat different estimates of the policy’s macroeconomic and budgetary effects. For example, if the starting point involved greater amounts of debt than are projected in CBO’s baseline, as is the case in the alternative fiscal scenario described in CBO’s 2011 Long-Term Budget Outlook, a given reduction in interest rates under the illustrative policy would result in a modestly larger reduction in interest costs.  For this and other reasons, the budgetary implications of the macroeconomic effects would be modestly larger in total.