August 24, 2011
The United States continues to face profound budgetary and economic challenges. CBO discusses those challenges in the Budget and Economic Outlook: An Update—an annual report, released today, which presents the agency’s updated budget and economic projections for the current year and the next decade.
Federal budget deficits and debt have surged in the past few years, and this year’s deficit—projected to be $1.3 trillion—stems in part from the long shadow cast on the U.S. economy by the financial crisis and the recent recession. Although economic output began to expand again two years ago, the pace of the recovery has been slow, and the economy remains in a severe slump. Recent turmoil in financial markets in the United States and overseas threatens to prolong the slump. CBO expects that the recovery will continue but that real (inflation-adjusted) GDP will stay well below the economy’s potential—a level that corresponds to a high rate of use of labor and capital—for several years.
In the remainder of this blog post, I’ll summarize key aspects of our projections; they are also illustrated in these figures.
What is the Economic Outlook?
CBO initially completed its economic forecast in early July, but it updated the forecast in early August only to reflect the policy changes enacted in the Budget Control Act. However, the forecast does not reflect any other developments since early July, including the recent swings in financial markets, weakness in certain economic indicators, and the annual revision to the national income and product accounts. Incorporating that news would have led CBO to temper its near-term forecast for economic growth.
GDP: On that basis, CBO projects that real GDP will increase by 2.3 percent this year and by 2.7 percent next year. That forecast reflects CBO’s expectation of continued strong growth in investment by businesses, moderate increases in spending by consumers, gains in net exports (exports minus imports), and the beginning of a recovery in new-home construction. Under current law, federal tax and spending policies will impose substantial restraint on the economy in 2013, so CBO projects that economic growth will slow that year before picking up again, averaging 3.6 percent per year from 2013 through 2016.
Unemployment rate: With modest economic growth anticipated for the next few years, CBO expects employment to expand slowly. The unemployment rate is projected to fall to 8.9 percent in the fourth quarter of this year and to 8.5 percent in the fourth quarter of 2012 and then to remain above 8 percent until 2014 (see figure below).
Inflation: Although inflation in consumer prices increased in the first half of 2011, spurred largely by a sharp rise in oil prices, CBO projects that it will diminish in the second half of the year and then stay below 2.0 percent over the next several years.
Interest rates: CBO’s projected paths for inflation and economic growth suggest that interest rates will remain quite low for the rest of 2011 and 2012. In CBO’s forecast, the interest rate on 3-month Treasury bills averages barely above zero in both years, and the rate on 10-year Treasury notes averages close to 3¼ percent in both years.
What is the Budget Outlook Under Current Law?
Deficit and debt in 2011: At 8.5 percent of gross domestic product (GDP), the budget deficit that CBO projects for 2011 will be the third-largest shortfall in the past 65 years (exceeded only by the deficits of the preceding two years). That deficit is also much larger than the average annual deficit of 2.8 percent of GDP experienced over the past 40 years. The historically high deficits of recent years have pushed debt held by the public from 40 percent of GDP at the end of 2008 to an estimated 67 percent at the end of this year.
Deficits and debt over the next 10 years: CBO’s baseline projections incorporate the assumption that current law remains in place so they can serve as a benchmark for policymakers to use in considering possible changes to law. If the recovery continues as CBO expects, and if tax and spending policies unfold as specified in current law, deficits will drop markedly as a share of GDP over the next few years. Under CBO’s baseline projections, deficits fall to 6.2 percent of GDP next year and 3.2 percent in 2013, and they average 1.2 percent of GDP from 2014 to 2021. Those projections incorporate the effects of the deficit reduction measures in the recently enacted Budget Control Act of 2011; they also reflect the sharp increases in revenues that will occur when provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 tax act) expire.
In CBO’s baseline, cumulative deficits total $3.5 trillion between 2012 and 2021, and by the end of 2021 debt held by the public equals $14.5 trillion, or 61 percent of GDP. That estimate of deficits over the next 10 years is considerably lower than the $6.7 trillion that the agency projected in March. About two-thirds of that reduction stems from the effects of enacting the Budget Control Act, which set caps on future discretionary spending and created a process for adopting additional deficit reduction measures; the remainder is the result of changes in the economic outlook and technical revisions to CBO’s projections.
How Would the Outlook Differ if Certain Current Policies are Extended?
The baseline projections understate the budgetary challenges facing the federal government in the coming years because changes in policy that are scheduled to take effect under current law will produce a federal tax system and spending for some federal programs and activities that differ noticeably from what people have been accustomed to.
In particular, the baseline projections in this report include the following policies specified in current law:
- Certain provisions of the 2010 tax act, including extensions of lower rates and expanded credits and deductions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief Reconciliation Act of 2003, and the American Recovery and Reinvestment Act (ARRA) expire at the end of 2012;
- The two-year extension of provisions designed to limit the reach of the alternative minimum tax, extensions for unemployment compensation, and the one-year reduction in the payroll tax all expire at the end of 2011;
- Sharp reductions in Medicare’s payment rates for physicians’ services take effect at the end of 2011;
- Funding for discretionary spending declines over time in real terms, in accordance with the caps established under the Budget Control Act; and
- Additional deficit reduction totaling $1.2 trillion over the 2012–2021 period will be implemented as required under the Budget Control Act.
If some of the changes specified in current law did not occur and current policies were continued instead, much larger deficits and much greater debt could result (see figure below). For example, if most of the provisions in the 2010 tax act that were originally enacted in 2001, 2003, 2009, and 2010 were extended (rather than allowed to expire on December 31, 2012, as scheduled); the alternative minimum tax was indexed for inflation; and cuts to Medicare’s payment rates for physicians’ services were prevented, then annual deficits from 2012 through 2021 would average 4.3 percent of GDP, compared with 1.8 percent in CBO’s baseline projections.
Deficits in CBO’s Baseline and Assuming a Continuation of Certain Policies
With cumulative deficits during that decade of nearly $8.5 trillion, debt held by the public would reach 82 percent of GDP by the end of 2021, higher than in any year since 1948 (see figure below).
Federal Debt Held by the Public—Historically, in CBO’s Baseline, and with a Continuation of Certain Policies
Under those alternative assumptions, real GDP would be higher in the first few years of the projection period than in CBO’s baseline economic forecast. For example, CBO estimates that the size of real GDP in 2013 would be between 0.6 percent and 2.3 percent greater than projected under current law. Faster GDP growth would result in a lower unemployment rate and somewhat higher interest rates over the next few years. In later years, however, real GDP would fall below the level in CBO’s baseline projection by increasing amounts over time.
Beyond the 10-year projection period, further increases in federal debt relative to the nation’s output almost surely lie ahead if certain policies remain in place. The aging of the population and rising costs for health care will push federal spending up considerably as a percentage of GDP. If that higher level of spending is coupled with revenues that are held close to their average share of GDP for the past 40 years (rather than being allowed to increase, as under current law), the resulting deficits will cause federal debt to skyrocket. To prevent debt from becoming unsupportable, policymakers will have to substantially restrain the growth of spending, raise revenues significantly above their historical share of GDP, or pursue some combination of those two approaches.