Budget and Economic Outlook: An Update

The United States is facing profound budgetary and economic challenges. At 8.5 percent of gross domestic product (GDP), the $1.3 trillion budget deficit that the Congressional Budget Office (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). This year's deficit 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. On the basis of economic data available through early July, when the agency initially completed its economic forecast, CBO projects that real GDP will increase by 2.3 percent this year and by 2.7 percent next year. 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.

With modest economic growth anticipated for the next few years, CBO expects employment to expand slowly. The unemployment rate is projected to fall from 9.1 percent in the second quarter of 2011 to 8.9 percent in the fourth quarter of the year and to 8.5 percent in the fourth quarter of 2012—and then to remain above 8 percent until 2014. Although inflation 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.

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, which generally reflect the assumption that current law will not change, 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 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.

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. But those 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 of emergency 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. 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. 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.

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.