This morning we released an update on the outlook for the budget and the economy. In a briefing for the press, I delivered the following summary of our analysis, with accompanying slides.
The Budget Outlook
The federal budget deficit for fiscal year 2015 will be smaller than we projected in March and will decline as a share of gross domestic product relative to last year's. Specifically, we estimate that the deficit for this fiscal year will reach $426 billion, $59 billion less than last year—or 2.4 percent of GDP, 0.4 percentage points less than last year. This will be the sixth straight year of a declining deficit relative to GDP. However, debt held by the public has grown over the same period and will reach nearly $13.2 trillion—or 74 percent of GDP—by the end of this year. That is slightly less than the ratio last year but higher than in any other year since 1950.
Over the next 10 years, the outlook does not differ substantially from the one we described in March. Under an assumption that current laws generally remain in place, deficits as a percentage of GDP are estimated to remain below this year's level for the next three years but then begin to rise. In CBO's current baseline, the deficit falls to 2.1 percent of GDP in 2017, but in the latter half of the decade, deficits average 3.5 percent of GDP. The cumulative deficit between 2016 and 2025 is projected to be $7.0 trillion. Those deficits occur because significant projected growth in spending on health care and retirement programs and rising interest payments on federal debt outpace the projected growth in revenues.
By the end of the 10-year projection period in the baseline, rising deficits push debt held by the public up to 77 percent of GDP, roughly twice the average it has been over the past five decades.
Under current law, both spending and revenues would remain high relative to historical levels as a share of GDP. Federal outlays are expected to remain near 21 percent of GDP for the next several years, above the 20.1 percent that they have averaged over the past 50 years. By 2025, as growth in outlays outstrips growth in the economy, outlays would total 22 percent of GDP.
Spending on three key components of the budget would grow faster than the economy:
- The major health care programs, including Medicare, Medicaid, and subsidies for health insurance purchased through exchanges;
- Social Security; and
- Net interest payments.
In contrast, spending in three other broad categories—mandatory spending other than that for the major health care programs and Social Security, and both defense and nondefense discretionary spending—would shrink markedly relative to the size of the economy. Outlays in those three categories taken together would fall to their lowest percentage of GDP since 1940, the earliest year for which comparable data have been reported.
Federal revenues as a share of GDP are projected to rise to 18.9 percent of GDP in 2016, primarily because several provisions of law expired at the end of calendar year 2014. Revenues then are estimated to decline modestly for several years (reaching 18.0 percent in 2021) before rising slowly to 18.3 percent of GDP by 2025, above the 17.4 percent that they have averaged over the past 50 years. The changing pattern in federal revenues as a share of GDP would result from several offsetting movements during all or part of the 10-year projection period:
- Individual income tax receipts would continue to increase relative to GDP—largely a result of real bracket creep, with smaller effects from recent changes in tax law and other factors.
- Payroll tax receipts would decline relative to GDP, especially over the next several years, reflecting several factors, such as declines to more typical levels in states' deposits to unemployment trust funds.
- Corporate income tax receipts would decline relative to the size of the economy after 2016, mostly because of an anticipated drop in domestic economic profits as a percentage of GDP and the waning effect of recently expired tax provisions.
- Remittances to the Treasury from the Federal Reserve—which have been very large since 2010 because of changes in the size and composition of the central bank's portfolio—would decline to more typical levels.
Beyond 2025, if current laws remained in place, the same pressures that contribute to rising deficits during the next decade would accelerate and push debt up sharply relative to GDP. Such high and rising debt would have serious negative consequences for the nation:
- When interest rates returned to more typical, higher levels, federal spending on interest payments would increase substantially.
- Because federal borrowing reduces national saving over time, the nation's capital stock would ultimately be smaller, and productivity and total wages would be lower than they would be if the debt was smaller.
- Lawmakers would have less flexibility than otherwise to use tax and spending policies to respond to unexpected challenges.
- Continued growth in the debt might lead investors to doubt the government's willingness or ability to pay its obligations, which would require the government to pay much higher interest rates on its borrowing.
The Economic Outlook
Our budget projections are built on our economic forecast, which anticipates that the economy is expected to grow modestly this year and at a solid pace for the next few years. Although real (inflation-adjusted) GDP grew weakly early in 2015, the economy now appears to be on firmer ground, and we expect the pace of economic activity to pick up in the second half of this calendar year and over the next few years. After that, we anticipate moderate economic growth, constrained by relatively slow growth in the labor force.
We project that real GDP will grow by 2.0 percent this calendar year, by 3.1 percent in 2016, and by 2.7 percent in 2017—above its potential (or maximum sustainable) rate over that period. For 2018 and 2019, we project that the economy will grow at an average annual rate of 2.2 percent, equal to its potential growth rate. The economic expansion through 2019 will be driven primarily by increases in consumer spending, business investment, and residential investment.
Over the next few years, the faster pace of growth in output is expected to reduce the quantity of underused resources, or "slack," in the economy. The difference between actual GDP and CBO's estimate of potential GDP was about 3.4 percent at the end of 2014. CBO expects that gap to narrow to its historical average by the end of 2017.
Although labor market conditions improved significantly in 2014 and in the first half of 2015, there is still significant slack in the labor market. Key measures of the remaining slack include these:
- The labor force participation rate remains about 1 percentage point below its potential rate;
- The unemployment rate is roughly one-half of a percentage point higher than it was at the beginning of the recession; and
- The share of workers employed part time who would prefer full-time work is about 1 percentage point higher than before the last recession.
A direct consequence of persistent slack in the labor market is that wages continue to grow more slowly than they did before the recession. We expect that as slack diminishes, increased competition for fewer available workers will lead firms to begin increasing wages more rapidly in order to attract workers.
The unemployment rate remains elevated today. We project that further hiring will reduce it from 5.2 percent in the fourth quarter of 2015 to 5.0 percent in the fourth quarter of 2017.
Currently, however, most of the labor force slack can be seen in the cyclically low labor force participation rate. We estimate that the current employment shortfall—or the number of people who would be employed if the unemployment rate equaled its rate in December 2007 and if the labor force participation rate equaled its potential rate—is about 2¾ million people, and the elevated unemployment rate accounts for only about one-fourth of that amount. (The depressed labor force participation rate accounts for the other three-fourths of the shortfall.)
Over the next couple of years, faster compensation growth will encourage some people to enter or stay in the labor force, in CBO's estimation. That development will slow the longer-term decline in labor force participation, which is attributable both to underlying demographic trends and to federal policies, but it will also slow the fall of the unemployment rate.
Over the next few years, reduced slack in the economy will put upward pressure on inflation and interest rates. Nevertheless, CBO expects the rate of inflation (as measured by the price index for personal consumption expenditures) to stay below the Federal Reserve's goal of 2 percent through mid-2017—an outcome that is consistent with some remaining but diminishing slack in the economy and with widely held expectations for low and stable inflation.
CBO anticipates that the interest rate on 3-month Treasury bills, which has been near zero since the end of 2009, will begin increasing in the fourth quarter of 2015 and rise to 3.4 percent by the end of 2019. The rate on 10-year Treasury notes, CBO expects, will rise from an average of 2.5 percent in the fourth quarter of 2015 to 4.2 percent by the end of 2019. Those rates rise with the anticipated increase in the federal funds rate and with expectations of continued improvement in economic conditions.
Keith Hall is CBO’s Director.