When CBO's Director testified before Congress at the beginning of February, he was asked how the baseline budget projections in The Budget and Economic Outlook: 2017 to 2027 would be affected if individual economic variables differed from what CBO expects. Appendix B in that volume answered that question in part, offering rough "rules of thumb" to give a broad sense of how the deficit might change if productivity growth, interest rates, or inflation proved less favorable than projected. This blog post recaps those rules and presents a fourth, which involves the effects of slower-than-projected growth in the labor force.
CBO's Rules of Thumb
Here are CBO's rules of thumb:
- Productivity growth that was 0.1 percentage point slower each year than CBO expects would affect gross domestic product (GDP), income, and interest rates, and thereby make the cumulative deficit for the 2018–2027 period $273 billion larger than projected in CBO's baseline.
- Interest rates that were 1 percentage point higher each year than CBO expects would make the cumulative deficit for the period $1.6 trillion larger than projected (if there were no changes in other economic variables).
- Inflation that was 1 percentage point higher each year than CBO expects would make the cumulative deficit for the period $1.3 trillion larger than projected (if there were no changes in other economic variables—except for nominal interest rates, so that real interest rates remained unchanged).
- Labor force growth that was 0.1 percentage point slower each year than CBO expects would affect GDP, income, and interest rates, and thereby make the cumulative deficit for the period $185 billion larger than projected.
Appendix B of The Budget and Economic Outlook: 2017 to 2027 provides more detail, as does this table.
When creating the four rules of thumb, CBO incorporated the assumption that the changes in economic conditions would begin in January 2017. Also, each rule of thumb is roughly symmetrical. Thus, if productivity growth or the labor force growth rate was higher than in CBO's baseline, or if interest rates or inflation was lower, the effects would be about the same as those shown here, but with the opposite sign.
In addition to being symmetrical, the rules are roughly scalable for moderate differences in growth rates. For example, a difference in inflation of 1.1 percentage points in each year, rather than 1 percentage point, would increase the change in the deficit by about 10 percent—but such a calculation would be less useful for a substantially different rate of inflation. CBO chose the magnitudes of the differences in economic variables, such as the difference of 1 percentage point each year in the rate of inflation, solely for simplicity. Those differences do not indicate any estimate of how actual economic performance might differ from CBO's projections.
Economic and budget projections are inherently uncertain. The economy, demographics, and other factors will undoubtedly differ from what CBO projects, and those variations will in turn cause budgetary outcomes to deviate from CBO's projections. The rules of thumb therefore provide a sense of how strongly differences in individual economic variables would affect projected budget totals—both directly and indirectly (that is, by affecting other economic variables). For example, different inflation from what CBO expected when making its baseline projections would directly affect spending and tax collections. The difference would also indirectly affect federal interest payments, because higher inflation leads to higher interest rates.
However, simple rules of thumb that focus on changes in a single economic measure do not capture the effects of more complicated interactions stemming from broader changes in the economy or changes in fiscal policy. For example, if a change in government spending caused changes in inflation, there would be more effects on the economy and the budget than those described by the inflation rule of thumb.
In addition, the effect of a change in a single variable on the rest of the economy and the budget would depend on the general economic conditions prevailing at the time. The rules of thumb presented here are consistent with the general economic conditions that underlie CBO's baseline projections.
Finally, combining two or more rules of thumb may not generate the same results as summing the individual effects reported here. For example, if rates of productivity growth and labor force growth were both higher than they are in CBO's baseline projections, the two effects would interact, resulting in a boost to output growth that was slightly larger than the boost that would be suggested by simply adding the two effects to each other.
Lower Rates of Labor Force Growth
CBO's new rule of thumb supposes that each year, starting in 2017, the labor force grows 0.1 percentage point more slowly than currently projected. If population growth followed CBO's projections, the slower growth of the labor force would imply a labor force participation rate that was about 0.7 percentage points lower than expected by 2027—a gap that would have grown in roughly equal increments each year. As a result, the cumulative deficit during the 2018–2027 period would be larger than projected in the baseline by $185 billion, CBO estimates. Specifically, lower revenues would add $211 billion to deficits, and higher mandatory outlays would add an additional $2 billion, but lower interest outlays would subtract $28 billion.
To arrive at those estimates, CBO performed a simplified analysis, beginning by examining how slower growth in the labor force might affect GDP, income (including labor compensation), and interest rates. Slower-than-projected growth in the labor force would push up CBO's estimate of the hourly wage rate, which would increase total labor compensation; however, that effect would be more than offset by a smaller labor supply, so in the end, total labor compensation would be lower than it is in CBO's baseline. Meanwhile, fewer workers would be using capital, so the returns on that capital would decline. Because Treasury securities compete with other investments for investors' money, lower private returns imply that interest rates on Treasury securities would also be lower.
CBO concluded that the slower growth in the labor force would reduce GDP growth by slightly less than 0.1 percentage point each year. Meanwhile, interest rates would be about 1 basis point (that is, 0.01 percentage point) below CBO's forecast for 2017; that difference would increase in each subsequent year by less than 1 additional basis point. By the end of 2027, GDP and labor income would be 0.9 percent lower than they are in the baseline, and interest rates would be about 6 basis points lower. (Other variables—such as the unemployment rate, inflation, consumer spending, the distribution of labor income, and rates of retirement—could also be affected by slower labor force growth; however, this rule of thumb does not include the effects of changes in those variables.)
The slower growth in the economy would lead to slower growth in taxable labor income and profits, resulting in tax revenues that were lower than projected in the baseline—$1 billion lower in 2017 and $44 billion lower in 2027. Also, higher wage rates among a smaller number of workers would lead to $2 billion more in mandatory outlays over the 2018–2027 period. Specifically, Medicare and Social Security benefits would increase, boosting mandatory spending by less than $6 billion, but a little more than $3 billion of that amount would be offset by a decrease in outlays for unemployment insurance benefits and the refundable portions of the earned income and child tax credits.
Because slower labor force growth would lower interest rates, the amount of interest that the federal government would pay on its debt would be $48 billion smaller than projected over the 2018–2027 period. However, the reduced revenues and slightly higher mandatory spending would require the federal government to borrow more to finance the resulting net increase in the deficit. That additional borrowing would add $19 billion to interest payments over the period. On net, CBO estimates, interest outlays would be $28 billion less over the 10-year period than projected in the agency's baseline.
Dan Ready is an analyst in CBO's Budget Analysis Division. Christina Hawley Anthony, Jonathan Huntley, Jamease Kowalczyk, Noah Meyerson, Shannon Mok, Felix Reichling, and Emily Stern contributed to the analysis.