Background for the Director’s Remarks to the Aspen Economic Strategy Group

Posted by
Phill Swagel
July 24, 2019

On Monday, I will be speaking to the Aspen Economic Strategy Group about the long-term fiscal challenges that the nation faces. I am providing this blog post to the members of the audience as background for my brief remarks.

The Long-Term Budget Outlook

In the Congressional Budget Office’s extended baseline projections, budget deficits drive federal debt held by the public to unprecedented levels. Debt rises from an amount equaling 78 percent of gross domestic product (GDP) in 2019, which is already high by historical standards, to 144 percent of GDP by 2049. That projected increase occurs because mandatory spending—in particular, outlays for Social Security and the major health care programs, primarily Medicare—and interest payments on federal debt grow more quickly than revenues do.

CBO’s extended baseline projections show the paths of federal spending, revenues, deficits, and debt for the next 30 years under a set of standard assumptions. One of those assumptions is that current laws generally do not change, but they also include the full payment of Social Security and Medicare benefits even if there are insufficient resources in the trust funds associated with each program. If instead lawmakers changed current laws to maintain certain major policies now in place—for example, if they prevented an increase in individual income taxes in 2026 or repealed an excise tax on high-cost employment-based health insurance that was enacted in 2010 and is scheduled to start in 2022—debt held by the public would increase even more than it does in the extended baseline projections.

The projections of debt incorporate our central estimates of various factors, such as productivity growth and interest rates on federal debt. The projections are also sensitive to changes in those factors. For example, if the growth of total factor productivity in the nonfarm business sector was one-half of one percentage point higher each year than we project, debt in 2049 would equal 106 percent of GDP, all else being equal; if such growth was one-half of one percentage point lower, debt in that year would equal 185 percent of GDP. If interest rates were one percentage point lower each year than we project, debt in 2049 would equal 107 percent of GDP; if they were one percentage point higher, debt in that year would equal 199 percent of GDP. The upshot is that even if productivity growth or interest rates differed in meaningful ways from our projections in the direction that would tend to reduce deficits, debt several decades from now would probably be much higher than it is today if current laws generally did not change.

Interest Rates

Interest rates play a particularly significant role in CBO’s projections, and they have been difficult for all forecasters to predict accurately. CBO projects a substantial increase in interest payments on federal debt—in part because of growing debt but also because of rising interest rates. Although the agency does not expect interest rates to rise as much as it previously anticipated, the projected increase in debt from an already high level means that even moderate increases in interest rates would lead to significantly higher interest payments.

CBO’s projections of interest rates reflect the slow growth of those rates over the past decade, which has generally surprised CBO, other government agencies, and many private-sector forecasters. CBO’s projections of interest rates also reflect the trajectory of federal debt in the agency’s baseline projections, prices in financial markets that indicate expectations of future interest rates, and other factors. Although factors such as slower labor force growth are projected to put downward pressure on interest rates, CBO expects rates to rise because of such factors as an increase in inflation, faster growth of productivity, increased demand for investment in emerging economies, and increases in federal borrowing.

Even as the outlook for federal borrowing has worsened over the past decade, financial markets have shown few signs of adverse effects, and interest rates on Treasury securities have remained relatively low. CBO has revised its projections of interest rates downward several times in response. For example, from 2030 to 2035, the average interest rate on federal debt is now projected to be 3.5 percent, 1.7 percentage points lower than the agency projected for that period in June 2010. Those downward revisions have reduced the projected costs of federal borrowing under current law. They have also reduced the size of the estimated changes in fiscal policy that would be necessary to stabilize debt as a percentage of GDP.

Although the government and the private sector have benefited from persistently low interest rates, which have dampened the costs of borrowing and investing, those low rates can also pose challenges, including their potential to constrain the implementation of monetary policy. Specifically, they could affect the Federal Reserve’s ability to use monetary policy to respond sufficiently to a negative economic shock, because conventional monetary policy would be less able to support economic growth once short-term interest rates were lowered to zero. In the long run, less effective monetary policy would reduce national income, on average. The current path of debt keeps rates from being even lower and could help mitigate those potential negative effects. It is also the case, however, that stronger economic growth for a sustained period could do the same without giving rise to the fiscal risks associated with growing debt.

Consequences of High and Rising Federal Debt

If federal debt as a percentage of GDP continued to rise at the pace that CBO projects that it would under current law, the economy would be affected in two significant ways. First, economic output over time would be dampened. Second, rising interest costs associated with that debt would increase interest payments to foreign debt holders and thus reduce the income of U.S. households by increasing amounts.

That debt path would also pose significant risks to the fiscal and economic outlook, although those risks are not currently apparent in financial markets. In particular, the risk of a fiscal crisis—that is, a situation in which the interest rate on federal debt rises abruptly because investors have lost confidence in the U.S. government’s fiscal position—would increase. There would also be a growing likelihood of less abrupt but still significant economic and financial consequences, such as expectations of higher inflation and more difficulty financing public and private activity in international markets.

In addition, high debt might cause policymakers to worry about the nation’s “fiscal space.” That is, they might feel restrained from implementing policies that would increase deficits further. Such policies might be intended to undertake investments, to otherwise promote economic activity, to strengthen national defense, or to respond to unforeseen events. (For more discussion of federal investment—that is, federal spending that is expected to contribute to the economy for some years into the future—see Federal Investment, 1962 to 2018.) And such policies could include changes to spending, revenues, or both. Policymakers would have to consider the trade-offs between the benefits and risks involved with new debt-financed activities.

In particular, concerns about fiscal space could affect the way policymakers responded to economic downturns. In a downturn, the economy would shrink, and certain increases in federal spending and reductions in revenues would take place automatically. As a result, deficits and debt (measured as a percentage of GDP) would be larger than they are in CBO’s extended baseline projections. The resulting higher and more steeply rising debt could increase the risk of a fiscal crisis. If so, policymakers would be facing that greater risk of a fiscal crisis in circumstances that in the past have led them to enact new policies that increased deficits. Moreover, in the next downturn, at the same time that policymakers could be concerned about fiscal space, they could also face a situation in which the Federal Reserve had less flexibility in implementing monetary policy. Those factors suggest that lawmakers could avoid some risks to the economy by reducing deficits in times of relatively strong economic growth, thus giving the budget more fiscal space.

Fiscal Policy Choices

To put the federal budget on a sustainable long-term path, lawmakers would need to make significant policy changes—allowing revenues to rise more than they would under current law, reducing spending for large benefit programs to amounts below those currently projected, or adopting some combination of those approaches. CBO does not make policy recommendations. Our role is to explain where we project the budget is headed and what the effects would be if the Congress made changes to current law.

Lawmakers may ask several questions as they consider policies that would reduce budget deficits.

  • What is an acceptable amount of federal debt? In considering that question, policymakers would assess the benefits, costs, and risks of the activities associated with varying levels of federal debt.
  • What is the proper size of the federal government, and what would be the best way to allocate federal resources?
  • How large would policy changes need to be to reach certain targets for debt?
  • When should any changes in deficits occur, and at what pace should they take place?
  • Is it more valuable to reduce budget deficits now, when the economy is in its 11th year of expansion, so that policymakers will feel that they have more fiscal space when a recession occurs—particularly given the potential constraints on monetary policy? Or is it more valuable to increase budget deficits now, by reducing taxes or increasing spending, in ways that could help reduce the chances of a reduction in output in the near term or fund investments that could support stronger growth in the future?
  • What types of policy changes would most enhance prospects for near-term and long-term economic growth?
  • What would be the distributional implications of proposed changes—that is, who would realize economic losses or benefits?

For some questions, such as how to quantify the risks of high and rising debt, how to assess the value of deficit-financed policies in the near term, and how to assess the potential effects of particular policies on long-term growth, more research is needed to provide answers. Answers to questions about issues such as the proper size of government and the best way to allocate federal resources can only be provided by voters and their elected officials. For other questions, CBO has examined some of the trade-offs involved.

The Size of Policy Changes Needed to Meet Various Goals for Deficit Reduction

Lawmakers have pointed out that federal debt held by the public as a percentage of total output cannot rise forever, and they have asked CBO what changes in federal budget deficits would be necessary to reduce that debt to various targets over the long term.

If lawmakers wanted debt in 2049 to match its current level of 78 percent of GDP, they could cut noninterest spending or raise revenues (or do both) beginning in 2020 by amounts totaling 1.8 percent of GDP each year. In 2020, 1.8 percent of GDP would be about $400 billion, or $1,200 per person. If such an adjustment was made in each year, the budget would show a primary surplus (that is, a surplus excluding net spending for interest) of 0.2 percent of GDP in 2030 and a primary deficit of 0.7 percent of GDP by 2049. If the changes came entirely from revenues or spending, they would amount to an 11 percent increase in revenues or a 10 percent cut in noninterest spending (relative to the amounts in CBO’s extended baseline projections).

If lawmakers wanted to decrease debt to 42 percent of GDP (its average over the past 50 years) by 2049, they could cut noninterest spending or raise revenues (or do both) beginning in 2020 by amounts totaling 2.9 percent of GDP each year. In 2020, 2.9 percent of GDP would be about $630 billion, or $1,900 per person.

  • If those changes came entirely from revenues, and if collections of the various types of revenues were increased proportionally, total revenues would need to be about 16 percent higher each year over the 2020–2049 period. On average, that adjustment would result in federal taxes that were about $2,100 higher than they are under current law for households in the middle fifth of the income distribution in 2020.
  • If the changes came entirely from spending, and if all types of noninterest spending were cut by an equal percentage, spending overall would need to be about 15 percent lower in each of the next 30 years. For example, initial annual Social Security benefits would be about $2,800 lower, on average, for people in the middle fifth of the lifetime earnings distribution who were born in the 1950s and who first claimed benefits at age 65.

Although spending cuts could be implemented in many ways, it would be difficult to make large cuts without affecting older people. In 2018, about 40 percent of noninterest outlays were for the population age 65 or older (mostly for Social Security and Medicare); that number is projected to rise to 50 percent by 2029.

In these examples, the projected effects on debt include both the direct effects of the policy changes and the feedback to the federal budget that would result from faster economic growth. In general, reducing federal debt increases the amount of money available for private investment in capital goods and services, which increases the stock of private capital and economic output. A given policy change could also alter productivity growth and people’s incentives to work and save, which would in turn affect overall economic output and feed back to the federal budget—but the policy changes mentioned here are illustrative, and therefore the results do not incorporate those effects.

Reducing the deficit sooner would result in less accumulated debt and less uncertainty about the policies that lawmakers would adopt, and the necessary policy changes would be smaller. However, if lawmakers cut spending or increased taxes abruptly, people might have insufficient time to plan for or to adjust to the new system. Over the first several years following their adoption, such policy changes would dampen overall demand for goods and services, thus decreasing output and employment below amounts projected under current law. That dampening effect is expected to be temporary, however, because the reductions in demand would push down prices of goods and services and the resulting actions by the Federal Reserve would lower interest rates. Those developments would ultimately lead to a rebound in overall demand.

Effects on Different Generations

Faster or slower implementation of policies to reduce budget deficits would tend to impose different burdens on different generations over the course of their lifetimes. Also, policy changes could have sharply different effects on different groups within any given generation.

Reducing deficits sooner would probably require older workers and retirees to sacrifice more but would benefit younger workers and future generations. Reducing deficits later would require smaller sacrifices from older people but greater ones from younger workers and future generations.

CBO has analyzed those trade-offs in two ways. First, it estimated the extent to which the size of policy adjustments would change if deficit reduction was delayed by 5 or 10 years. (Again, CBO did not make any assumptions about the specific policy changes that might be used to reduce the deficit.) For example, if lawmakers sought to reduce debt as a share of GDP to its historical 50-year average of 42 percent in 2049, and if the necessary policy changes did not take effect until 2025, the annual reduction in the primary deficit would need to equal 3.5 percent of GDP, rather than the 2.9 percent that would accomplish the same goal if the changes were made starting in 2020. If lawmakers chose to wait another 5 years to implement the policies—that is, until 2030—even larger changes would be necessary; the required annual reduction in the primary deficit would amount to 4.4 percent of GDP. The larger changes in the event of later policy actions would concentrate the burden of those actions on people who are younger today and on people who will be born in the future.

Second, CBO studied the effects of waiting to resolve the long-term fiscal imbalance on the average per capita income of various generations. CBO compared economic outcomes under two approaches. One would stabilize debt as a percentage of GDP starting in a particular year, and the other would wait 10 years to do so. For policies such as across-the-board benefit cuts or tax rate increases for all adults, CBO estimates, the average income of generations born after the earlier implementation date would be lower under the approach with a 10-year delay. In contrast, people born more than 25 years before the earlier implementation date would have a higher average income if action was delayed—mainly because they would partly or entirely avoid the policy changes needed to stabilize the debt. Generations born between those two groups could either gain or lose from delayed action, depending on the specific details of the policy changes.

CBO’s analysis indicates that delaying policy changes would reduce the well-being of younger generations compared with the effects of making policy changes earlier. Moreover, the further in the future a policy change occurred, the more the well-being of older generations would be improved and that of younger generations worsened. However, the additional burden on younger generations resulting from delaying policy changes would be relatively small compared with their lifetime earnings potential because, on average, future generations are expected to have much higher income than current generations have.

Even if lawmakers waited to implement policy changes to reduce debt in the long term, deciding about those changes sooner would offer two main advantages. First, people would have more time to prepare by changing the number of hours that they worked, the age at which they planned to retire, and the amount they chose to save. Second, policy changes that reduced debt over the long term would hold down longer-term interest rates and could lessen uncertainty, thus enhancing businesses’ and consumers’ confidence. Those factors would boost output and employment in the near term.

Such generational issues are just one of several areas in which policymakers would consider the trade-offs inherent in stabilizing the fiscal outlook.

Phillip L. Swagel is CBO’s Director.