As part of the legislative process, the Congressional Budget Office supplies the Congress with cost estimates for legislation, economic and budget projections, and other economic assessments. Information from the research community is an important element of CBO’s analyses. This is the fifth in a series of blog posts discussing research that would enhance the quality of the information that CBO uses in its work. (Earlier posts in the series discussed the need for new research in the areas of energy and the environment, finance, health, and labor.) Please send comments to communications@cbo.gov.
CBO regularly prepares forecasts of key economic variables, including output, income, employment, inflation, and interest rates. The agency also evaluates the macroeconomic effects of proposed or enacted legislation. CBO is on the lookout for new research on various topics in the area of macroeconomics, including trends in productivity growth and interest rates on Treasury securities, as well as the effects of fiscal policy on a broad range of economic variables. The agency is currently working on those topics, and there are significant gaps in the relevant research literature.
CBO’s macroeconomic forecasts are produced by a team of analysts who closely follow economic developments and data, consult with experts from within and outside the agency, and use several models, including a large-scale macroeconometric model (Arnold 2018). CBO’s macroeconometric model focuses on the interactions between aggregate demand (which is driven by consumer spending, business and residential investment, government spending, and net exports) and aggregate supply (which is underpinned by the factors that determine potential output). CBO’s Panel of Economic Advisers, a group of widely recognized experts with a variety of backgrounds, reviews the agency’s forecasts.
CBO uses a suite of models to analyze the short- and longer-term economic effects of changes in fiscal policy. In the agency’s view, fiscal policy affects the economy in the short term mainly by altering the aggregate demand for goods and services. To analyze those effects, CBO considers empirical evidence about how households, businesses, and federal, state, and local governments would respond to changes in certain policies. CBO also uses structural models that describe how policy changes would affect economic output, employment, interest rates, inflation, and other macroeconomic variables (Lasky 2022, CBO 2020, CBO 2014). To analyze the longer-term economic effects of fiscal policy stemming from changes in national saving, people’s incentives to work and save, and businesses’ incentives to invest, the agency generally uses a Solow-type growth model (CBO 2021) and a life-cycle growth model (CBO 2019; Reichling and Nishiyama 2015). CBO also uses dynamic general-equilibrium models and vector autoregression models to assess specific aspects of policies and the uncertainty of the economic effects of policy changes.
How Will Future Rates of Productivity Growth and Interest Rates Differ From Those in the Past?
CBO’s budget projections crucially depend on the agency’s projections of economic variables—especially projections of productivity growth and the interest rates on Treasury securities.
A key variable underpinning CBO’s projections of productivity growth is the growth of total factor productivity (TFP). In CBO’s long-term projections, TFP growth accounts for more than half of the growth of real gross domestic product (that is, GDP adjusted to remove the effects of inflation). The agency draws on academic research to assess trends in TFP growth and to estimate the effects of policy changes on TFP. That research has developed methods to assess how the trend growth rate of TFP varied across business cycles and changed during the coronavirus pandemic; whether TFP growth is additive or geometric; and the contributions to TFP growth from factors such as workers’ average educational attainment, federal investment, and climate change (Fernald and Li 2022, Philippon 2022, CBO 2021, Bom and Ligthart 2014). Further research that identifies trends in TFP growth could enhance CBO’s projections of economic growth, tax revenues, and government spending.
Research about the factors driving trends in the interest rates on Treasury securities is also important to CBO. Economic theory suggests that the real rate of return on private capital is determined by the growth rate of potential output, the private rate of saving, and the share of income paid to capital. Identifying and projecting trends in each of those determinants is critical for forecasting interest rates in the long run. Although the real rate of return on private capital has remained relatively constant in recent decades, the real rate of return on safe assets—like Treasury securities—has declined considerably (Rachel and Smith 2017). Researchers have attributed that growing disconnect to several factors (Gamber 2020). Better understanding the magnitude and persistence of each factor and also of the linkages between the rates of return on investments in risky assets (such as physical capital) and Treasury securities would enhance the framework that CBO uses to project interest rates and net interest payments on federal debt.
How Do Changes in Fiscal Policy Affect Broad Economic Outcomes?
Most of the existing research examining the economic effects of spending and tax policies provides estimates of fiscal multipliers (changes in GDP resulting from a one-dollar change in spending or revenues) that are averaged across different policies, economic conditions, and income, wealth, and demographic groups (Ramey 2019). Less is known about the effects of policy changes on variables such as inflation, wages, interest rates, and relative prices—or about how those effects vary depending on specific spending and tax policies, different income, wealth, and demographic groups, or different economic conditions (including conditions in labor markets and supply chains).
A better understanding of how federal spending and tax policies affect a broader set of economic variables would help CBO evaluate the ways that such policies affect the economy and distributional outcomes. Further research on the state-dependent or nonlinear effects of policies would help the agency better assess how those effects vary under different economic, financial, and budgetary circumstances.
Richard DeKaser is CBO’s Director of Macroeconomic Analysis. This blog post includes contributions from the following CBO staff: Aaron Betz, Scott Craver, Devrim Demirel, Jeffrey Kling, Mark Lasky, Junghoon Lee, Chandler Lester, Jaeger Nelson, and Jeffrey Schafer.