Revised February 1, 2004

DEFICIT PICTURE GRIMMER THAN NEW CBO PROJECTIONS SUGGEST
By Richard Kogan, David Kamin, and Joel Friedman

PDF of analysis

View Related Reports

If you cannot access the files through the links, right-click on the underlined text, click "Save Link As," download to your directory, and open the document in Adobe Acrobat Reader.

Summary

On January 26, the Congressional Budget Office issued new budget projections that show the federal government running a large cumulative deficit over the next ten years.  As CBO acknowledges, however, its baseline projection is unrealistically optimistic, since it does not include the costs of continuing various policies, such as the recent tax cuts.[1]  Omitted costs that are likely or virtually certain to be incurred exceed $­­3.3 trillion.  Adjusting the CBO baseline for such costs raises the deficit projection to $5.2 trillion over the next ten years.  Other analysts, such as economists at the Brookings Institution and Goldman Sachs, have also projected that deficits will exceed $5 trillion over the decade.

This analysis explains why — and to what extent — the budget picture is grimmer than the CBO projections may suggest.  It also examines new CBO data that shed light on the causes of the sharp fiscal deterioration of recent years.  These data indicate that among actions policymakers have taken, tax cuts have added the most to the deficits.

Key Findings

  • If the tax cuts are extended and other likely costs occur, deficits will total $5.2 trillion over the next ten years, will never fall below $400 billion in any year, and will exceed $700 billion by 2014.
  • Since January 2001, the budget outlook for the ten years 2002 to 2011 has deteriorated by $9.3 trillion, with projections of surpluses being replaced by projections of large, sustained deficits.
  • In terms of legislation since 2001, tax cuts are the single most important factor in explaining the move from surpluses to deficits.

Key findings of the analysis include:

Federal spending, on the other hand, will average about 20.6 percent of GDP over the next 10 years, assuming enactment of all likely expenditures reflected in the more realistic ten-year deficit projection.  This is lower than the level of federal spending in every year from 1980 through 1995.

Tax Cuts Are The Single Largest Way Policymakers Have Increased Deficits

In January 2001, CBO projections showed surpluses over the ten-year period from 2002 through 2011 totaling $5 trillion.  (This figure has been adjusted down from the official $5.6 trillion CBO 2001 estimate to include likely or inevitable costs that were left out at that time, thereby making the 2001 projection comparable methodologically to our current projections; see box on page 6.)  Our current estimate of this same ten-year period shows cumulative deficits of $4.3 trillion, for a total deterioration of $9.3 trillion over the ten-year period 2002 to 2011.  (This $4.3 trillion figure differs from the $5.2 trillion cumulative deficit cited above, because the latter figure covers the years 2005-2014.)

What caused a projected surplus of $5 trillion to become a projected deficit of $4.3 trillion?  Approximately 35 percent of this stunning $9.3 trillion deterioration is due to the tax cuts enacted over the past three years or assumed in this analysis, making tax cuts the single largest factor attributable to policymakers’ actions.  Another 28 percent of the deterioration is due to spending legislation, with more than two-thirds of the growth in spending representing increased costs for defense, homeland security, and the war on terrorism (and only one-twenty-fifth of the new spending representing increased costs for domestic discretionary programs outside homeland security).  The remainder of the deterioration stems from the view CBO now holds that the economic and technical underpinnings of its 2001 projection were too rosy.

Continuing Large Deficits Harm The Economy

The deficits we project — which will only grow larger when the baby boomers begin to retire at the end of the decade — pose a threat to the long-term health of the economy.  Persistent large deficits tend to reduce national saving, crowd out private investment, and slow economic growth.  In addition, former Treasury Secretary Robert Rubin and several economists recently warned that the projected long-term budget imbalances have become so large that they ultimately could lead to serious “financial and fiscal disarray” and cause a “fundamental shift in market expectations and a related loss of confidence at home and abroad.”[2]

 

CBO’s 10-year Projections Do Not Reflect Several Trillion Dollars in Likely Costs

Table 1

CBO Projections Do Not Include Likely Costs,

2005-2014

(In trillions of dollars)

CBO January Projections

$1.9

Tax Cut Extension

$2.2

AMT Relief

$0.7

Defense and International Spending

$0.4

Other Domestic Appropriations

$0.0

Resulting Deficit Projections

$5.2

May not add due to rounding; figures include associated interest costs

Under CBO’s official baseline projection, large deficits in 2004 will be followed by falling deficits and then by a small budget surplus in 2014.  Over the ten-year period from 2005 through 2014, the sum of CBO’s projected deficits and surpluses nets to a cumulative deficit of $1.9 trillion.  CBO’s projections imply steadily improving budgets after 2004.

But as is widely recognized, this projection is unrealistic.  It omits an estimated $3.3 trillion in costs over the next ten years that result from legislation Congress and the President are likely — and in many cases, virtually certain — to enact.[3] 

CBO does not include any of these various costs in its projection because it follows mechanical rules that permit the inclusion only of tax and entitlement provisions that have already been enacted as well as funding levels for discretionary (i.e., non-entitlement) programs — including defense, international, and homeland security programs — that equal current levels adjusted only for inflation.  Adding likely or inevitable costs raises the projected deficits to $5.2 trillion over the next ten years.  (See Table 1, on page 3.  For further details, see Appendix A.)

Other analysts have reached similar conclusions about likely deficits.  For example, Brookings economists estimate the deficits at $5.5 trillion over the ten years from 2005-2014.[5]  (Their estimate is modestly larger than the one presented here, primarily because it includes a somewhat larger cost for AMT relief.)  Deficit estimates from Wall Street firms such as Goldman Sachs are similar as well.

This projection of $5.2 trillion in cumulative deficits over the next ten years includes $2.4 trillion in surpluses in the Social Security trust funds.  Outside of Social Security, the projected ten-year deficits total $7.6 trillion.

Administration to Use Gimmicks to Achieve Goal of Cutting Deficit in Half by 2009

These projections contradict Administration claims that deficits, as a share of the economy, will be cut in half in five years.  The President’s budget, to be released February 2, is likely to meet this self-constructed goal, but it will do so only by leaving out about $200 billion in likely costs in 2009, the fifth year.  

Specifically, the OMB figures are likely to exclude the costs of extending relief from the mushrooming Alternative Minimum Tax after 2005; to omit the costs after 2005 or 2006 of extending a series of very popular tax breaks that come up for renewal every couple of years and always are extended; to leave out the costs of fighting terrorism internationally after September 30, 2004; and to fail to reflect the full costs of the Administration’s own “Future Year Defense Plan.” [6]

In this regard, the Administration’s budget for years after 2005 is likely to be something of an exercise in fiscal fantasy.  Instead of being cut in half over the next five years, the deficit is likely to hold steady at above 3 percent of GDP through 2010, and from there to rise to approximately 3.9 percent of GDP by 2014 and higher levels in subsequent years.

 

How Did These Deficits Come About?

In January 2001, CBO’s baseline projection showed surpluses totaling $5.6 trillion over the ten-year period 2002-2011.  Since that time, the budget world has turned on its head.  Over the same ten-year period, deficits now are expected to total $4.3 trillion.

From a $5.6 trillion surplus to a $4.3 trillion deficit is a swing of $9.9 trillion.  On a comparable basis, the deterioration is $9.3 trillion, however, rather than $9.9 trillion (see box on page 6).  A deterioration of $9.3 trillion in the budget outlook over a period of 36 months is remarkable.  Of this $9.3 trillion drop, 37 percent is due to economic and technical reestimates.  The most important legislative factor is the tax cuts, accounting for 35 percent of the $9.3 trillion deterioration.  Spending increases enacted by Congress and the President are responsible for the final 28 percent of the shift from surpluses to deficits.

Comparable Projections

In January 2001, CBO projected a $5.6 trillion surplus over the ten-year period 2002-2011.  To use that projection as a basis for comparison with the current projection, we need to make sure that both projections are made on a comparable basis.  Since we have incorporated certain likely or inevitable costs into the current deficit projection, similar costs also must be incorporated into CBO’s January 2001 projection before the projections can be compared.

Doing so reduces the surpluses reflected in the January 2001 projection by about $600 billion.  After making these adjustments for comparability purposes, the difference between the surpluses projected in January 2001 for the 2002-2011 period and the deficits we now project for those years is $9.3 trillion.

Reestimates.  Economic and technical assumptions account for nearly $3.4 trillion of the fiscal deterioration since January 2001.  The economic and technical assumptions that CBO employed in January 2001 have proven too optimistic.  In January 2001, CBO did not foresee the recession that was a few months off.   The recession is significant primarily in the short term, however; the larger problem is with CBO’s “technical assumptions.”  In particular, CBO now believes that its January 2001 projections significantly overstated the level of tax revenues that the U.S. economy will generate.  (The figures for the cost of CBO’s economic and technical reestimates, like the figures for all components of the budget deterioration discussed here, include the associated increases in interest payments on the debt.)

Tax legislation.  Tax cuts account for $3.3 trillion of the $9.3 trillion deterioration for the years 2002-2011, making them the most costly legislative change since 2001.  Moreover, the share of the fiscal deterioration that is attributable to tax cuts rises over time.  By 2014, tax cuts will account for 40 percent of the deterioration. 

Defense, Homeland Security, and International Affairs.  Since 2001, new funding in the areas of defense, homeland security, and international affairs has accounted for more than two-thirds of all legislated spending increases.  Of the $9.3 trillion fiscal deterioration, $1.8 trillion — or about 20 percent — comes from increases in funding for these areas.[7]

Prescription drugs and other entitlement legislation.  Enacted entitlement increases, including the new Medicare prescription drug benefit, account for $663 billion — or 7 percent — of the $9.3 trillion deterioration.  The lion’s share of this amount is for the prescription drug benefit.  The enacted entitlement increases also include the farm bill, the first airline bailout, compensation for victims of the terrorist attacks, two temporary provisions for extended unemployment benefits, temporary state fiscal relief, two bills increasing payments to Medicare providers, and legislation increasing benefits for certain categories of veterans.

Table 2

The Projected $9.3 Trillion Deterioration
(2002-2011 totals in trillions of dollars)

Economic reestimates

$0.7

8%

Technical reestimates

$2.7

29%

Tax legislation

$3.3

35%

Defense, homeland, & int.

$1.8

20%

Rx drugs & other entitlement legislation

$0.7

7%

Domestic disc. other than homeland

$0.1

1%

TOTAL changes

$9.3

100%

May not add due to rounding; all figures include associated interest costs.

Domestic Appropriations other than Homeland Security.  A final $111 billion — or 1 percent — of the deterioration is due to increases in domestic “discretionary” programs other than homeland security.  This amount is less than one-sixteenth the increase in costs for defense, homeland security, and international programs.

Although substantial, the increase in spending caused by Congressional actions is considerably smaller than the loss of revenues that has resulted from the tax cuts.  In recent months, some have blamed current federal deficits on “exploding” spending.  The budget data contradict such claims.  The cost of the tax cuts is nearly 25 percent larger than the cost of spending legislation over the 2002-2011 period. 

Furthermore, the economic and technical reestimates are almost entirely downward revisions in revenues.  Combining the tax cuts and the downward revisions in revenues, Table 3 shows that 79 percent of the $9.3 trillion deterioration — or $7.3 trillion of the total — reflects a decline in revenues plus the associated interest costs.  Only $1.9 trillion, or 21 percent, of the deterioration reflects an increase in spending.  The drop in revenues has thus been nearly four times as important as the increase in spending in explaining the large shift from surpluses to deficits.

 

Revenues At Historic Lows Over the Decade

This dramatic drop in federal revenues has left them at historic lows.  Over the coming decade, revenues measured as a share of the economy will remain well below their modern average.   Spending, on the other hand, will be near its recent historical norm as a share of the economy.  This decade thus will feature large deficits stemming from unusually low revenue levels, coupled with spending levels that are normal in historical terms.

Table 3

The Projected $9.3 Trillion Deterioration
(2002-2011 totals in trillions of dollars)

Revenues

$7.3

79%

Expenditures

$2.0

21%

TOTAL changes

$9.3

100%

May not add due to rounding; all figures include associated interest costs.

Table 4 compares the spending and revenue levels for the coming decade to the levels during the previous business cycle, 1989 through 2000.  The 1989 – 2000 period covered both good times and bad; more significantly, those were years of greater fiscal discipline.

  • Table 4 shows that the average level of revenues over the next ten years is expected to be 17.1 percent of GDP.  This is 1.6 percent of GDP lower than the average for 1989 – 2000.  As the table also shows, this drop in revenues accounts for all of the difference between average deficits during the 1989 – 2000 period and the deficits now projected for the next ten years.
  • The 17.1 percent average revenue level is low compared not only with levels in the 1989 – 2000 period but also with average revenue levels during the entire second half of the 20th century.  The average revenue level projected for the next ten years, measured as a share of the economy, is lower than the average revenue levels for the 1950s, 1960s, 1970s, 1980s, and 1990s.
  • Revenues will remain at historically low levels even after a full economic recovery.  In 2014, revenues are projected to reach 17.5 percent of GDP.  This still will be below the average revenue levels for all post-war decades except the 1950s.
  • In contrast, despite the increases in spending for defense and certain other programs that are built into our more realistic projections, spending from 2005 through 2014 will average 20.6 percent of GDP.  This is directly in line with the average level of spending from 1989 through 2000.
  • The average spending level that we project, measured as a share of the economy, is lower than the spending levels for every year from 1980 through 1995.
Table 4

As a Share of GDP

 

 

89-00

05-14

 

Difference

Revenues

18.7%

17.1%

-1.6%

Spending

20.6%

20.6%

 0.0%

Deficits

-1.8%

-3.5%

-1.6%

May not add due to rounding

By the end of this decade, the aging of the population and continued increases in health care costs will drive up spending for Social Security, Medicare, and Medicaid, and total outlays will rise to historic levels.  If that increase in spending is coupled with the continuation of historically low revenues, as is projected, the nation will face even larger deficits.  This upsurge in spending is still some years away, however, and the story of this decade’s deficits — and of the dramatic turnabout of the past three years — is more about falling revenues than rising spending.

 

Implications for the Nation’s Economic Health: Rising Debt and Slower Growth

By the end of the decade, the first of the baby-boomers will have reached retirement age. Deficits are projected to rise substantially in the years that follow.  The costs of Medicare, Medicaid, and Social Security will grow faster than the economy and the nation’s revenue base.  By running large deficits in the years before the baby boomers retire, the country is squandering the opportunity to prepare for this major demographic change.

If the debt were to decrease substantially during the coming decade — as it was on course to do only a few years ago — the federal government could avoid hundreds of billions of dollars a year in interest payments every year in the future.  Had we continued to adhere to policies to shrink the debt over this decade, we would largely have eliminated the cost of one of the biggest and most wasteful of federal programs — interest payments on the debt.

Three years ago, net interest payments on the debt were projected to disappear before the end of the decade as the debt shrank to zero.  Now, under our projections, the debt will reach $9.7 trillion in 2014, or almost 54 percent of GDP.  This is a major increase from 2001, when debt was 33 percent of GDP.  As a result, interest payments on the debt are projected to rise significantly.

For instance, in January 2001, interest payments were projected to be $715 billion over the 2002 to 2011 period; today, we estimate that interest payments will total $2.5 trillion for that same ten-year period, a more than three-fold increase.  Over the ten years from 2005 to 2014, interest payments are estimated to total $3.4 trillion.  By 2014, interest payments are projected to consume $486 billion a year and eat up 13 percent of the federal budget.  That will make it harder to fund programs like Social Security, Medicare, and Medicaid without running massive deficits.

The projected deficits also pose risks to the nation’s long-term economic health.  Higher deficits reduce national saving and thereby result in less domestic investment (and more borrowing from overseas).  Expectations of persistently high future deficits also can raise long-term interest rates.  Such outcomes lower the nation’s future income and standard of living.

The large long-term deficits that the United States now faces are stirring concern internationally.  An International Monetary Fund report released earlier this month scolded U.S. policymakers in terms usually reserved for third-word countries with unstable fiscal policies.  As the New York Times reported, “. . . the [IMF] report sounded a loud alarm about the shaky fiscal foundations of the United States, questioning the wisdom of the Bush administration’s tax cuts and warning that large budget deficits pose ‘significant risks’ not just for the United States but for the rest of the world.”[8]

Similarly, a new analysis by former Treasury Secretary Robert Rubin, Brookings Institution economist Peter Orszag, and Wall Street economist Allen Sinai warns that “the scale of the nation’s projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur.”  Rubin and his colleagues warn that the budget deficits we will face if we remain on our current policy course, by making the tax cuts permanent and continuing other spending and tax policies, could lead to “financial and fiscal disarray” and cause a “fundamental shift in market expectations and a related loss of confidence at home and abroad.”  While it is impossible to know at what point this change in market expectations might take place, Rubin and his colleagues observe that once it occurs, it would “magnify the costs associated with any given underlying budget deficit and depress economic activity much more than the conventional analysis would suggest.”[9]

 

Conclusion

CBO now projects cumulative deficits of $1.9 trillion over the next ten years.  But as CBO notes, this projection is based on a mechanical formula that leaves out various likely costs.  Adjusting for the extension of the tax cuts, continuation of AMT relief, and full funding of the Administration’s defense plan, among other costs, brings the ten-year cumulative deficit to $5.2 trillion.

This represents a fiscal sea change from three years ago.  In 2001, surpluses were projected through the end of the decade, and the federal debt was expected to disappear.  Now, unsustainably large deficits loom as far as the eye can see.

The single largest legislative factor in explaining this dramatic shift from surpluses to deficits is the tax cuts.  This year, revenues are expected to represent 15.8 percent of GDP, the lowest level since 1950.  Even after the economy recovers, revenues will be lower, as a percentage of the economy, than the average revenue levels for the 1960s, 1970s, 1980s, or 1990s.

When the baby-boomers begin to retire at the end of the decade, the federal government will face even more difficult fiscal times.  Spending will rise to historically high levels as the aging of the population and continued increases in health care costs drive up costs for Social Security, Medicare, and Medicaid.  In short, if we remain on our current policy course, revenues will remain at unusually low levels while expenditures grow to historically high levels.  The large imbalance between revenues and spending that lies ahead threatens to produce dangerously large deficits.

The story of this decade’s deficits and of the dramatic turnabout of the past three years, however, is more about falling revenues rather than rising spending.  By running large deficits over this decade, federal policymakers are missing an opportunity to help prepare for the baby boomers’ retirement and to place the nation on firmer fiscal and economic footing for the long term.

Appendix A
The CBO Baseline and What It Does Not Include

CBO’s official baseline estimates are a projection of future expenditures and revenues, calculated according to a rigid set of rules under which the baseline reflects current law as it is scheduled to apply in future years.  CBO’s official projections thus assume, for example, that all of the tax cuts scheduled to expire will terminate on schedule.

These projections are the basic benchmark against which analysts routinely assess the costs of proposed and actual changes in law.  These projections do not necessarily provide a realistic assessment, however, of the future fiscal outlook, and are not intended to do so.  Because of the rules on which they are based, the CBO projections present a much rosier picture of the future than is likely to occur.

In the past, when the significance of scheduled expirations of tax cuts was trivial, the budget baseline functioned both as a benchmark against which to measure the cost of legislation and as a plausible predictor of future deficits.  It no longer does the latter.  As former CBO Director (and current Urban Institute President) Robert Reischauer has remarked, “Rarely have the policies underlying the baseline projections been as disconnected from the policy makers’ agendas as they are today.”[10]

The official CBO projections are unrealistically rosy for two essential reasons.  First, they omit the costs of extending the 2001 and 2003 tax cuts beyond their scheduled expiration dates, providing relief from the mushrooming alternative minimum tax, and extending various tax breaks that are scheduled to expire but that Congress always renews.  Second, they understate costs for appropriated programs, especially in the areas of defense, homeland security, and the occupation and reconstruction of Iraq and Afghanistan.  The CBO projection does overstate certain costs for appropriated programs due to the assumed repetition of the $87.5 billion Iraq supplemental appropriation each year, but this overstatement is outweighed by understatements in other projected defense and anti-terrorism costs.

 Likely or Inevitable Costs Not Reflected in the CBO Baseline

 The adjustments to the CBO baseline made for this analysis, and discussed below, are consistent with the methodology followed in developing the deficit projections that the Committee for Economic Development, the Concord Coalition, and the Center on Budget and Policy Priorities jointly released in September 2003.[11]

Extending the 2001 and 2003 tax cuts:  CBO’s projections assume the entire 2001 tax cut will expire on schedule in 2010.  Few observers believe this will occur.

Table A-1

Adjustments to CBO Deficit Projections
(in billions of dollars)

 

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Total

CBO January 2004 projections

-362

-269

-267

-278

-268

-261

-162

-24

-16

13

-1,893

Tax cut extension

-57

-115

-124

-125

-131

-141

-274

-389

-419

-455

-2,230

AMT relief

-9

-26

-34

-43

-55

-69

-82

-95

-112

-134

-658

Defense & international

2

-9

-7

-11

-22

-34

-53

-81

-87

-106

-410

Domestic discretionary

5

8

6

3

0

-4

-9

-13

-19

-25

-47

Resulting deficit projections

-420

-410

-426

-454

-477

-509

-580

-602

-654

-708

-5,239

Resulting deficit projections as a percent of GDP

-3.5%

-3.2%

-3.2%

-3.3%

-3.3%

-3.3%

-3.7%

-3.6%

-3.8%

-3.9%

-3.5%

Notes: Negative values indicate deficits or costs that increase deficits.  Positive values reflect surpluses or policies that reduce deficits.  All figures include both the policy’s direct costs and the additional interest costs it generates.

The 2003 tax cut, which was enacted in May 2003, was advertised at the time as costing $330 billion through 2013.  (The measure also included $20 billion of fiscal assistance to the states, bringing the total official cost to $350 billion.)  The official cost of the tax cuts was held to $330 billion, however, only because eight of the nine tax-cutting provisions in the legislation were written so those provisions would expire in 2004, 2005, or 2008.  If these “artificial sunset dates” are removed and the tax cuts remain in place — a likely occurrence given that the President and Congressional Leadership seem intent on extending most or all of these provisions — the costs of the 2003 tax-cut legislation will exceed $1 trillion through 2014.

Combining the costs of extending the 2001 tax-cut law after 2010, the removal of the artificial sunsets in the 2003 tax-cut law, and the routine extension of a number of expiring tax breaks that are slated to expire every few years and always are extended with strong bipartisan support results in a total of $1.9 trillion in likely revenue losses that are not reflected in the CBO baseline.  This $1.9 billion figure is CBO’s own and is reflected in its new budget report.  When the added interest costs are included, these tax-cut extensions add $2.2 trillion to CBO’s 10-year deficit projection, as Table A-1 indicates.

The Alternative Minimum Tax:  The provisions of current law that prevent the Alternative Minimum Tax from affecting large numbers of middle-class taxpayers are scheduled to expire at the end of 2004.  There is little question such relief will be extended.  Without it, the number of taxpayers subject to the AMT will explode from about 3 million today to 44 million by 2014, assuming the 2001 tax cut is extended past its 2010 expiration date.  Observers consider continuation of AMT relief a virtual certainty, and the Administration has said it plans to address the AMT issue in 2005.  CBO estimates that the cost of limiting the growth of the AMT by extending the current relief and indexing the AMT exemption and tax brackets to inflation equals $658 billion through 2014, including interest costs.[12]  (See Appendix B for further discussion of the AMT issue.)

Table A-2

Differences Between the 2001 CBO Projections (Adjusted for Comparability)
 and Our Current Projections for 2002-2011
(in billions of dollars)

 

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2002-2011

Totals

CBO’s 2001 surplus projection (adjusted for comparability)

281