The Congressional Budget Office (CBO) has had another look at federal finances. Its forecast, though mostly a technical exercise, has nonetheless made clear the underlying budget difficulties facing this country. It tells of some short-term good news, such as shrinking deficits into 2015. It also highlights that over the longer term the country will have to engage in major entitlements reform or else it will not be able to avoid counterproductive tax hikes, expanding deficits, a squeeze on other aspects of the budget, or some combination of these ugly alternatives.
The Immediate Outlook Looks Fairly Good
It appears, however, that the next 18 months likely will enjoy financial improvement. The CBO, relying on reasonable economic projections, looks for the federal budget deficit to shrink, from $680 billion in 2013 to $506 billion this year, to $469 billion in 2015—for a net decline of 31% over the next two years. Relative to the gross domestic product (GDP), this anticipated flow of red ink constitutes a major decline in the deficit, from 10.0% of the overall economy in 2009 and the 4.1% in 2013 to only 2.6% in 2015—lower even than the 3.1% of GDP the deficit has averaged over the last 40 years.1 It is indeed an impressive improvement.
Part of this picture reflects the CBO’s expectation of an annualized growth of 8.7% in revenues over 2014 and 2015. Though the CBO forecasts only 2.4% real economic growth a year and 1.7% inflation, revenues tend to outpace the nominal economy. Aside from the tax hikes, there are two other reasons: 1) the progressive tax code takes on average proportionally more from each additional dollar of personal income and 2) the farther the economy gets from the recessionary years, the fewer firms have past losses to write against their tax obligations. Accordingly, the CBO projects individual income tax receipts to rise 7.7% a year over the two-year period and corporate tax receipts to increase at a 19.2% rate. Payroll taxes, which otherwise miss either of these leveraged effects, nonetheless show a relatively strong 6.0% annual growth rate largely because a partial payroll tax holiday ended at the start of this year.
The expected deficit decline also emerges from slower growth in outlays. The CBO projects an expansion of only 4.2% a year for the two years. Much reflects an expected 2.3% drop in defense outlays. Mandatory programs (as the CBO calls social spending)—such as Social Security, Medicare, Medicaid, the Affordable Care Act—will, the CBO expects, expand at an annual rate of 4.0%. An 11.3% annualized expansion in Medicaid, itself driven by the implementation of the Affordable Care Act, and a 4.8% annualized advance in outlays for Social Security are offset by a slowdown in outlays for income security programs—food stamps, welfare, unemployment, and related activities—to 4.4% a year. Here, the biggest difference comes from declines in unemployment compensation (down at about a 27% annualized rate) due in part to declines in the number of unemployed, but mostly because of the expiration of extended benefits starting in 2014.
The Bad News Comes after 2015
In contrast to this rosy picture, the CBO sees things deteriorating after 2015. Flows of red ink, it forecasts, will expand to $560 billion by 2018 and then go to $960 billion by 2024, an increase of 8.2% a year after 2015. Even in an expanding economy, that deficit growth will take the budget shortfall from 2.6% of GDP in 2015 to 3.6% in 2024. Though this CBO estimate is reasonable, these figures actually lean toward the optimistic side in large part because the office’s analysts assume that the economy avoids recession over that entire long stretch of time. Still, the CBO’s forecast of 2.4% a year real growth is far from overly optimistic. It is, in fact, lower than the long-term historical trend of more than 3.0% real growth a year on average.
On this economic base, the CBO’s forecasts moderate revenues growth of 4.4% a year on average. It projects individual income tax receipts will grow at a 5.6% yearly rate, payroll taxes at a 4.1% rate, and corporate taxes at a 2.6% rate. Tax reform could, of course, change these figures radically, but the CBO, as a matter of policy, works on the assumption that the law remains steady over the entire forecasting horizon. It is, admittedly, an unrealistic assumption, but probably the only practical way to proceed, since potential changes are impossible to predict and including possibilities multiplies the potential outcomes infinitely.
However one might cavil over the revenues projections, it is the outlays projections that cause the underlying deficit problem. The CBO expects so-called mandatory programs to rise at an annual rate of 5.1%. A portion of this rapid growth reflects the reasonable expectation that healthcare costs will rise. The lion’s share reflects the growing average age of the population that will enlarge Social Security rolls and multiply spending for Medicare. This longer period will, the CBO expects, experience an acceleration of outlays growth due to the full implementation of the Affordable Care Act, or, in the report’s words, the “expansion in federal healthcare programs.”
The other spending pressure comes from rising financing costs. The CBO expects these to rise 13.7% a year over this longer period. To some extent, this surge reflects the cumulative effect of ongoing deficits on federal debt outstanding, but mostly it reflects the expectation that interest rates will rise. Because the Fed has made it clear that it will begin to raise rates only in 2015, this financing cost consideration has little impact in the near term. The longer term, however, is a different matter. The CBO anticipates that three-month Treasury bill rates will rise from nearly zero now to about 1.1% in 2016, to 3.5% by 2019, and then stay at that level for the remainder of the forecast horizon. It assumes that the 10-year Treasury yield will rise to 3.8% by 2019, where it likely will stay thereafter.
The Crux of the Problem
Because both these major spending streams—social programs and interest costs—grow faster than revenues, the longer-term financial picture is unavoidably strained. The country, then, will engage in major entitlements reform or it will accept more burdensome taxes or larger deficits or Washington will squeeze the rest of the budget unmercifully. Even with the CBO assumption that defense spending grows at only 2.2% a year after 2015 and non-defense discretionary spending grows at an even slower pace, the deficits increase as a percentage of GDP. If the country faces a war, even a contained one, or wants to upgrade its infrastructure, the pressure will be that much greater. Since neither higher taxes nor entitlements reform looks likely, the prospects outlined so well by the CBO would seem to describe an absolute best-case deficit picture.
