Congressional Budget Office
Director's Blog

I testified this morning to the Senate Budget Committee about the economic outlook and CBO’s analysis of the potential impact on the economy of various fiscal policy options. You can read a summary of my testimony (the full version, which is rather long, is also available), or you can glance at the slides I used, which are below.

Policymakers cannot reverse all of the effects of the housing and credit boom, the subsequent bust and financial crisis, and the deep recession. However, in CBO’s judgment, there are both monetary and fiscal policy options that, if applied at a sufficient scale, would increase output and employment during the next few years. But there would be a price to pay: Those same fiscal policy options would increase federal debt, which is already larger relative to the size of the economy than it has been in more than 50 years—and is headed higher. If policymakers wanted to achieve both stimulus and sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it relative to baseline projections after a few years.

To assist policymakers in their decisions, CBO has quantified the effects of some alternative fiscal policy options. In a report last January, we analyzed a diverse set of temporary policies and reported their two-year effects on the economy per dollar of budgetary cost, what one might call the “bang for the buck.” The overall effects of those policies would depend also on the scale at which they were implemented; making a significant difference in an economy with an annual output of nearly $15 trillion would involve a considerable budgetary cost.

In brief, CBO found the following: A temporary increase in aid to the unemployed would have the largest effect on the economy per dollar of budgetary cost. A temporary reduction in payroll taxes paid by employers would also have a large bang-for-the-buck, as it would both increase demand for goods and services and provide a direct incentive for additional hiring. Temporary expensing of business investment and providing aid to states would have smaller effects, and yet smaller effects would arise from a temporary increase in infrastructure investment and a temporary across-the-board reduction in income taxes.

Today’s testimony went on to address the effects of another set of fiscal policy options. At the request of the Chairman of the Senate Budget Committee, we have now estimated the short-term and longer-term effects of extending the 2001 and 2003 tax cuts, extending higher exemption amounts for the alternative minimum tax, and reinstating the estate tax as it stood in 2009 (adjusted for inflation). The methodology for this analysis was quite similar to the methodology that CBO follows in analyzing the President’s budget each spring; we used several different models and made different assumptions about people’s behavior.

We examined four alternative approaches to extending the tax cuts: a “full permanent extension” that would extend all of the provisions permanently; a “partial permanent extension” that would extend permanently all of the provisions except those applying only to high-income taxpayers; a “full extension through 2012” that would extend all provisions but only through 2012; and a “partial extension through 2012” that would extend through 2012 all provisions except those applying only to high-income taxpayers. As shown in the following figure, all four of the options would raise national income, output, and employment during the next two years, relative to what would occur under current law. That would occur because, all else being equal, lower tax payments increase demand for goods and services and thereby boost economic activity.

Ranges of Effects of Four Tax Policy Options on Real GNP in 2011 and 2012

But the effects of those policy options on the economy in the longer term would be very different from their effects during the next two years. The averages of the estimates across different models and assumptions indicate that all four of the options would probably reduce income relative to what would otherwise occur in 2020 (see the figure below). Those effects are largely the net result of two competing forces: All else being equal, lower tax revenues increase budget deficits and thereby government borrowing, which reduces economic growth by crowding out investment. At the same time, lower tax rates boost growth by increasing people’s saving and work effort.

Effects of Four Tax Policy Options on Real GNP in 2020

Beyond 2020, and again relative to what would occur under current law, the reductions in income from all four of the policy options would become larger. Either a full or a partial extension of the tax cuts through 2012 would reduce income by much less than would a full or partial permanent extension.

In sum, and as CBO has reported before: Permanently or temporarily extending all or part of the expiring income tax cuts would boost income and employment in the next few years relative to what would occur under current law. However, even a temporary extension would add to federal debt and reduce future income if it was not accompanied by other changes in policy. A permanent extension of all of those tax cuts without future increases in taxes or reductions in federal spending would roughly double the projected budget deficit in 2020; a permanent extension of those cuts except for certain provisions that would apply only to high-income taxpayers would increase the budget deficit by roughly three-quarters to four-fifths as much. As a result, if policymakers then wanted to balance the budget in 2020, the required increases in taxes or reductions in spending would amount to a substantial share of the budget—and without significant changes of that sort, federal debt would be on an unsustainable path that would ultimately reduce national income. Similarly, even temporary increases in government spending would add to federal debt and reduce future income, and permanent large increases in spending that were not accompanied by other spending reductions or tax increases would put federal debt on an unsustainable path. Compared with the options examined here for extending the expiring tax cuts, various other options for temporarily reducing taxes or increasing government spending would provide a bigger boost to the economy per dollar of cost to the federal government.

In responding to questions raised by Congressional staff and outside analysts, we have found some errors in one section of our report The Long-Term Budget Outlook, which was released on June 30, 2010 and discussed in a previous blog entry. To correct those errors, we issued a revised version of the report today along with a letter explaining the changes.

The errors did not affect CBO’s primary findings—the long-term budget projections under the extended-baseline scenario and the alternative fiscal scenario—as discussed in the summary of the report, nor did they affect numbers presented in any of the tables. Rather, the errors were limited to the analysis of how the projected growth of debt would reduce, or crowd out, private investment and thereby lower gross domestic product (GDP) in the United States. The corrected estimates of the effects of crowding out on GDP are smaller than those shown in the original report. Also, the effects of crowding out on gross national product (which equals GDP plus income received from other countries minus income sent abroad) are now shown; those effects were discussed in last year’s Long-Term Budget Outlook (released in June 2009) but were not included in the original publication this year.

A discussion of the original and revised projections of the crowding-out effects is included in the letter. The changes affect Figures 1-5 and 1-6 and related text, and appear on pages 19 through 22 of the revised report.

In fiscal crises in a number of countries around the world, investors have lost confidence in governments’ abilities to manage their budgets, and those governments have lost their ability to borrow at affordable rates. With U.S. government debt already at a level that is high by historical standards, and the prospect that, under current policies, federal debt would continue to grow, it is possible that interest rates might rise gradually as investors’ confidence in the U.S. government’s finances declined, giving legislators sufficient time to make policy choices that could avert a crisis. It is also possible, however, that investors would lose confidence abruptly and interest rates on government debt would rise sharply, as evidenced by the experiences of other countries.

Unfortunately, there is no way to predict with any confidence whether and when such a crisis might occur in the United States. In a brief ("Federal Debt and the Risk of a Fiscal Crisis") released today, CBO notes that there is no identifiable “tipping point” of debt relative to the nation’s output (gross domestic product, or GDP) that would indicate that such a crisis is likely or imminent. However, in the United States, the ratio of federal debt to GDP is climbing into unfamiliar territory—and all else being equal, the higher the debt, the greater the risk of such a crisis.
 
Over the past few years, U.S. government debt held by the public has grown rapidly. According to CBO’s projections, federal debt held by the public will stand at 62 percent of GDP at the end of fiscal year 2010, having risen from 36 percent at the end of fiscal year 2007, just before the recession began. In only one other period in U.S. history—during and shortly after World War II—has that figure exceeded 50 percent.

Further increases in federal debt relative to the nation’s output almost certainly lie ahead if current policies remain in place. The aging of the population and rising costs for health care will push federal spending, measured as a percentage of GDP, well above the levels experienced in recent decades. Unless policymakers restrain the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches, growing budget deficits will cause debt to rise to unsupportable levels, as shown in the figure below. (For more details, see CBO’s recent report The Long-Term Budget Outlook.)

Note: The extended-baseline scenario adheres closely to current law, following CBO’s 10-year baseline budget projections through 2020 (with adjustments for the recently enacted health care legislation) and then extending the baseline concept for the rest of the long-term projection period. The alternative fiscal scenario incorporates several changes to current law that are widely expected to occur or that would modify some provisions that might be difficult to sustain for a long period.

Although deficits during or shortly after a recession generally hasten economic recovery, persistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually—but a high level of federal debt, combined with an unfavorable long-term budget outlook, would also increase the probability of a sudden fiscal crisis prompted by investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. The resulting abrupt rise in interest rates would create serious challenges for the U.S. government. For example, a 4-percentage-point across-the-board increase in interest rates would raise federal interest payments next year by about $100 billion; if those higher rates persisted, net interest costs in 2015 would be nearly double the roughly $460 billion that CBO currently projects for that year. Such an increase in rates could also precipitate a broader financial crisis because it would reduce the market value of outstanding government bonds, inflicting losses on mutual funds, pension funds, insurance companies, banks, and other holders of federal debt.

Options for responding to a fiscal crisis would be limited and unattractive. The government would need to undertake some combination of three actions. One action could be changing the terms of its existing debt. This would make it difficult and costly to borrow in the future. A second action could be adopting an inflationary monetary policy by increasing the supply of money. However, this approach would have negative consequences for both the economy and future budget deficits. A third action could be implementing an austerity program of spending cuts and tax increases. Such budgetary adjustments, in the face of a fiscal crisis, would be more drastic and painful than those that would have been necessary had the adjustments come sooner.

This brief was prepared by Jonathan Huntley of CBO’s Macroeconomic Analysis Division.
 

Recently, the federal government has been recording the largest budget deficits, as a share of the economy, since the end of World War II. As a result of those deficits, the amount of federal debt held by the public has surged. At the end of 2008, that debt equaled 40 percent of the nation’s annual economic output (as measured by gross domestic product, or GDP), a little above the 40-year average of 36 percent. Since then, large budget deficits have caused debt held by the public to shoot upward; CBO projects that federal debt will reach 62 percent of GDP by the end of this year—the highest percentage since shortly after World War II. The sharp rise in debt stems partly from lower tax revenues and higher federal spending related to the recent severe recession and turmoil in financial markets. However, the growing debt also reflects an imbalance between spending and revenues that predated those economic developments.

This morning CBO released the latest in its series of reports on the long-term budget outlook. (Addendum: I presented the key findings of the report to the National Commission on Fiscal Responsibility and Reform.) The report examines the pressures on the federal budget by presenting our  projections of federal spending and revenues over the coming decades. Under current laws and policies, an aging population and rapidly rising health care costs will boost outlays for Social Security benefits and sharply increase federal spending for health care programs. Unless revenues increase at a similar pace, such spending will cause federal debt to grow to unsustainable levels. If policymakers are to put the nation on a sustainable budgetary path, they will need to let revenues increase substantially as a percentage of gross domestic product, decrease spending significantly from projected levels, or adopt some combination of those two approaches.

The Outlook for Major Health Care Programs and Social Security

Growth in spending on health care programs remains the central fiscal challenge facing the nation. CBO projects that if current laws do not change, federal spending on major mandatory health care programs will grow from roughly 5 percent of GDP today to about 10 percent in 2035 and will continue to increase thereafter. (Mandatory programs are those that do not require annual appropriations; the major mandatory health care programs include Medicare, Medicaid, the Children’s Health Insurance Program, and the subsidies that will be provided through the insurance exchanges that will be established as a result of the new health care legislation.)

That estimate includes all of the effects of the recently enacted health care legislation. Although, CBO expects the legislation to reduce federal budget deficits over the first 10 years and in subsequent decades (through its effects on both revenues and spending), it is expected to increase federal spending in the next 10 years and for most of the following decade; by 2030, however, that legislation will slightly reduce federal spending for health care if all of its provisions are fully implemented, CBO projects. (The estimates for the health care legislation that are used in this report are unchanged from the ones that CBO and the staff of the Joint Committee on Taxation published in March, when the legislation was being considered.)

Under current law, spending on Social Security is also projected to rise over time as a share of GDP, albeit much less dramatically—from 5 percent to 6 percent of GDP. (Later this week, CBO will release a report on a number of different policy options for changing Social Security.)

All told, CBO projects, the aging of the population and the rising cost of health care will cause spending on the major mandatory health care programs and Social Security to grow from roughly 10 percent of GDP today to about 16 percent of GDP 25 years from now if current laws are not changed. (By comparison, spending on all of the federal government’s programs and activities, excluding interest payments on debt, has averaged 18.5 percent of GDP over the past 40 years.)

Budget Outcomes Under Two Long-Term Scenarios

In the report, CBO presents the long-term budget picture under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Budget projections grow increasingly uncertain as they extend farther into the future, so this report focuses largely on the next 25 years.

One scenario, the extended-baseline scenario, adheres closely to current law. That set of policies would result in steadily higher average tax rates because they incorporate the assumptions that most of the tax cuts enacted in 2001 and 2003 expire and that the alternative minimum tax applies to more and more people each year—and because the combination of economic growth and the structure of the tax system generates additional tax revenues as a percentage of income. Those rising rates, combined with the tax provisions of the recent health care legislation, would push total revenues to 23 percent of GDP by 2035—much higher than has typically been seen in recent decades—and to larger percentages thereafter. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt—activities such as national defense and a wide variety of domestic programs—would decline to the lowest percentage of GDP since before World War II. Despite those substantial revenue increases and constrained spending for a portion of the budget, the rising costs of health care programs and Social Security would lead to continued budget deficits, and federal debt held by the public would grow from an estimated 62 percent of GDP this year to about 80 percent by 2035.

The budget outlook is much bleaker under the alternative fiscal scenario, which incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period. In this scenario, CBO assumed that Medicare’s payment rates for physicians would gradually increase (which would not happen under current law) and that several policies enacted in the recent health care legislation that would restrain growth in health care spending would not continue in effect after 2020. In addition, under the alternative scenario, spending on activities other than the major mandatory health care programs, Social Security, and interest would fall below the average level of the past 40 years relative to GDP, though not as low as under the extended-baseline scenario.

More important, CBO assumed for this scenario that most of the provisions of the 2001 and 2003 tax cuts would be extended, that the reach of the alternative minimum tax would be kept close to its historical extent, and that over the longer run, tax law would evolve further so that revenues would remain at about 19 percent of GDP, near their historical average.

Under that combination of policy assumptions, federal debt would grow much more rapidly than under the extended-baseline scenario. With significantly lower revenues and higher outlays, debt would reach 87 percent of GDP by 2020, CBO projects. After that, the growing imbalance between revenues and noninterest spending, combined with spiraling interest payments, would swiftly push debt to unsustainable levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2025 and would reach 185 percent in 2035.

Neither of those scenarios represents a prediction by CBO of what policies will be in effect during the next several decades—but these projections, encompassing two very different sets of policy assumptions, provide a clear indication of the serious nature of the fiscal challenge facing the nation.

The Impact of Growing Deficits and Debt

In fact, CBO’s projections understate the severity of the long-term budget problem because they do not incorporate the significant negative effects that accumulating substantial amounts of additional federal debt would have on the economy:

• Large budget deficits would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment—which in turn would lower income growth in the United States.
• Growing debt would also reduce lawmakers’ ability to respond to economic downturns and other challenges.
• Over time, higher debt would increase the probability of a fiscal crisis in which investors would lose confidence in the government’s ability to manage its budget, and the government would be forced to pay much more to borrow money.

Keeping deficits and debt from growing to unsustainable levels would require raising revenues as a percentage of GDP significantly above past levels, reducing outlays sharply relative to CBO’s projections, or some combination of those approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that long-term changes to spending and revenues are agreed on, and the sooner they are carried out once the economic weakness ends, the smaller will be the damage to the economy from growing federal debt. Earlier action would require more sacrifices by earlier generations to benefit future generations, but it would also permit smaller or more gradual changes and would give people more time to adjust to them.

CBO has just released an estimate of the budgetary effects of the health bill, H.R. 3590, that passed the Senate on December 24. Today’s estimate differs from the estimate for a slightly earlier version of the legislation that we released on December 19 in that it encompasses all of the amendments that were adopted by the Senate, reflects a revised assumption about its enactment date, and incorporates some technical revisions. Like the December 19 estimate, this estimate is based on CBO’s baseline projections from March 2009. We and the staff of the Joint Committee on Taxation (JCT) prepared this updated estimate in preparation for further consideration of health care legislation. However, the changes we have made do not result in an estimate that differs substantially from the earlier one.

CBO and JCT now estimate that, on balance, the direct (mandatory) spending and revenue effects of enacting H.R. 3590 as passed by the Senate would yield a net reduction in federal deficits of $118 billion over the 2010–2019 period. (Direct spending—as distinguished from discretionary spending—is spending that stems from legislation other than appropriation acts.)  In our earlier estimate, the budgetary impact was a net reduction in deficits of $132 billion.

The gross cost of the proposed expansions in insurance coverage over those 10 years is now projected to be $875 billion, reflecting subsidies provided through insurance exchanges, increased net outlays for Medicaid and the Children’s Health Insurance Program (CHIP), and tax credits for small employers. Those costs are partly offset by revenues from an excise tax on high-premium insurance plans and net savings from other coverage-related sources, leaving a net cost of $624 billion for the coverage provisions. Other provisions affecting direct spending save $478 billion, on net—mostly in Medicare—and other provisions affecting revenues reduce the deficit by $264 billion, on net. Thus, the net effect on deficits of the bill as a whole equals $624 billion less $478 billion less $264 billion, or a reduction of $118 billion over the 2010-2019 period. In total, CBO and JCT estimate that the legislation would increase outlays by $355 billion and increase revenues by $473 billion between 2010 and 2019.

CBO has not completed an estimate of all of the discretionary costs that would be associated with the legislation. Those costs would depend on future appropriations and are not included in today’s estimate of the direct spending and revenue effects of the bill. As indicated in CBO’s earlier estimate, such costs would probably include an estimated $5 billion to $10 billion over 10 years for administrative costs of the Internal Revenue Service and at least a similar amount for expenses of the Department of Health and Human Services. CBO has also identified at least $50 billion in specified and estimated authorizations of future discretionary spending for a number of grant programs and other provisions of the legislation; whether some or all of those costs would be incurred would depend on future appropriation legislation.

Other elements of the analysis that CBO and JCT provided on December 19 have not changed significantly:

• Although CBO and JCT have not updated their estimates of the likely impact of the legislation on health insurance premiums, that impact would probably be quite similar to the one estimated for an earlier version of the legislation.
• CBO expects that the legislation, if enacted, would reduce federal budget deficits over the decade after 2019 relative to those projected under current law—with a total effect during that decade that is in a broad range between one-quarter percent and one-half percent of GDP. That judgment is unchanged from CBO’s previous assessment, and the imprecision of that calculation reflects the even greater degree of uncertainty that attends to it, compared with CBO’s 10-year budget estimates.
• Under the legislation, federal outlays for health care would increase during the 2010–2019 period, as would the federal budgetary commitment to health care (a term that CBO discussed earlier). CBO now estimates that the federal commitment would increase by about $210 billion over that period, rather than by $200 billion as previously estimated. In subsequent years, however, the effects of the legislation that would tend to decrease the federal budgetary commitment to health care would grow faster than those that would increase it. As a result, CBO expects that the legislation would generate a reduction in the federal budgetary commitment to health care during the decade following 2019; that judgment is unchanged from CBO’s previous assessment.

Today CBO released a letter to Congressman Paul Ryan, Ranking Member of the House Budget Committee, analyzing the Roadmap for America’s Future Act of 2010. This legislation, which Congressman Ryan introduced today, would make comprehensive changes to the Social Security program; to federal involvement in health care, including Medicare, Medicaid, and the tax treatment of health insurance; to other federal spending; and to other features of the tax system. CBO’s analysis is based on the proposal as modified by specifications provided by Congressman Ryan’s staff. In particular, the specifications for Medicaid and the tax system that CBO analyzed are highly stylized versions of the more detailed provisions in the bill.

CBO’s letter summarizes the agency’s analysis of the impact that the bill (along with the simplifying specifications) would have on federal outlays, budget deficits, and debt during the next 75 years. The analysis is subject to a great deal of uncertainty, because of both the complexity of the proposal and the very long time horizon over which its many provisions would unfold. The analysis does not represent a cost estimate for the legislation, which would require much more detailed analysis and would be much more limited in the time span that could be examined.

The Roadmap, in the form that CBO analyzed, would result in less federal spending for Medicare and Medicaid as well as lower tax revenues than projected under CBO’s “alternative fiscal scenario” described in CBO’s June 2009 publication The Long-Term Budget Outlook. Federal spending for Social Security would be slightly higher than under CBO’s alternative fiscal scenario for much of the projection period, but the system would become sustainable as revenues increase and traditional benefits decline. The budget deficit would peak at 5 percent of GDP in 2034 and then decline. By 2080, the Roadmap would generate a budget surplus of about 5 percent of GDP. Under the Roadmap, the ratio of government debt held by the public to economic output (the ratio of debt to GDP) would be lower than that under the alternative fiscal scenario in every year. In particular, debt is projected to peak at 100 percent of GDP in 2043 and to decline thereafter, reaching zero by 2080. (Debt held by the public was about 53 percent of GDP at the end of fiscal year 2009.) The federal government would accumulate net financial assets equal to 17 percent of GDP by 2083. In contrast, under the alternative fiscal scenario, debt is projected to skyrocket over the next several decades.

This analysis was undertaken by Joyce Manchester, Charles Pineles-Mark, Michael Simpson, and Julie Topoleski of CBO’s Long-Term Modeling Group.
 

What amount of budgetary resources might be needed in the long term to carry out the Administration’s plans for defense that were proposed during 2009? CBO addresses that question in a study prepared at the request of the Chairman and the Ranking Member of the Senate Budget Committee. The study updates the resource projections contained in CBO’s January 2009 paper Long-Term Implications of the 2009 Future Years Defense Program, reflecting changes that the new Administration made to defense plans in preparing the President’s budget request for fiscal year 2010.

In CBO’s estimation, carrying out the Department of Defense's (DoD’s) 2009 plans for 2010 and beyond—excluding overseas contingency operations (the wars in Iraq and Afghanistan and some much smaller military actions elsewhere)—would require defense resources averaging at least $573 billion annually (in 2010 dollars) from 2011 to 2028. That amount, CBO’s base projection, is about 7 percent more than the $534 billion in total obligational authority the Administration requested in its regular 2010 budget, again excluding overseas contingency operations.  The projection also exceeds the peak of about $500 billion (in 2010 dollars) during the height of the Reagan Administration’s military buildup in the mid-1980s. During that period, for example, DoD was pursuing a Navy fleet of 600 battle force ships, more than twice the size of the current fleet of 287.

The department’s resource requirements to execute the same plans could be even greater. CBO has also estimated some “unbudgeted” costs that reflect the likelihood that weapon systems would cost more than initially estimated; that medical costs and fuel prices would grow at rates faster than DoD has anticipated; and that pay raises the Congress enacts for military personnel and DoD’s civilian employees might exceed the percentages in the department’s plans. Furthermore, additional appropriations may be necessary to fund overseas contingency operations.

Including the unbudgeted costs increases the projection to an annual average of $632 billion through 2028, or 18 percent more than the regular funding requested for 2010. Some 35 percent of the total unbudgeted costs between 2013 and 2028 are associated with overseas contingency operations; in particular, the analysis includes the potential costs—about $20 billion per year—of deploying 30,000 troops to contingency operations from 2013 through 2028. The total costs of $670 billion at the endpoint in 2028 would approach the peak of the past three years (measured in 2010 dollars), which includes the height of operations in Iraq.

Not included in the unbudgeted cost projections, however, is the funding needed to increase U.S. presence in Afghanistan as the President announced on December 1, 2009.  Although the Administration’s 2010 budget planned for an increase in U.S. service members in Afghanistan from 59,000 to 68,000, neither that budget nor CBO’s projection anticipated the further increase of 30,000 troops in Afghanistan. (See CBO’s recent analysis of the funding needed to support an additional 30,000 troops in Afghanistan.)

This study was prepared by a team led by Matthew Goldberg; the primary authors were Adam Talaber and Daniel Frisk of CBO’s National Security Division.
 

Yesterday CBO senior analyst Eric Labs testified before the House Armed Services Committee’s Subcommittee on Seapower and Expeditionary Forces to discuss the challenges that the Navy is facing in its plans for building its future fleet. Specifically, the testimony focused on three matters: the Navy’s draft shipbuilding plan for fiscal year 2011; the effect that replacing Ohio class submarines (certain submarines that carry ballistic missiles) with a new class of submarines will have on the Navy’s shipbuilding program; and the number of ships that may be needed to support ballistic missile defense from the sea. CBO’s analysis of those issues indicates the following:

• If the Navy receives the same amount of money (adjusted for inflation) for ship construction in the next 30 years that it has over the past three decades—an average of about $15 billion per year in 2009 dollars—it will not be able to execute its fiscal year 2009 plan to increase the fleet from 287 battle force ships to 313. As a result, the draft 2011 shipbuilding plan drastically reduces the number of ships the Navy would purchase over 30 years, leading to a much smaller fleet than today’s fleet or the one envisioned in the 2009 plan.
• The draft 2011 shipbuilding plan increases the Navy’s stated requirement for its fleet from 313 ships to 324 through 2040, but the production schedule in the plan would buy only 222 ships, too few to meet the requirement.  The reduction would come from the Navy’s combat ships.  By 2040, the fleet would decline to 237 ships: 185 combat ships and 52 logistics and support ships.  In comparison, today’s fleet has 287 ships:  239 combat ships and 48 logistics and support ships.
• CBO’s preliminary estimate is that implementing the draft 2011 shipbuilding plan would cost an average of about $20 billion per year (in 2009 dollars) for all activities related to ship construction (including modernizing some current surface combatants and refueling ships’ nuclear reactors). A more detailed estimate will follow after the Navy formally submits its final 2011 plan to the Congress in February with the President’s budget request.
• Replacing the 14 ballistic missile submarines (SSBNs) of the Ohio class—which are due to start reaching the end of their service lives in the late 2020s—with 12 new SSBNs could cost about $85 billion.
• Sea-based ballistic missile defense, a relatively new mission for the Navy, could require a substantial commitment of resources. That commitment could make it difficult for the Navy to fund other ship programs.

Yesterday I gave a talk over lunch to the National Economists Club.  If I’d known when I was invited how much legislative activity would be occurring this week, I wouldn’t have agreed—but I enjoyed the chance to talk with the group.

My topic was CBO’s outlook for the federal budget and the economy, drawing on our August report The Budget and Economic Outlook: An Update and our June report The Long-Term Budget Outlook.  You can read the slides from my remarks.

CBO estimates that, if current laws remained in place, the federal deficit would shrink significantly—from about 11 percent of GDP this fiscal year to around 3 percent of GDP between 2013 and 2019.  The country has experienced persistent large deficits before; for example, deficits averaged about 4 percent of GDP during the economic expansion of the 1980s. However, the budget challenge facing policymakers during the coming decade will be more acute than the challenge they faced during the 1980s in three important respects:

• First, federal debt held by the public will exceed 50 percent of GDP at the end of this fiscal year, compared with roughly 30 percent when the expansion of the 1980s began.  As a result, further large deficits and increases in the debt will raise more serious economic risks.  Under current law, CBO projects that debt held by the public will reach 68 percent of GDP by 2019, the highest level since 1950, and will be continuing on an upward trajectory.

• Second, the difference between current law (which underlies CBO’s baseline projections) and current policy as perceived by many people (in particular, the personal income tax rates now in effect) is especially large now.  For example, most of the tax cuts enacted in 2001 and 2003 are scheduled to expire at the end of December 2010, and the exemption amount for the alternative minimum tax (AMT) is scheduled to fall back sharply; those provisions of current law are reflected in CBO’s baseline projections, adding to projected revenues.  If, instead, the tax cuts were extended and the AMT exemption was indexed for inflation after 2009, the revenue loss and the resulting increase in interest payments on the federal debt would widen the deficit to more than 6 percent of GDP by 2019.

• Third, the aging of the U.S. population and rising costs for health care are making federal spending on Social Security, Medicare, and Medicaid a much larger burden relative to GDP.  During the expansion of the 1980s, federal spending on those three programs stayed close to 7 percent of GDP; in the 2013 to 2019 period, CBO projects that spending on those programs will rise from just over 10 percent of GDP to a little below 12 percent.  Beyond the 10-year budget window, CBO expects that this share would continue to rise rapidly under current law.

This sobering outlook for the federal budget is likely to weigh on policy decisions for some time.  High deficits in the near term may be an inevitable consequence of the severe economic downturn and the turmoil in the financial markets.  However, continued large deficits and increases in federal debt over time would adversely affect the nation’s economic growth by lowering saving and investment.

Today CBO released a background paper examining whether the demand for assets, such as stocks and bonds, will fall after the retirement of the baby-boomer generation—the segment of the nation’s population born between 1946 and 1964, whose oldest members turned 62 in 2008. Some economists have warned of the possibility of a dramatic decline in demand as baby boomers sell off their assets to finance their retirement; they assert that the sell-off could cause a dramatic decline in prices. An evaluation of the evidence, however, indicates that such a dramatic decline in asset demand and prices is unlikely.

Demand for Assets

In general, retirees sell assets to finance their retirement, whereas young and middle-aged workers buy assets to save for old age. As a population ages, the share of older, retired people selling assets increases relative to the share of younger, working people buying them. In principle, if an unusually large cohort, such as the baby boomers, were to sell its assets to finance retirement, the total demand for assets in the economy could fall substantially over several decades and the prices of those assets could decline as well.

However, empirical evidence about the behavior of earlier groups of retirees suggests that baby boomers will not sell their assets quickly after they retire. Several factors probably explain that evidence. First, retirees generally are cautious about selling assets to finance consumption because they might need those assets in the future: They might live longer than expected, and medical costs, which are likely to rise as people age, could be higher than anticipated. Second, rather than spend all of their assets, retirees might intentionally retain some to make bequests. Third, wealth in the United States is highly concentrated: One-third of the nation’s financial assets is held by the wealthiest 1 percent of the U.S. population. The wealthiest people do not spend significant portions of their assets during retirement and in most cases die leaving bequests.

The demand for assets will be reinforced if baby boomers change the timing of their retirement as a result of the recent financial turmoil. Some baby boomers who have lost or spent a significant portion of their assets may defer retirement, shortening the duration of retirement and reducing the amount of assets needing to be sold to finance consumption. The aggregate effect on asset demand might be small, however, if people delayed retiring for only a year or two.

Foreign demand is likely to help sustain the demand for U.S. assets. A rising demand for U.S. financial assets is anticipated to come from developing countries with emerging economies whose populations are younger or aging less quickly than is the U.S. population. By contrast, the demand for assets by new immigrants to the United States is unlikely to have much effect on overall demand.

Prices of Assets

Although the retirement of the baby boomers is not likely to cause a large decline in aggregate demand for assets, several economic studies suggest that the retirement and aging of baby boomers could cause a temporary decrease in asset prices. That prediction of a temporary decrease is based on the studies’ expectation that the retirement of baby boomers will cause the demand for assets to fall more rapidly than the stock of capital will be reduced, causing asset prices to fall while the capital stock adjusts. Empirical evidence, however, has not revealed much connection between demographic trends and the price changes observed in financial markets.

This paper was prepared by Marika Santoro of CBO’s Macroeconomic Analysis Division.