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Appendix
CHow Changes in Economic Assumptions Can Affect Budget Projections
The federal budget is highly sensitive to economic conditions. Revenues depend on the amount of taxable income, including wages and salaries, other (nonwage) income, and corporate profits. Those types of income generally rise or fall in tandem with overall economic activity. Spending for many mandatory programs is pegged to inflation, either directly (as with Social Security) or indirectly (as with Medicaid). In addition, the Treasury regularly refinances portions of the government’s outstanding debt—and issues more debt to finance any new deficit spending—at market interest rates. Thus, the amount that the federal government spends for interest on its debt is directly tied to those rates.
To show how assumptions about the economy can affect projections of the federal budget, the Congressional Budget Office (CBO) has constructed simplified "rules of thumb." The rules provide rough orders of magnitude for gauging how changes in individual economic variables, taken in isolation, would affect the budget totals. (The rules of thumb are not intended to substitute for a full analysis of an alternative economic forecast.)
This illustration addresses four variables:
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Real (inflation-adjusted) growth of the nation’s gross domestic product (GDP),
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For real growth, CBO’s rule of thumb shows the effects of rates that are 0.1 percentage point lower each year, beginning in January 2008, than the rates assumed for the agency’s baseline budget projections. (Those projections are outlined in Chapter 1; the economic assumptions that underpin them are described in Chapter 2.) The rules of thumb for interest rates and inflation assume that those rates are 1 percentage point higher each year, also starting in January 2008, than the rates in the baseline. The final rule of thumb assumes that, beginning in January 2008, wages and salaries as a percentage of GDP are 1 percentage point larger each year than those projected in the baseline. Correspondingly, corporate profits are assumed to be 1 percentage point smaller each year relative to GDP. (The scenario incorporates no changes in projected levels of nominal or real GDP.)
Each rule of thumb is roughly symmetrical. Thus, if economic growth was higher or interest rates, inflation, or wages and salaries as a percentage of GDP were lower than CBO projects, the effects would be about the same as those shown here, but with the opposite sign.
The calculations that appear in this appendix merely illustrate the impact that such changes can have. CBO chose the variations of 0.1 percentage point or 1 percentage point solely for the sake of simplicity. Those changes do not necessarily indicate the extent to which actual economic performance might differ from CBO’s assumptions. For example, although the rule of thumb for real GDP shows the effects of a 0.1 percentage point change in the average rate of growth over the next 10 years, the standard deviation for growth rates of real GDP over 10-year periods is roughly five times larger, or about 0.5 percentage points.1 Extrapolating from small, incremental rule-of-thumb calculations to much larger changes would be inadvisable, however, because the size of the effect of a larger change is not necessarily a multiple of a smaller change.
The other rules of thumb—each of which considers an average change of 1 percentage point from the assumption used for the baseline projection—are much closer to historical deviations for those variables. The standard deviation for the 10-year average of real interest rates is about 1.3 percentage points. Standard deviations for inflation and for wages and salaries as a percentage of GDP are each about 2 percentage points, slightly less than twice the change incorporated in CBO’s rules of thumb.
Stronger economic growth improves the budget’s bottom line, and weaker economic growth worsens it. The first rule of thumb illustrates the impact of slightly weaker-than-expected economic growth on federal revenues and outlays.2
CBO’s baseline reflects an assumption that real GDP grows by 1.7 percent in calendar year 2008, by 2.8 percent in 2009, and by an average of 2.7 percent annually from 2010 to 2018. Subtracting 0.1 percentage point from each of those growth rates implies that by 2018, GDP would be roughly 1 percent smaller than in CBO’s baseline.
Slower growth of GDP would have several budgetary implications. For example, it would imply less growth in taxable income and thus a smaller amount of tax revenues—$1 billion less in 2008 and $51 billion less in 2018 (see Table C-1). With a smaller amount of revenues, the federal government would have to borrow more and incur higher interest costs. Payments to service federal debt would be slightly larger during the first few years of the 10-year projection period but substantially larger in later years, with the increase reaching $13 billion by 2018. Mandatory spending, however, would be only minimally affected by slower economic growth: Medicare outlays would be slightly lower, but that decrease would be mostly offset by higher outlays for the refundable portions of the earned income and child tax credits.3
How Selected Economic Changes Might Affect CBO’s Baseline Budget Projections
Source: Congressional Budget Office.
Notes: GDP = gross domestic product; * = between -$500 million and $500 million.
a. Negative amounts indicate an increase in the deficit or a decrease in the surplus.
b. The change in outlays attributable to higher rates in this scenario is different from the estimate in the rule of thumb for interest rates because the principal on the Treasury’s inflation-protected securities grows with inflation.
All told, if growth in real GDP each year was 0.1 percentage point lower than the rates assumed in CBO’s baseline, annual deficits would be larger or surpluses smaller by amounts that would climb to $63 billion in 2018. The cumulative surplus for the 2009–2018 period would fall by $297 billion. Those effects differ from the effects of a cyclical change in economic growth, such as a recession, which are usually larger but of much shorter duration. (For a discussion of the possible budgetary effects of a recession, see Box C-1.)
Box C-1. The Potential Budgetary Impact of a Recession
The Congressional Budget Office (CBO), in its current economic outlook, does not forecast a recession for this year, but it does assume that growth will be very slow. That slowdown will increase the deficit even without a recession, just as periods of sluggish growth have increased it in the past. If the economy were to slide into a recession, however, the outcome for the budget during the period covered by CBO’s economic forecast—2008 and 2009—would be worse than CBO now projects. A recession’s overall effect on the budget would depend not only on the downturn’s depth and length but also on other factors that might accompany it, such as a further drop in the stock market.
CBO’s estimate of movements in the cyclical component of the budget deficit (relative to potential gross domestic product, or GDP) over the two-year periods associated with each of the past six recessions help illustrate the potential impact of such an event (see the table).1 The cyclical component— also known as the automatic stabilizers—is the drop in revenues that automatically occurs when GDP and incomes decline, plus the increase in benefit payments for programs such as unemployment insurance that accompanies a rise in the unemployment rate.2
Budgetary Effects of the Past Six Recessions
Year Before the
Peak to the TroughaChange as a Percentage of Potential GDPb Actual Deficit Cyclical Componentc GDP Gapd 1969 to 1971 -2.5 -1.9 4.5 1973 to 1975 -2.1 -2.5 6.6 1979 to 1981 -0.9 -1.1 2.7 1981 to 1983 -3.1 -1.7 4.6 1990 to 1992 -0.7 -1.1 2.9 2000 to 2002 -4.0 -1.6 4.2 Average, all periods -2.2 -1.6 4.3 Source: Congressional Budget Office.
a. In this table, the period before the peak is the fiscal year preceding the onset of a recession, and the trough is either the fiscal year containing the last quarter in which the economy was in recession or the fiscal year following that last quarter.
b. Potential GDP is the level of gross domestic product that corresponds to a high rate of resource (labor and capital) use.
c. The cyclical component—also known as the automatic stabilizers—is the decline in revenues that automatically occurs when GDP and incomes decline, plus the increase in benefit payments for programs such as unemployment insurance that occurs when the rate of unemployment rises. For further discussion, see The Cyclically Adjusted and Standardized Budget Measures: An Update (August 2007).
d. The GDP gap equals the difference between potential and actual GDP as a percentage of potential GDP
During the past six recessions, the cyclical component of the deficit rose by amounts ranging from 1.1 percent of potential GDP to 2.5 percent. (CBO estimates that in 2008, GDP will be about $14 trillion.) The largest change was in the 1973–1975 period, which experienced the biggest jump in the gap between actual and potential GDP. By contrast, the largest increase in the actual deficit occurred during the most recent recession, which included a sizable loss of revenues associated with the bursting of the stock market bubble. The estimated increase in the cyclical component of the deficit during that downturn was the same as the average for the past six recessions as a group.
It is unclear to what extent a recession this year would resemble those of the past. The post-World War II period has recorded 10 recessions, and the two most recent ones have been relatively mild. The combination of problems in the subprime mortgage market, falling house values, and high oil prices could lead to weaker growth than CBO anticipates. However, without the addition of a further drop in the stock market similar to that beginning in 2000, a recession this year would probably not have as big an impact on the actual budget deficit as the effects felt during and following the recession in 2001.
1. By contrast with the rule-of-thumb estimates for the currentlaw effects on the budget of persisting changes in real growth, inflation, interest rates, and the wages and salaries share of GDP (shown in Table C-1), CBO’s estimates of changes in the cyclical component of the deficit during the past six recessions reflect the short-term effects of the economy’s movements away from its potential level—that is, potential GDP. (Potential GDP is the level of real output corresponding to a high rate of resource—labor and capital—use.)
2. For further discussion, see Congressional Budget Office, The Cyclically Adjusted and Standardized Budget Measures: An Update (August 2007).The second rule of thumb illustrates the sensitivity of the budget to changes in interest rates, which affect the flow of interest payments to and from the federal government. When the budget is in deficit, the Treasury must borrow additional funds from the public—by selling bonds and other securities—to cover any shortfall. (The Treasury currently issues 1-, 3-, and 6-month bills; 2-, 5-, and 10-year notes; 5-, 10-, and 20-year inflation-protected securities; and 30-year bonds.) When the budget is in surplus, the Treasury uses some of its income to reduce federal debt held by the public. In either case, the Treasury refinances a portion of the nation’s debt at market interest rates. Those rates also determine how much the Federal Reserve earns on its holdings of securities, which in turn affects federal revenues.
If interest rates on all types of Treasury securities were 1 percentage point higher each year through 2018, compared with the interest rates underlying the baseline, and all other economic variables were unchanged, the government’s interest costs would be approximately $9 billion greater in 2008 (see Table C-1). That jump would be fueled largely by the extra costs of refinancing Treasury bills, which make up about 22 percent of the government’s marketable debt. Roughly $1 trillion in Treasury bills are currently outstanding, all of which mature within the next six months. However, most marketable government debt is in the form of coupon securities, which consist of medium-term notes, inflation-protected securities, and long-term bonds. As Treasury securities mature, they are replaced with new issues. Therefore, the budgetary effects of higher interest rates would mount each year, peaking under this scenario at an additional $43 billion in 2017. (In 2018, the budget surplus projected in CBO’s baseline and the effect of projected surpluses in prior years would reduce projected federal borrowing, thereby slightly lessening the effect of higher interest rates.)
As part of its conduct of monetary policy, the Federal Reserve buys and sells Treasury securities in the open market. The interest that it earns on its securities portfolio helps determine its profits, which are counted as revenues when they are turned over to the Treasury. If interest rates each year were 1 percentage point higher than CBO projects, annual earnings on those securities—and thus revenues—would increase by amounts growing from $2 billion in 2008 to $11 billion in 2018.
In addition, the larger deficits or smaller surpluses that would accompany higher interest rates would require the Treasury to raise more cash than the amounts assumed in the baseline. The resulting increase in annual debt-service costs would be as much as $22 billion by 2018.
All told, if interest rates were a full percentage point higher than the rates assumed in CBO’s baseline, the budget’s bottom line would worsen by increasing amounts over the projection period: by $8 billion in 2008, up to $52 billion in 2018. The cumulative surplus over the 2009–2018 period would drop by $399 billion.
The third rule of thumb shows the budgetary impact of inflation that is 1 percentage point higher than the rates assumed in the baseline. That change has a bigger effect on federal revenues and outlays than do the other rules of thumb. For the most part, the effects of inflation on revenues and outlays offset each other, although after a few years, the impact on revenues is the larger of the two effects.
On the one hand, higher inflation leads to increases in wages and other income, which translate directly into more income and payroll taxes being withheld from people’s paychecks. The resulting impact on revenues is dampened (with a lag) because the thresholds for various tax rate brackets are indexed to rise with inflation. In addition, the faster growth of prices boosts corporate profits, which quickly leads to greater federal receipts from firms’ quarterly estimated tax payments.
On the other hand, higher inflation increases spending for many federal benefit programs and, because of the statutory rules governing the baseline, drives growth in projections of discretionary spending. Many mandatory programs automatically adjust their benefit levels each year to reflect price increases. Social Security, federal employees’ retirement programs, Supplemental Security Income, veterans’ disability compensation, Food Stamps, and child nutrition programs, among others, are adjusted (with a lag) for changes in the consumer price index or one of its components. Many Medicare payment rates are also adjusted annually for inflation. Other programs, such as Medicaid, are not formally indexed but grow with inflation nonetheless. In addition, to the extent that initial benefit payments to participants in retirement and disability programs are related to wages, changes in nominal wages as a result of inflation will be reflected in future outlays for those programs—because the initial payments are the basis for future cost-of-living adjustments. Finally, future spending for discretionary programs is projected on the basis of assumed rates of wage and price growth.
Inflation also has an impact on federal net interest outlays because it is one component of nominal long-term interest rates (the other being a real rate of return). For example, if real rates of return remain constant but inflation rises, interest rates will climb, and new federal borrowing will incur higher interest costs. For this rule of thumb, CBO assumed that nominal interest rates would rise in step with inflation, thus increasing the cost of financing the government’s debt.
If inflation each year was 1 percentage point higher than the rate assumed in CBO’s baseline, total revenues over the 2009–2018 period would be about 7 percent and outlays about 6 percent larger compared with projections. The effects of higher inflation on outlays and revenues in the near term, from 2008 to 2011, would basically offset each other, mainly because CBO assumed that interest rates would rise with inflation and thus drive up federal interest payments relatively quickly. Higher inflation would also boost mandatory spending in the short run. As a consequence, over the 2008–2011 period, the increase in outlays would slightly exceed the rise in revenues projected under this scenario (see Table C-1).
By 2012, however, the growth in revenues associated with higher inflation would outdistance the growth in outlays; the gap between the two would widen thereafter, reaching $83 billion (plus $13 billion in additional debt-service costs) by 2018. As a result, the cumulative surplus for the 10-year projection period (including debt-service costs) would be $278 billion larger than in CBO’s baseline.
Wages and Salaries as a Larger Share of GDP
Because different types of income are taxed at different rates, changes over time in the share of total income that each type represents have contributed to changes in federal tax receipts measured as a percentage of GDP. However, considerable uncertainty surrounds projections of those income shares.
Two of the most important categories of income for projecting federal revenues are wages and salaries and corporate profits. Wages and salaries are the most highly taxed form of income because they are subject to the individual income tax as well as to payroll taxes for Social Security (up to a maximum annual amount) and for Medicare. Consequently, an additional dollar of wages and salaries will produce more revenues than will an additional dollar of corporate profits, CBO estimates. Larger projections of wages and salaries and correspondingly smaller projections of profits will thus result in larger projected federal revenues.
CBO’s baseline incorporates the assumption that total wages and salaries will equal about 46 percent of GDP between 2008 and 2018 and that taxable corporate profits will range from 6.4 percent to 8.6 percent of GDP (see Chapter 4). If, instead, wages and salaries each year were 1 percentage point larger relative to GDP and corporate profits were 1 percentage point smaller, annual revenues would be $10 billion greater in 2008 and $21 billion greater by 2018 (see Table C-1).
Two years stand out in what is basically a pattern of steadily increasing revenues under this scenario. The first is 2009, when revenues are higher by $8 billion, which is less than the $10 billion increase in 2008. That relatively small drop results from CBO’s assumption that corporations pay the taxes they owe on profits more slowly than individuals pay the taxes they owe on their wages (which are subject to automatic withholding). Those slower payments delay the fall in corporate receipts—from the 1 percentage point cut in corporate profits—from 2008 to 2009. In addition, firms can carry forward any losses they incur in earlier years to help reduce their tax liability in subsequent years—specifically, in 2009 and beyond. Those effects make the decline in corporate receipts larger in 2008 than in 2009.
The net effect on revenues also dips slightly in 2012 before resuming an upward trend over the rest of the 10-year period. That drop is primarily attributable to legislation that shifts estimated corporate tax payments from 2013 into 2012. The shift thereby magnifies the effect that lower profits under the rule of thumb have on changes in corporate receipts in 2012 and offsets some of the impact of increased individual and payroll taxes.
The larger amount of revenues that would result from an increase in wages and salaries as a share of GDP would further improve the budget’s bottom line by reducing the borrowing costs assumed in the baseline in each year of the projection period. That decrease in interest payments would gradually reach $9 billion by 2018. Overall, under this scenario, the cumulative 10-year surplus would be $186 billion larger than the surplus in CBO’s baseline.
A conventional way to measure past variability is to use the standard deviation. In the case of GDP growth, CBO calculates the extent to which actual growth over 10-year periods differs from the post-World War II average. The standard deviation is the size of the difference that is exceeded about one-third of the time.
A change in the rate of real growth could affect other economic variables, such as inflation and unemployment; however, CBO’s rule of thumb does not include such effects.
Medicare’s payment rates for physicians’ services are computed using a formula that compares annual spending with a target amount that partly reflects the growth of GDP. The impact of lower real growth would not affect those payment rates until 2017.
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