Long-Term Budget Forecasts for Beginners

In this season of debate over long-term deficits, this is ground zero:

That’s the key chart from the Congressional Budget Office’s Long-Term Budget Outlook, published just last month, which I read from cover to cover. The CBO is generally considered the authoritative source of budget projections, and CBO “scoring” has been an important aspect of legislative debates over the past few years. Although politicians from both sides criticize the CBO when they don’t like its results, I think it’s fair to say that it is generally both respected and nonpartisan.

Now, when people say that the federal government faces a long-term budget gap, they (including me) are generally starting from the bottom half of this picture: the CBO’s “alternative fiscal scenario.” The alternative scenario is widely considered the most likely path the budget will follow under current policy (although the CBO itself makes no such claim*). That’s probably a close enough approximation for most purposes. But if you’re going to think hard about long-term budgetary paths, you need to be a bit more careful about what it means.

To start off with, you have to understand what the “extended baseline scenario” — the top half of that picture — means. That’s pretty simple: it means under current law. And the first thing you should notice is that, under current law, there is no long-term budget gap. From 2015 into the indefinite future, the government’s primary spending equals its revenues. The only spending not included in primary spending is interest on the debt. Since the debt stabilizes at about 75-80 percent of GDP, interest payments are only about 3-4 percent of GDP, which is barely above real economic growth; under these conditions, the debt will grow very slowly.

But everyone knows this is not going to happen. Most obviously, Congress will patch the alternative minimum tax so that it does not suddenly hit one-fifth of the population,** and it will pass the “doc fix” so that Medicare reimbursement rates do not suddenly fall by 28 percent on January 1.***  The former will cost $800 billion over the next decade and the latter will cost $300 billion — money that is not reflected in the extended baseline scenario. (See the CBO’s January 2011 Budget and Economic Outlook, Table 1-7.)

The alternative fiscal scenario is the CBO’s response to this problem. The question is what assumptions should go into this scenario.

As I said, virtually everyone agrees that the AMT and Medicare reimbursement rates will continue to get patched because Congress does it every year – AMT since 2001 or so, Medicare since 2003. Another obvious one is that spending on the Iraq and Afghanistan Wars will decline, saving over a trillion dollars over the next decade. (The rules governing the CBO’s baseline projections force it to assume that war-related spending grows with the inflation rate, regardless of conditions on the ground.) But after that, things get murkier.

On the revenue side, the CBO’s alternative scenario assumes that all of the 2001, 2003, 2009, and 2010 tax cuts are made permanent, except for the two percentage point payroll tax cut passed in December 2010, at a cost of about $3.8 trillion (in addition to the AMT patch, assuming the AMT is patched). If I were to guess what would happen to tax policy, that would be my best guess, too, given politicians’ love for tax cuts. But this feels much more like a bet than a foregone conclusion. But then there’s an even bigger assumption: that total tax revenues will remain constant at 18.4 percent of GDP beginning in 2021. See the flat line in revenues in the bottom half of the picture above? That’s due to that one assumption.

Now, it’s not a crazy assumption. There are some people saying that revenues can’t exceed 18-19 percent of GDP for long, and that’s clearly wrong: if there were some magical limit to taxation, it would have to apply at the total level, not just the federal level; and in any case, it clearly doesn’t apply in other economies similar to ours. But it’s plausible to argue that, for political reasons, tax revenues are likely to wobble around 18-19 percent, which is the long-term average, after all. That is, if one party manages to push tax revenues above 20 percent, the other will get voted in and cut taxes down below 18 percent. In fact, this is exactly what happened a decade ago: the Bush I tax increase, the Clinton tax increase, and the 1990s boom pushed revenues above 20 percent, and then Bush II came in and (helped by a recession) cut taxes down to the mid-teens, where they are now.

But what feels slippery about both of these assumptions — full extension of the recent tax cuts and fixed revenues as a percentage of GDP thereafter — is that they basically assume that the Republicans win on tax policy. (Note that the one tax cut that is not extended — the reduction in the payroll tax — is the one that Democrats pushed for last year.) Hold that thought.

On the spending side, the big assumption in the alternative scenario is that several of the cost-control mechanisms in the Affordable Care Act won’t work. For example, the CBO assumes that the Independent Payment Advisory Board will have no effect on Medicare spending (Long-Term Budget Outlook, p. 45); it also assumes that an indexing provision that would reduce the number of people qualifying for health insurance subsidies will not take effect (same). Again, these are not bad guesses about the future. In general, whenever existing law is about to reduce benefits under entitlement programs, it is a fair bet that Congress will prevent those reductions from taking effect. In effect, this is like saying that the Democrats will win on entitlement policy.****

So on both sides, taxes and spending, I can see where the CBO is coming from. But the result is that the definitive report on our long-term budget gap implicitly assumes that we do nothing about that budget gap — that we keep cutting taxes and blocking spending cuts at every opportunity. At the same time, we know this is not going to happen. The alternative scenario says that in 2035, the national debt will be 187 percent of GDP, the primary deficit will be 6.6 percent, and interest payments will be 8.9 percent, for a total deficit of 15.5 percent. We all know something will change before we get to that point: the question is what.

The CBO is really in an impossible position, since it’s impossible to predict what will change. So I actually think they did the right thing: they painted a picture of where we are heading, assuming that we continue making the political choices we have been making for the past decade. In other words, they assumed that the kinds of choices we make will not change even as the overall fiscal environment does change. The resulting picture is pessimistic on both the revenue side and the outlay side, but that’s really because it’s a commentary — as neutral a commentary as possible — on our current political course.

* This is what they actually say:

“The alternative fiscal scenario embodies several changes to current law that would continue certain tax and spending policies that people have grown accustomed to (because the policies are in place now or have been in place recently). . . . After 2021, the alternative fiscal scenario also incorporates modifications to several provisions of current law that might be difficult to sustain for a long period. . . . Together, the changes incorporated in this scenario represent one interpretation of what it would mean to continue today’s underlying fiscal policy” (p. 2).

** The AMT is an alternative income tax system that disallows a bunch of deductions and taxes all income at 26-28 percent. The parameters of the AMT are not indexed for inflation, so over time it should affect a growing percentage of the population. However, Congress periodically patches the AMT by raising its parameters temporarily. This is like indexing, except the patches are always temporary (because otherwise they would create a huge budgetary gap).

*** Same basic idea as the AMT. The 28 percent figure is from the CBO’s Budget and Economic Outlook, January 2011, p. 62.

**** This isn’t quite right, since both parties have become vocal defenders of entitlement spending (see the Republican behavior during the health care reform debate), but you know what I mean.

This post originally appeared at The Baseline Scenario and is reproduced here with permission.