Our projections for the budget balance and national debt, which we discuss in chapter 4 and later chapters, are based on the ten-year and long-term forecasts of the Congressional Budget Office. This appendix describes the adjustments to the CBO forecasts that we incorporate in our projections.
We begin with the CBO’s latest baseline forecast (as of the time of writing), published in The Budget and Economic Outlook: An Update, August 2011.1 By law, the CBO’s baseline forecast must follow certain rules that, many people believe, make it unrealistic. The most important rules, for our purposes, are, first, that discretionary spending in future years will grow at the rate of inflation; and, second, that current law regarding revenues and mandatory spending will remain unchanged. Because military spending is a type of discretionary spending, the first rule produces the anomalous result that spending on “overseas contingency operations”—primarily fighting in Afghanistan and Iraq—is forecast to grow at the rate of inflation over the next decade, even though our current plans are to reduce force levels and spending. For this reason, we adjust the baseline to account for the expected reduction in troop deployments, using the estimate provided by the CBO.2 (For other discretionary spending, the general rule does not apply because future discretionary spending was subject to explicit caps by the Budget Control Act of 2011.)3
Because of the second rule, the CBO’s baseline assumes that Congress will not act to change current law. This assumption is particularly unrealistic in cases where the law is scheduled to change but Congress has acted repeatedly in the past to override such a change. Our projections assume that Congress will make two changes to current law that it has made multiple times in the past. First, it will continue to increase the threshold for the alternative minimum tax (AMT) along with inflation so that it does not suddenly affect a large number of middle-class households.a Second, it will protect physicians from a sudden drop in Medicare reimbursement rates.4 For each of these changes, we adjust the baseline forecast using the CBO’s estimate of its impact over the next ten years.5
The next major area of policy uncertainty is the 2010 tax cut, which extended the 2001 and 2003 income and estate tax cuts as well as certain provisions of the 2009 stimulus bill. The CBO’s baseline forecast assumes that these tax cuts will all expire as scheduled on December 31, 2012, as dictated by current law. Because they have been extended once already, President Obama is in favor of extending most of them, and congressional Republicans are in favor of extending all of them, it seems politically unlikely that these tax cuts will all expire. One of our arguments, however, which we make in chapters 4 and 7, is that they should be allowed to expire. For this reason, our projections include two scenarios: one in which the tax cuts expire and one in which they do not expire. For the latter scenario, we adjust the baseline forecast using the CBO’s estimate.6 Finally, there are a number of other miscellaneous tax cuts that are scheduled to expire over the next several years. No doubt some will be extended and some will not. For simplicity, our projections assume that none of them will be extended.7
The CBO’s most recent long-term forecast was published in its 2011 Long-Term Budget Outlook in June 2011. This forecast extends to 2085, although the report focuses mainly on the period through 2035. The June 2011 long-term forecast was constructed as an extension of the then current ten-year forecast from March 2011.8 In August, however, the Budget Control Act of 2011 was enacted, which entailed significant changes in the CBO’s most recent ten-year forecast, published later that same month. For these reasons, our projections attempt to reconstruct what the CBO’s long-term forecast would be today (with a few adjustments), incorporating the August ten-year forecast. In other words, our long-term projection is based on the August ten-year forecast in roughly the same way that the CBO’s June long-term projection was based on the March ten-year forecast.
The CBO’s 2011 Long-Term Budget Outlook includes two scenarios: the extended-baseline scenario and the alternative fiscal scenario.9 The extended-baseline scenario, like the ten-year baseline forecast, assumes that current law will remain largely unchanged. The alternative fiscal scenario assumes that the law will change where it is inconsistent with current policy (for example, it assumes that all expiring tax cuts will be extended indefinitely); it is similar to our ten-year projections except in the treatment of expiring tax cuts.
As above, we provide long-term projections for two scenarios: one in which the 2001–2010 tax cuts are allowed to expire and one in which they are extended indefinitely. We construct these projections the same way; the only difference is the 2021 starting point. In particular, we make the following assumptions:
• Tax revenues will grow from their 2021 level, as a percentage of GDP, at the average annual rate given by the CBO’s alternative fiscal scenario in its 2009 long-term forecast.10
• Social Security spending will grow from its 2021 level, as a percentage of GDP, at the same rate as in the CBO’s long-term forecast until it stabilizes at 6.1 percent of GDP in the early 2030s; after that point it will be identical to the CBO’s long-term forecast. (Social Security spending is the same in the CBO’s two scenarios.)
• Total spending on Medicare, Medicaid, the Children’s Health Insurance Program, and subsidies for health insurance bought through exchanges (most government health care spending) will grow from its 2021 level, as a percentage of GDP, at the same rate as in the CBO’s alternative fiscal scenario. Spending in this scenario is higher than in the extended-baseline scenario.11
• Other spending, other than interest payments, will remain constant as a percentage of GDP at its 2021 level. This is a close approximation to the method followed by the CBO in both of its scenarios.12
• Other means of financing (changes in government accounts that affect the amount of government borrowing) will decline from 0.3 percent of GDP in 2021 to 0.1 percent in 2023.13
• The average effective real interest rate on federal government debt in the long term will be 2.7 percent and the average inflation rate, as measured by the Consumer Price Index, will be 2.5 percent. We project that these rates will change linearly from their 2021 values to reach their long-term values in 2031. These assumptions are very similar to those in the CBO’s long-term forecast.14
• The average annual growth rate of real GDP will be 2.1 percent over the 2021–2035 period and 2.2 percent over the 2035–2085 period, as in the CBO’s long-term forecast.15 The GDP deflator (another measure of inflation that reflects changes in the mix of goods and services produced from year to year) will grow at 2.2 percent per year. This assumption is taken from the CBO’s long-term forecast.16
In general, these assumptions are similar to those in the CBO’s 2011 alternative fiscal scenario. The major difference is that that scenario assumes that tax revenues remain constant as a percentage of GDP from 2021.17 We consider this an excessively conservative assumption, since it essentially states that, even in the face of rising deficits, Congress will not only refuse to increase taxes, but will actively reduce tax rates. (If the tax code were to remain exactly the same, tax revenues would grow slowly as a percentage of GDP due to rising real incomes.) We think a better assumption to use as a starting point is that Congress will simply do nothing (other than effectively indexing the alternative minimum tax), in which case tax revenues will rise slowly.
Because these are the only adjustments we make to CBO forecasts, we are incorporating the economic assumptions made by the CBO with no changes. Those assumptions may be too optimistic or too pessimistic, but we do not claim to know which one. The CBO’s economic forecasts do not reflect the economic impact of higher debt levels;18 if the national debt does increase significantly, it could have feedback effects on the economy that would increase interest rates and reduce economic growth.19 For this reason, our scenario in which the 2001–2010 tax cuts are made permanent is probably too optimistic; in that case, while we show the national debt rising to 100 percent of GDP around 2030, feedback effects would probably cause it to reach that level even sooner. This concern is less applicable to our scenario in which the tax cuts are allowed to expire because debt levels in that scenario remain near current levels. (For the same reason, this concern is also less relevant to our “fiscal adjustment” scenarios, described below, in which we model the effect of specific reductions in the government’s annual budget deficit.)
The Budget Control Act of 2011, which ended the debt ceiling standoff of 2011, placed caps on discretionary spending through 2021 that reduced spending, relative to the CBO’s previous baseline, by a total of $900 billion.20 The CBO’s August 2011 baseline, and by extension our projections, assume that those caps will be effective. This is an optimistic assumption (from a deficit reduction perspective) because Congress and the president could simply agree to lift those caps in the future.
The Budget Control Act also mandated a bipartisan congressional Joint Select Committee on Deficit Reduction (popularly known as the “supercommittee”) to propose a plan to reduce deficits by at least $1.2 trillion over the next ten years. Since the CBO could not know what the supercommittee would propose, its August 2011 baseline simply spreads that $1.2 trillion in deficit reduction equally over the 2013–2021 period.21 Our ten-year projections incorporate this CBO assumption. Our long-term projections, however, assume that whatever policies reduce deficits by $1.2 trillion over the next ten years will have no impact on later years. This is a conservative assumption, since it is highly unlikely that any set of deficit reduction policies could have a large impact through 2021 and no impact thereafter. The supercommittee’s subsequent failure does not affect this analysis because, under the Budget Control Act, the $1.2 trillion of deficit reduction it was supposed to identify is simply replaced by $1.2 trillion in automatic spending cuts, mainly to discretionary programs.22 Our projections assume that those automatic spending cuts will reduce deficits by $1.2 trillion over ten years but will have no effect in later years, which is still a conservative assumption.
In summary, it is difficult to tell what the long-term impact of the Budget Control Act will be. The two major questions are whether its discretionary spending caps will be observed by Congress and whether its automatic spending cuts will have an impact on later years,23 and there is no way to know the answers to those questions today. Our assumptions are optimistic (lower deficits) on the first question and conservative (higher deficits) on the second question.
In chapters 6 and 7, we discuss the impact on our projections of reducing budget deficits by 3.0 percent of GDP (in the scenario where the 2001–2010 tax cuts expire on schedule) or 5.5 percent of GDP (in the scenario where the tax cuts are made permanent). In each case, it is implausible that such adjustments would be made entirely in one year, and in many cases our recommendations are for policy changes to be phased in gradually. For simplicity, however, we assume an improvement in the primary balance by 3.0 percent of GDP (or 5.5 percent) that begins in 2022 and continues in every year thereafter. This may be a conservative assumption, since our proposals could theoretically be adopted tomorrow, in which case the phase-in period could begin in 2013 or 2014 (although it would still last for several years). On the other hand, it is more likely that any major deficit reduction plan will not be adopted for several years and then will require years to phase in, so an average implementation date of 2022 seems reasonable.
a The threshold at which the AMT applies is not itself indexed for inflation. Periodically, Congress adjusts the threshold to take inflation into account, protecting most middle-class households from having to pay the AMT. These “patches,” however, are always temporary, so if one were to expire without being replaced by another, the threshold would automatically revert to its previous, lower level, immediately affecting many middle-class taxpayers.