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One tradition in American budget politics—and much anticipated among budget wonks—is the annual release of the economic and budget outlooks by the administration and the Congressional Budget Office (CBO). In January, CBO released its annual report detailing its forecast for the economy and projections for spending, revenues, deficits, and federal debt through fiscal year 2026. The president followed in February with his final budget submission. The president’s budget, while interesting from a policy perspective, is unlikely to receive much attention or support in Congress. The essentials of the federal government’s fiscal trajectory are better reflected in the CBO report.
In August 2015, CBO indicated the budget deficit would remain relatively level for a few years before entitlement spending (from an aging population and rising health care costs) and growing net interest on the debt would drive the deficit and debt higher. The current report largely repeats the story except the near-term outlook will be worse than projected last August primarily because of tax cuts and spending increases passed between August and the end of last year.
This year’s report takes the projections a year further into the future, to 2026. Last year’s report said deficits or debt would rise steadily in the out-years, and this year’s report confirms that assessment. In fact, because the forecast period goes one year farther into the future, the 10-year totals for the deficit and debt include another bad out-year (2026) and exclude a comparatively good year (2015). The effect on the cumulative deficit or debt levels is that the cumulative 10-year reported deficit is $1.5 trillion higher than what was reported last August.
Making matters worse, CBO’s economic assumptions were overly optimistic last year and appear even more overly optimistic this year. CBO assumes more rapid growth than is likely, especially for this year and next; more rapid wage increases; and higher inflation. Moreover, CBO assumes no recessions in the forecast period—an increasingly unlikely event.
Changes to the Projections
The short-term changes to the budget projections stem from the passage of three major pieces of legislation last year: the FAST Act authorizing highway spending, the PATH Act extending important tax provisions, and the Consolidated Appropriations Act, 2016.
These bills added to outlays and reduced revenues over the entire forecast. However, much of the estimated revenue reduction reflects a perverse methodology CBO employs with respect to tax policy. When tax provisions reducing revenues expire, CBO raises the total revenue projection accordingly from the date of expiration. In contrast, in constructing baseline spending projections, CBO generally assumes spending provisions remain in effect even after they expire in law. No justification exists for this asymmetric treatment between temporary tax provisions and temporary spending provisions.
The Budget Outlook
As a result of the last-minute legislative push as well as changes in technical and economic assumptions, the government deficit is projected to increase to $544 billion (2.9% of GDP) in 2016 from $439 billion in 2015 (2.5% of GDP). Over the next 10 years, the deficit is expected to increase every year and will surpass $1.3 trillion in 2026 (4.9% of GDP).
What accounts for the massive increase in the deficit over the next decade? According to CBO, rising budget deficits result almost entirely from growth in outlays rather than from a shortfall on the revenue side. Revenues are projected to remain stable over the forecast horizon, ranging from 17.9% of GDP to 18.3%, consistent with their historical average.
In contrast, outlays rise from 20.7% in 2015 to 23.1% in 2026, well above historical averages. Among the three components of government outlays, net interest and mandatory spending account for most of this increase. Discretionary spending shows a relatively modest increase from $1.2 trillion to $1.4 trillion over the forecast horizon. As a share of GDP, discretionary spending is projected to decline from 6.5% in 2015 to 5.2% in 2026.
CBO expects a substantial increase in net interest spending, resulting from rising interest rates and a growing debt burden. Net interest costs are projected to soar from $223 billion (1.3% of GDP) in 2015 to $830 billion (3.0% of GDP) in 2026 due to a combination of rising debt levels and a forecast of rising interest rates. Mandatory outlays are also projected to grow rapidly, rising from $2.3 trillion in 2015 (12.9% of GDP) to $4.1 trillion in 2026 (15.0% of GDP).
Rising deficits are projected to drive up the debt. The debt held by the public is projected to grow more than 80%, from $13.1 trillion in 2015 to $23.8 trillion in 2025. As a share of GDP, the debt would rise from 73.6% in 2015 to 86.1% in 2026.
Since the end of the recession, the U.S. economy has achieved a few quarters of fairly strong growth interspersed with many more of subpar progress. On net, growth has averaged only 2.1% annually. Despite repeated optimistic forecasts, the recovery has continually disappointed on the downside.
Despite this trend, CBO assumes growth will average 2.5% in 2016 and 2.6% in 2017, considerably above the consensus forecast of private forecasters. In CBO’s defense, its latest forecast was developed before the dismal fourth-quarter GDP reading of 0.7% was released and the subsequently weak data that has since appeared. Nor does it entirely reflect the sharp slide in U.S. equity markets. The recent slowdown in domestic activity will require CBO to soften its economic forecast substantially, thereby presenting an even grimmer fiscal picture.
Another problematic feature of the CBO forecast is it does not anticipate a recession at any point over the next 10 years, even as the current expansion is approaching 7 years. While a recession does not appear on the immediate horizon, continued uninterrupted growth throughout the forecast horizon is not a realistic projection.
The absence of a recession highlights a long-standing issue with CBO and administration economic forecasts— recessions happen. In modern U.S. history, the economy has only once experienced 10 years of sustained growth without a recession. No recession appears on the horizon, but when a recession occurs it will wreak havoc with CBO’s projections, as outlays will undoubtedly increase and revenues will fall, significantly altering the long-run fiscal outlook CBO is attempting to describe.
A Diminished Future
The disappointing recovery has forced CBO to lower its estimate of potential GDP growth repeatedly in response. Its latest report is no different. For the period 2016–2026, CBO estimates annual potential GDP growth to be only 2.0%. Potential GDP is a fair proxy for overall prosperity. When potential GDP is rising rapidly, the American economic dream is bright. When GDP’s potential growth rate falls, America’s future dims. In recent years, CBO has had to steadily reduce its forecast for potential GDP growth as the administration’s policies and the overly long period of extended weakness have combined to undermine the economy’s fundamentals.
The Bottom Line
The fiscal situation last year was worrisome, but because the near-term deficits were projected to be stable, few raised alarms. All too often the focus was on the progress made in reducing the deficit after years of trillion-dollar deficits. This shifted attention away from the rapid deterioration just ahead.
The long-run story this year is pretty much the same, but the short-run picture is a bit worse. Deficits and debt levels are too high and poised to rise rapidly. Entitlement programs and interest on the debt remain the primary culprits. Furthermore, the situation is probably worse than what is forecast because of unrealistic economic assumptions.
The economy is facing headwinds from all directions. The CBO report makes a compelling case that potential growth has declined substantially under the president’s policies. The good news is that we can change course, adopting the kinds of pro-growth policies the U.S. Chamber has long advocated.