Editor's note: The latest downloadable version of this paper, dated June 30, 2011, includes updates to account for the CBO long term budget outlook.
We present new estimates of the budget outlook, based on the latest projections from the Congressional Budget Office and the Medicare and Social Security Trustee reports. The medium-term and long-term budget outlook have not changed appreciably since last year. Under reasonable assumptions, the federal government is likely to face deficits in excess of 6 percent of GDP by late in the decade, even with a strong economy, with the debt-GDP ratio reaching 98 percent by 2021. The long-term budget outlook is sensitive to assumptions about how health care spending will respond to recent legislation. However, even under the most optimistic assumptions regarding health care spending, the most likely estimate suggests a long-term fiscal gap of between 6 and 7 percent of GDP. Policy makers and the public will eventually be forced to address these issues, but addressing them sooner rather than waiting until a full-blown crisis hits would allow for more reasonable and gradual adjustments.
The United States faces the prospect of large federal fiscal deficits in the immediate future, the next 10 years, and the longer term. The short-term deficits - the result of the tax cuts and spending increases of the last decade, the "Great Recession," and economic policy adjustments in the past year - are generally thought to be helping the economic recovery. In contrast, the medium-term deficits projected for the next 10 years and the long-term deficits projected beyond 2021 are a source of concern. Even if they do not lead immediately to a crisis, they will nevertheless create growing and serious burdens on the economy.
The unsustainability of federal fiscal policy has been discussed at least since the 1980s. But the problem has increased in importance and urgency in recent years, for several reasons. First, the medium-term projections have deteriorated significantly. Second, the issues driving the long-term projections - in particular, the retirement of the baby boomers and the aging of the population and the resulting pressure on Medicare and to some extent Social Security - which were several decades away in the 1980s - are now imminent. Third, there are increasing questions about the rest of the world's appetite for U.S. debt, as the United States has changed from a net creditor country in 1980 to a vast net debtor currently. Fourth, many countries around the world and many of the U.S. states also face daunting fiscal prospects currently.
In light of these issues, this paper provides new projections of the federal budget over the medium and long terms.1 This paper provides new projections of federal budget outcomes, using the January 2010 Congressional Budget Office (CBO 2011) projections, recent reports by the Social Security and Medicare trustees (Medicare Trustees 2010), an analysis by Medicare actuaries (Medicare Actuary 2010). It updates the analysis in Auerbach and Gale (2010a, 2010b).
The analysis begins with the most recent Congressional Budget Office (CBO) baseline budget projections. CBO (2011) projects the 2011 deficit to be $1.5 trillion, about 9.8 percent of GDP. Other than 2009, this represents the largest deficit as a share of the economy since World War II. For 2012-2021, the CBO baseline projects a cumulative deficit of $6.9 trillion, with deficits declining sharply to 3 percent of GDP by 2015 and hovering around 3.0 percent of GDP through 2021. This would be a reassuring outcome, at least for the medium term, except that the CBO baseline is not intended to represent likely or probable outcomes. Rather, it essentially reports the implications of the assumption that Congress does nothing over the next 10 years. All major tax provisions currently scheduled to expire are assumed to do so as scheduled, for example.
A more plausible way to project future outcomes may be to assume that future Congresses will act more or less like previous Congresses, for example in granting continuances to expiring tax provisions. To generate a better measure of where fiscal policy is headed, we alter the CBO baseline assumptions in ways that we believe are more representative of the continuation of current policies. Under this extended policy scenario, we estimate a 10-year deficit of $12.1 trillion, or 6.2 percent of GDP. As in CBO's baseline, deficits decline in the near term, but only to 5.6 percent of GDP by 2015, and unlike in CBO's baseline, deficits then rise substantially.
By 2021, although the economy is projected to have been at full employment for several years, the deficit under these alternative assumptions rises to 6.6 percent of GDP. Spending rises to 24.9 percent of GDP (the highest since World War II, except for the current downturn), the debt-to-GDP ratio rises to 98.1 percent (the highest since 1947), and net interest payments rise to 4.3 percent of GDP (the highest share ever and larger than defense or non-defense discretionary spending).
All of these figures are poised to rise further after 2021, and revenue growth is projected to be much weaker than spending growth, implying that the situation is unsustainable. The debt-to-GDP ratio will pass its 1946 high of 108.6 percent early in the 2020's under extended policy and in the following decade under the CBO baseline. Under both scenarios, however, the debt-to-GDP ratio would then continue to rise rapidly, contrary to its sharp decline in the years immediately after 1946.
All of the estimates above, for the 10-year horizon and the debt-GDP ratio headed into the next decade, are very close to those provided in Auerbach and Gale (2010a, 2010b). That is, little has changed to alter the medium-term (10-year) budget outlook in the period since last year, except for health care legislation, which our earlier work already incorporated.
The health reform package's impact on the long-term budget outlook is more controversial. To examine long-term issues more formally, we estimate a long-term fiscal gap - the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt-to-GDP ratio at its current level. Using current-law assumptions for Medicare spending, as put forth by the Medicare trustees (2010), and depending on the time frame employed, the fiscal gap is estimated to be about 4-5 percent of GDP under the assumptions in the CBO baseline, and about 6-7 percent of GDP in the extended policy scenario. However, the fiscal gap rises by 2-3 percent of GDP under both of these scenarios when substituting the Medicare outlay estimates put forth by the Medicare actuaries (Medicare Trustees 2010) and rises by an additional 1-2 percent when using assumptions employed by CBO (2010d). As a result, the gap is estimated to be as high as 12 percent of GDP under our worst-case scenario. These estimates show both that health care reform is an important part of the long-term budget outlook, but that even very substantial and sustained reform of health care will leave a significant fiscal gap. As a result, the budget outlook will create difficult trade-offs for policy makers and the American public.
1. This paper builds on analysis and conventions we have developed in numerous previous papers including Auerbach and Gale (1999, 2000, 2001, 2009, 2010a, 2010b), Auerbach et al. (2003), and Auerbach, Furman and Gale (2007, 2008).