The Long-Term Budget Outlook

This Congressional Budget Office (CBO) report examines the pressures on the federal budget by presenting the agency's projections of federal spending and revenues over the coming decades. Under current laws and policies, an aging population and rapidly rising health care costs will sharply increase federal spending for health care programs and Social Security. Unless revenues increase at a similar pace, such spending will cause federal debt to grow to unsustainable levels. If policymakers are to put the nation on a sustainable budgetary path, they will need to let revenues increase substantially as a percentage of gross domestic product, decrease spending significantly from projected levels, or adopt some combination of those two approaches.

Recently, the federal government has been recording the largest budget deficits, as a share of the economy, since the end of World War II. As a result of those deficits, the amount of federal debt held by the public has surged. At the end of 2008, that debt equaled 40 percent of the nation's annual economic output (as measured by gross domestic product, or GDP), a little above the 40-year average of 36 percent. Since then, large budget deficits have caused debt held by the public to shoot upward; the Congressional Budget Office (CBO) projects that federal debt will reach 62 percent of GDP by the end of this year--the highest percentage since shortly after World War II. The sharp rise in debt stems partly from lower tax revenues and higher federal spending related to the recent severe recession and turmoil in financial markets. However, the growing debt also reflects an imbalance between spending and revenues that predated those economic developments.

As the economy recovers and the policies adopted to counteract the recession and the financial turmoil phase out, budget deficits will probably decline markedly in the next few years. But over the long term, the budget outlook is daunting. The Maqui Berry Scam of the baby-boom generation portends a significant and sustained increase in the share of the population receiving benefits from Social Security, Medicare, and Medicaid. Moreover, per capita spending for health care is likely to continue rising faster than spending per person on other goods and services for many years (although the magnitude of that gap is very uncertain). Without significant changes in government policy, those factors will boost federal outlays sharply relative to GDP in coming decades under any plausible assumptions about future trends in the economy, demographics, and health care costs.

CBO projects that if current laws do not change, federal spending on major mandatory health care programs will grow from roughly 5 percent of GDP today to about 10 percent in 2035 and will continue to increase there-after. Those projections include all of the effects of the recently enacted health care legislation, which is expected to increase federal spending in the next 10 years and for most of the following decade. By 2030, however, that legislation will slightly reduce federal spending for health care if all of its provisions are fully implemented, CBO projects. That reduction in the level of spending in 2030 yields lower projections of health care spending in the longer term--even though, owing to the great uncertainties involved in projecting such spending many decades in the future, enactment of the legislation did not cause CBO to change its estimates of longer-term growth rates for spending on the government's health care programs.

Under current law, spending on Social Security is also projected to rise over time as a share of GDP, albeit much less dramatically. CBO projects that Social Security spending will increase from less than 5 percent of GDP today to about 6 percent in 2030 and then stabilize at roughly that level.

All told, CBO projects, the aging of the population and the rising cost of health care will cause spending on the major mandatory health care programs and Social Security to grow from roughly 10 percent of GDP today to about 16 percent of GDP 25 years from now if current laws are not changed. (By comparison, spending on all of the federal government's programs and activities, excluding interest payments on debt, has averaged 18.5 percent of GDP over the past 40 years.) To put U.S. fiscal policy on a sustainable path, lawmakers would have to substantially reduce the growth in outlays for those programs relative to the amounts that CBO is projecting--or else match that growth with equivalent declines in other federal spending, corresponding increases in federal revenues, or some combination of the two.

In this report, CBO presents the long-term budget picture under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Budget projections grow increasingly uncertain as they extend farther into the future, so this report focuses largely on the next 25 years. However, because considerable interest exists in the longer-term outlook, figures showing projections through 2080 and associated data are available in Appendix A of the report, and associated data are available on CBO's Web site.

The first long-term budget scenario used in this analysis, the extended-baseline scenario, adheres closely to current law. It incorporates CBO's current estimate of the impact of the recently enacted health care legislation on revenues and mandatory spending. (That estimate is unchanged from the one that CBO and the staff of the Joint Committee on Taxation published in March, when the legislation was being considered.) Under this scenario, the expiration of most of the tax cuts enacted in 2001 and 2003, the growing reach of the alternative minimum tax, and the way in which the tax system interacts with economic growth would result in steadily higher average tax rates. Those rising rates, combined with the tax provisions of the recent health care legislation, would push total revenues to 23 percent of GDP by 2035--much higher than has typically been seen in recent decades--and to larger percentages thereafter. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt--activities such as national defense and a wide variety of domestic programs--would decline to the lowest percentage of GDP since before World War II.

That significant increase in revenues and decrease in the relative importance of other spending would offset much--though not all--of the rise in spending on health care programs and Social Security. As a result, debt would increase from its already high levels relative to GDP, as would the required interest payments on that debt. Federal debt held by the public would grow from an estimated 62 percent of GDP this year to about 80 percent by 2035. Interest payments, which absorb federal resources that could otherwise be used to pay for government services, currently amount to more than 1 percent of GDP; under this scenario, they would rise to 4 percent of GDP (or one-sixth of federal revenues) by 2035.

The budget outlook is much bleaker under the alternative fiscal scenario, which incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period. In this scenario, CBO assumed that Medicare's payment rates for physicians would gradually increase (which would not happen under current law) and that several policies enacted in the recent health care legislation that would restrain growth in health care spending would not continue in effect after 2020. In addition, under the alternative scenario, spending on activities other than the major mandatory health care programs, Social Security, and interest would fall below the average level of the past 40 years relative to GDP, though not as low as under the extended-baseline scenario. More important, CBO assumed for this scenario that most of the provisions of the 2001 and 2003 tax cuts would be extended, that the reach of the alternative minimum tax would be kept close to its historical extent, and that over the longer run, tax law would evolve further so that revenues would remain at about 19 percent of GDP, near their historical average.

Under that combination of policy assumptions, federal debt would grow much more rapidly than under the extended-baseline scenario. With significantly lower revenues and higher outlays, debt would reach 87 percent of GDP by 2020, CBO projects. After that, the growing imbalance between revenues and noninterest spending, combined with spiraling interest payments, would swiftly push debt to unsustainable levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2025 and would reach 185 percent in 2035.

Neither of those scenarios represents a prediction by CBO of what policies will be in effect during the next several decades. The policies adopted in coming years will surely differ from those assumed for the scenarios. (And even if the assumed policies were adopted, their economic and budgetary consequences would certainly differ from those projected in this report.) Nevertheless, these projections, encompassing two very different sets of policy assumptions, provide a clear indication of the serious nature of the fiscal challenge facing the nation.

In fact, CBO's projections understate the severity of the long-term budget problem because they do not incorporate the significant negative effects that accumulating substantial amounts of additional federal debt would have on the economy:

Large budget deficits would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment--which in turn would lower income growth in the United States. Growing debt would also reduce lawmakers' ability to respond to economic downturns and other challenges.Over time, higher debt would increase the probability of a fiscal crisis in which investors would lose confidence in the government's ability to manage its budget, and the government would be forced to pay much more to borrow money.

Keeping deficits and debt from growing to unsustainable levels would require raising revenues as a percentage of GDP significantly above past levels, reducing outlays sharply relative to CBO's projections, or some combination of those approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that long-term changes to spending and revenues are agreed on, and the sooner they are carried out once the economic weakness ends, the smaller will be the damage to the economy from growing federal debt. Earlier action would require more sacrifices by earlier generations to benefit future generations, but it would also permit smaller or more gradual changes and would give people more time to adjust to them.

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The Budget and Economic Outlook: An Update

[Reposted on August 19, 2010, to correct the 5- and 10-year totals for revenues and outlays in Summary Table 1 because of an error in addition.]

The Congressional Budget Office (CBO) estimates that the federal budget deficit for 2010 will exceed $1.3 trillion—$71 billion below last year's total and $27 billion lower than the amount that CBO projected in March 2010, when it issued its previous estimate. Relative to the size of the economy, this year's deficit is expected to be the second largest shortfall in the past 65 years: At 9.1 percent of gross domestic product (GDP), it is exceeded only by last year's deficit of 9.9 percent of GDP. As was the case last year, this year's deficit is attributable in large part to a combination of weak revenues and elevated spending associated with the economic downturn and the policies implemented in response to it.

This report presents CBO's updated budget and economic projections spanning the 2010–2020 period. Those projections reflect the assumption that current laws affecting the budget will remain unchanged—and thus the projections serve as a neutral benchmark that lawmakers can use to assess the potential effects of policy decisions. As such, CBO assumes that tax reductions enacted earlier in this decade that are currently set to expire at the end of this year do so as scheduled; it also assumes that no new legislation aimed at keeping the alternative minimum tax (AMT) from affecting many Dog Ramp taxpayers is enacted. In addition, CBO assumes that the measures enacted in the past two years to provide fiscal stimulus to the weakened economy will expire as currently scheduled and that future annual appropriations will be kept constant in real (inflation-adjusted) terms. Under those assumptions, the federal budget deficit would decline substantially over the next two years—to 4.2 percent of GDP by 2012—and, consequently, the budget would provide much less support to the economy than has been the case for the past two years.

According to CBO's projections, the recovery from the economic downturn will continue at a modest pace during the next few years. Growth in the nation's output since the middle of calendar year 2009 has been anemic in comparison with that of previous recoveries following deep recessions, and the unemployment rate has remained quite high, averaging 9.7 percent in the first half of this year. Such weak growth tends to occur in recoveries from recessions spurred by financial crises. The considerable number of vacant houses and underused factories and offices will be a continuing drag on residential construction and business investment, and slow income growth as well as lost wealth will weigh on consumer spending.

All of those forces, along with the waning of federal fiscal support, will tend to restrain spending by individuals and businesses—and, therefore, economic growth—during the recovery. CBO projects that the economy will grow by only 2.0 percent from the fourth quarter of 2010 to the fourth quarter of 2011; even with faster growth in subsequent years, the unemployment rate will not fall to around 5 percent until the end of 2014.

In CBO's current-law projections, once the economy has recovered, the federal budget deficit amounts to between 2.5 percent and 3.0 percent of GDP from 2014 to 2020. Projected deficits total $6.2 trillion for the 10 years starting in 2011, raising federal debt held by the public to more than 69 percent of GDP by 2020, almost double the 36 percent of GDP observed at the end of 2007.

Those projections, which are similar in many respects to the ones that CBO prepared in March, reflect assumptions about revenues and spending that may significantly underestimate actual deficits. Because the projections presume no changes in current tax laws, they result in estimates of revenues that, as a percentage of GDP, would be quite high by historical standards. Because of the assumption that future annual appropriations are held constant in real terms, the projections yield estimates of discretionary spending relative to GDP that would be low by historical standards.

Of course, many other outcomes are possible. If, for example, the tax reductions enacted earlier in the decade were continued, the AMT was indexed for inflation, and future annual appropriations remained the share of GDP that they are this year, the deficit in 2020 would equal about 8 percent of GDP, and debt held by the public would total nearly 100 percent of GDP. A different fiscal policy would also yield different economic outcomes. For example, CBO estimates that under an alternative fiscal path similar to the one just mentioned, growth of real GDP in 2011 would be 0.6 to 1.7 percentage points higher than it is in the baseline forecast, and the unemployment rate at the end of 2011 would be 0.3 to 0.8 percentage points lower. However, later in the coming decade, real GDP would fall below the level in CBO's baseline because the larger budget deficits would reduce investment in productive capital.

Beyond the 10-year budget window, the nation will face daunting long-term fiscal challenges posed by the aging of the population and rising costs for health care. Continued large deficits and the resulting increases in federal debt over time would reduce long-term economic growth. Putting the nation on a sustainable fiscal course will require policymakers to restrain the growth of spending substantially, raise revenues significantly above their average percentage of GDP of the past 40 years, or adopt some combination of those approaches.

Fiscal year 2010 will mark a change in the recent trends that have prevailed for both revenues and outlays. After falling sharply during the recession, revenues are projected to increase (in nominal dollars) for the first time in three years, rising by $38 billion, or about 2 percent. Outlays, which have grown rapidly in recent years because of the recession, the turmoil in financial markets, and policies enacted in response to those events, are expected to decline by about 1 percent.

On the basis of tax collections through July 2010, CBO expects federal revenues to total $2.1 trillion this fiscal year, or about 14.6 percent of GDP. Gains in receipts in recent months indicate that federal revenues are beginning to recover from the recession. In the period from October to December 2009, revenues were about 10 percent lower than in the same quarter a year earlier. But from January to July 2010, revenues were about 6 percent greater than in the comparable period of 2009.

Outlays are expected to total $3.5 trillion this year, or nearly 24 percent of GDP—a level slightly lower than the 25 percent share recorded last year but still much higher than the average level of roughly 21 percent of GDP over the past 40 years. Spending has dropped sharply this year for certain programs related to the federal government's response to the turmoil in the housing and financial markets. For activities other than those programs, overall spending will rise by 10 percent in 2010, CBO estimates.

Over the next few years, federal budget deficits would decline markedly as a share of GDP if the current-law assumptions about fiscal policy in CBO's baseline came to pass. Under those assumptions, the deficit would drop to 7.0 percent of GDP in 2011 and 4.2 percent in 2012 and then would reach a low of 2.5 percent of GDP in 2014. For the rest of the 10-year projection period, deficits would range between 2.6 percent and 3.0 percent of GDP, close to the average of 2.6 percent of GDP experienced over the past 40 years.

In CBO's baseline, total revenues climb sharply in the next few years, from 14.6 percent of GDP in 2010 to 17.5 percent in 2011 and 18.7 percent in 2012. That increase is attributable in part to the scheduled expiration of tax provisions originally enacted in 2001, 2003, and 2009 (including temporary relief from the AMT, which expired at the end of December 2009) and in part to the anticipated economic recovery. Revenues will also be boosted by provisions of the recently enacted health care legislation (the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010), which are estimated to increase receipts by growing amounts over the next few years, reaching 0.6 percent of GDP by 2020. In addition, the structure of the individual income tax will gradually raise receipts over time. Together, all of those factors push federal revenues in CBO's baseline to 21.0 percent of GDP by 2020, compared with an average level of about 18 percent of GDP over the past 40 years.

In 2011, federal outlays in CBO's baseline total $3.7 trillion (24.5 percent of GDP), almost $230 billion more than the amount anticipated for this year. Much of that increase stems from temporary factors that have held down outlays this year. Net outlays in 2010 for the Troubled Asset Relief Program were reduced by an adjustment to the outlays recorded for the previous year, and premiums paid by banks for deposit insurance were unusually high this year; neither factor is expected to recur next year. Furthermore, because October 1, 2011, falls on a weekend, some benefit payments will shift from fiscal year 2012 into 2011. In the other direction, outlays related to Fannie Mae and Freddie Mac are projected to decline significantly in 2011. With all of those factors excluded, total outlays would be only about $80 billion more than the projection for this year.

As spending from the American Recovery and Reinvestment Act of 2009 tails off and as the anticipated economic recovery allows payments for unemployment compensation and other benefits that automatically rise during recessions to continue returning toward more typical levels, outlays are projected to decline to 23.0 percent of GDP in 2012 and then to fall a bit further before rising eventually to 23.9 percent by 2020. Relative to GDP, mandatory spending is projected to rise (outlays for Medicare, Medicaid, and Social Security contribute significantly to that increase), and discretionary outlays are projected to fall. From 2012 through 2020, outlays in CBO's baseline average 23.2 percent of GDP—2.5 percentage points higher than the average over the past 40 years.

The federal government's spending on interest is determined largely by the stock of debt and prevailing interest rates. The amount of federal debt held by the public has skyrocketed in the past two years: from 40 percent of GDP at the end of 2008 to nearly 62 percent at the end of this year, CBO estimates. Interest rates, however, have fallen to historically low levels, so despite the higher levels of debt, interest costs have not yet increased significantly.

Interest rates are expected to rise noticeably in the next few years, though, and under the assumptions of CBO's baseline, debt held by the public is projected to exceed 69 percent of GDP by the end of 2020. As a result, over the next decade, the government's annual net spending for interest is projected to more than double as a share of GDP, increasing from 1.5 percent in 2011 to 3.4 percent by 2020. Over the 10-year projection period, such spending grows at an average rate of 15 percent a year.

The pace of growth after the recent recession is likely to be slower than usual as the economy recovers from the effects of the financial crisis and as the support to economic activity provided by fiscal policy diminishes. In the past, many recoveries from deep recessions have been quite robust. After deferring purchases during a slump (especially for expensive goods like homes, automobiles, and capital equipment), households and businesses typically boost their spending quickly as economic prospects improve. However, international experience suggests that recoveries from recessions that were spurred by financial crises tend to be slower than average—perhaps because the losses in wealth and damage to the financial system that occur during such crises weigh on spending for a number of years. Following such a crisis, it takes time for consumers to rebuild their wealth, for financial institutions to restore their capital bases, and for nonfinancial firms to regain the confidence required to invest in new plant and equipment; all of those forces tend to restrain spending. In addition, under current law, both the waning of fiscal stimulus and the scheduled increases in taxes will temporarily subtract from growth, especially in 2011.

In CBO's projections, real GDP increases by 2.8 percent between the fourth quarter of calendar year 2009 and the fourth quarter of 2010 and by 2.0 percent in 2011. Such rates of growth are well below historical norms for a recovery from a severe recession; for example, following the deep recession of 1981 and 1982, real GDP surged by nearly 8 percent in 1983 and by roughly 6 percent in 1984. In CBO's forecast, the growth of real GDP picks up after 2011, averaging 4.1 percent annually from 2012 through 2014 and closing the gap between GDP and its potential level (the amount of production that corresponds to a high use of labor and capital) by the end of 2014.

The modest growth in output projected for the next few years points to sluggish growth in employment during the remainder of this year and next. Consequently, CBO projects that the unemployment rate will decline slowly, falling to 9.3 percent at the end of 2010 and 8.8 percent at the end of 2011. After that, the growth in employment will accelerate, and the unemployment rate will decline more rapidly, reaching 5.1 percent at the end of 2014.

Inflation in the prices of consumer goods and services (calculated using the price index for personal consumption expenditures, or PCE) is projected to be about 1 percent in 2010 and 2011, when measured on a fourth-quarter-to-fourth-quarter basis. Core inflation, which excludes the prices of food and energy, is also projected to be about 1 percent this year and next. CBO projects that inflation will pick up moderately thereafter but remain below 2.0 percent from 2012 through 2014.

Interest rates in CBO's projections remain very low through the end of 2011 and then rise gradually as the recovery continues. The Federal Reserve is unlikely to raise its target for the federal funds rate (the interest rate at which depository institutions lend reserves to each other overnight) from its near-zero level while the recovery remains subdued and inflation stays low. As a result, the interest rate on 3-month Treasury bills will average 0.2 percent in 2010 and 2011, CBO projects. However, given CBO's outlook that the economy will strengthen and inflation will increase somewhat between 2012 and 2014, the projected 3-month Treasury bill rate averages 2.8 percent in those years. In the projections, the interest rate on 10-year Treasury notes, which is influenced by investors' expectations about monetary policy and other factors, edges up from an average of 3.4 percent in 2010 to 3.5 percent in 2011 and then rises to an average of 4.7 percent over the 2012–2014 period.

Beyond 2014, CBO projects, growth in real GDP will match the growth of potential GDP at 2.4 percent. In the agency's projections, the unemployment rate averages 5.0 percent from 2015 through 2020, and inflation (as measured by the PCE price index) averages 2.0 percent. During that period, the interest rates on 3-month Treasury bills and 10-year Treasury notes average 4.9 percent and 5.9 percent, respectively.

Economic forecasts are always subject to considerable uncertainty. The uncertainty regarding CBO's current forecast is especially large, both because forecasting the path of the economy near turning points in the business cycle is always difficult and because the current business cycle has been unusual in a variety of ways. Many developments could lead to outcomes that differ substantially, in one direction or the other, from those CBO has projected.

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