December 16, 2005

December 16, 2005 | WebMemo on Federal Budget

Grim New CBO Long-Term Budget Projections Show Deterioration, Yet Understate Situation

This week the Congressional Budget Office (CBO) released an update to its December 2003 "Long-Term Budget Outlook," which projects federal spending and taxes through 2050. Like the previous version, CBO's assumptions result in projections that severely underestimate the spending explosion that will result from the retirement of the baby boom generation.[1] CBO now projects that federal spending as a percentage of GDP will rise from 20 percent today to almost double that (38 percent) in 2050. Even this grim picture is probably too rosy. A more realistic projection shows Washington spending an unsustainable 73 percent of GDP in 2050.

What accounts for this large difference in projections? The more realistic projection shows that program spending in 2050 will be 2 percent of GDP higher than CBO estimates and that net interest spending in 2050 will be 33 percent higher.

  • 2050 Program Spending. The federal government currently spends 18.6 percent of GDP on federal programs (which is all spending except net interest expenses). As the baby boomers retire, steep hikes in the costs of Social Security, Medicare, and Medicaid will add 10 percent of GDP in new spending.

    CBO projects that spending on federal programs will rise to 25.4 percent or GDP by. However, Heritage Foundation analysts project that 2050 program spending will reach 27.6 percent of GDP. There are three primary reasons for this difference:
  • CBO assumes defense spending will drop from 4.0 percent of GDP today to just 1.5 in 2050. But defense experts are very skeptical of that assumption in light of current U.S. commitments abroad.
  • The Medicare trustees project a faster growth rate of Medicare than CBO assumes.
  • CBO assumes discretionary spending grows at the rate of inflation, but it is more realistic to assume that it grows in line with population and GDP.
  • 2050 Net Interest Spending. Steep spending increases push up budget deficits and the federal debt, resulting in higher net interest costs. CBO projects that net interest costs will rise from 1.5 percent of GDP today to 12.4 percent of GDP by 2050. This is probably low. CBO assumes that interest rates will remain roughly constant through 2050. Considering that the current public debt-to-GDP ratio of 38 percent has been too small to significantly raise interest rates, this may seem sensible. However, the sea of red ink that CBO and others project will push the public debt past 200, 300, and then 400 percent of GDP beginning in the 2020s.

    Debt at those levels could begin to affect on interest rates significantly, according to many economists. If this is correct and interest rates are assumed to rise even minutely in response to this unprecedented peacetime debt, the effect on government spending would be huge. Even a miniscule interest rate response beginning in 2025 (when public debt surpasses 100 percent of GDP) could add the current equivalent of $20 trillion in additional net interest spending through 2050 and push 2050 net interest spending to a remarkable 45.6 percent of GDP. A larger interest rate response would add even more net interest spending.

Spending as a percentage of GDP

Tough Choices Ahead

What does this grim picture imply? Simply that if lawmakers still refuse to implement significant changes in the three major entitlement programs-Medicare, Medicaid, and Social Security-they will be left with three unpalatable options: 1) Closing the fiscal gap with huge tax hikes, leading to tax levels similar to slow-growth Europe; 2) Closing it by eliminations of other major programs, including defense; or 3) Allowing deficits and debt to rise to unprecedented levels of GDP, risking higher interest rates and an enormous debt burden on future generation.

  1. Steep tax increases. Keeping up with unrestrained spending would require an immediate tax increase of 3.0 percent of GDP, or $3,323 per household, to balance the budget. These tax increases would continue every year, and by 2050 tax revenues would be a full 10.0 percent of GDP higher than today (in today's economy, 10 percent of GDP would mean an additional $10,918 per household in taxes). To raise that much revenue, lawmakers could boost the top marginal income tax rate from 35 percent to 80 percent and the typical family's marginal tax rate from 25 percent to 57 percent. However, because tax increases harm economic growth, rates would have to rise even more than this to raise the necessary revenue. If lawmakers delay, additional debt accumulated in the meantime (and the resulting net interest costs) would require even larger tax hikes, possibly $20,000 per household by 2040.

  2. Eliminate other programs. Lawmakers could balance the budget while funding the big three entitlements by cutting other programs. Balancing the budget in 2006 would require immediately terminating such programs as homeland security, justice, highways, veterans' benefits, unemployment benefits, environmental spending, social services, community development, energy, international aid, science research and farm subsidies. From there, making room for the big three would require such things as eliminating education spending by 2018, health research by 2020, federal employee retirement benefits by 2021, other anti-poverty spending by 2026, and defense spending by 2045. By that point, the entire federal budget would fund only Social Security, Medicare, Medicaid, and remaining net interest from pre-2005 debt.

  3. Mounting debt and huge interest costs. If lawmakers remain on the current budget path, revenues would remain at 18 percent of GDP and program spending would reach 28 percent of GDP. This would push the national debt above 400 percent of GDP and add trillions in net interest spending. By 2040, federal spending would top 44 percent of GDP, and 73 percent of GDP by 2050. Such huge spending increases could continue for only so long before triggering an international loss of faith in the American economy and a major economic crisis.

For a Heritage's comprehensive long-term spending projections, see Brian M. Riedl, "Entitlement-Driven Long-Term Budget Substantially Worse Than Previously Projected," Heritage Foundation Backgrounder No. 1897, November 30, 2005.

Brian Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe InstiĀ­tute for Economic Policy Studies at The Heritage Foundation.

About the Author

Brian M. Riedl Grover Hermann Fellow in Federal Budgetary Affairs
Thomas A. Roe Institute for Economic Policy Studies

Show references in this report

[1] Congressional Budget Office, "The Long-Term Budget Outlook," December 2005, located at http://www.cbo.gov/showdoc.cfm?index=6982&sequence=0.