January 27, 2006

January 27, 2006 | WebMemo on Federal Budget

New CBO Baseline Substantially Understates Grim Budget Picture

The Congressional Budget Office (CBO) projects a balanced budget by 2012. A number of CBO's assumptions underlying this projection are, to say the least, problematic. For example, CBO's projections assume that all of the President's 2001 and 2003 tax cuts, as well as all other temporary tax cuts, are allowed to expire and that the Alternative Minimum Tax is not fixed before it digs further into middle-class incomes. CBO is also required by law to assume that there will be no more appropriations for the conflicts in Iraq and Afghanistan and for Gulf Coast reconstruction; that the pending reconciliation budget will have no effects; and that discretionary spending will not grow at all, in inflation-adjusted terms. With all these caveats in place, CBO's budget baseline is extremely unrealistic.

To present a more realistic picture of the federal budget over the next ten years, Heritage Foundation analysts corrected these shortcomings in CBO's projections. The numbers in this paper are based on CBO's projections but also include the following:

  • CBO numbers for extending the tax cuts and fixing the AMT;
  • CBO numbers on gradual phase-downs in Iraq and Afghanistan;
  • CBO numbers for past Gulf Coast reconstruction spending, as well as modest Heritage Foundation estimates of future appropriations;
  • CBO numbers for the reconciliation bill about to be signed into law;
  • A 5-percent annual increase in defense discretionary outlays (excluding supplemental bills) after 2006; and
  • A 2-percent rise in non-defense discretionary outlays (excluding supplemental bills) in 2006 and a 4-percent annual increase thereafter.

With this more realistic set of assumptions in place, several points become clear:

1) Budget deficits are far larger than CBO projects.

Realistic baseline assumptions show that the federal budget is in much worse shape than the CBO's baseline numbers indicate. While CBO projects a balanced budget by 2012, it is far more likely that the deficit will explode:

  • The deficit will reach $394 billion in 2006;
  • $412 billion in 2007;
  • $428 billion in 2008;
  • $436 billion in 2009;
  • $458 billion in 2010; and
  • $805 billion in 2015.

By 2015 it would it take a $6,500-per-household tax increase just to balance the budget.

2) Tax revenues are not the problem.

  • Between 2004 and 2006 revenues are projected to rise by an unprecedented $420 billion.
  • This 22 percent revenue jump is the largest 2-year revenue surge since 1976-1978, when high inflation and bracket creep steeply increased revenues.
  • This increase will bring revenues near the post-war average of just under 18 percent of GDP.

3) Runaway spending is the problem.

  • Spending surged 8 percent in 2005, the second-highest rate of growth since 1985.
  • Spending is projected to leap 9 percent more in 2006.
  • Overall, spending will leap $402 billion from 2004 to 2006.
  • From 2005 to 2016, revenues will increase by 5 percent annually, but spending is projected to increase by 6 percent annually.

4) Social Security, Medicare, and Medicaid are out of control.

  • In 2005, these 3 programs cost $1,034 billion, or 8.4 percent of GDP. In 2016 they will consume $2,260 billion, or 10.8 percent of GDP.
  • From 2005 through 2007, Medicare spending will increase by $112 billion, a 34 percent rise, as the drug benefit begins.
  • Over the next decade, Medicare spending will grow 9 percent annually, Medicaid spending 8 percent annually, and Social Security spending by 6 percent annually.
  • 2006 will be the first year when Medicare and Medicaid together, with a $582 billion total cost, outspend Social Security, with a $550 billion cost.

5) Halving the deficit by 2009 will be difficult, but it is the long-term deficit that matters more.

  • When the 2004 projected deficit was projected to be $521 billion, or 4.5 percent of GDP, the President promised to halve the deficit by 2009-that is, to bring the 2009 deficit down to 2.25 percent of GDP.
  • The actual 2004 budget deficit ended up much lower than that projected figure.
  • The President's pledge currently translates into a 2009 deficit of $343 billion.
  • The projections above show a 2009 budget deficit of $436 billion, which is $93 billion above the target.
  • The 2009 deficit is not the issue. Long-term spending trends in Social Security, Medicare, and Medicaid should be the focus of deficit reduction efforts. The deficit is set to explode soon after 2009 due to the growing costs of entitlements, and the problem only gets worse after 2016.

6) Net interest spending is growing.

  • The combination of large deficits and rising interest rates push projected net interest costs up from $184 billion in 2005, to $494 billion in 2016 (after updating the CBO baseline as described above).
  • Until entitlements are brought under control, the annual deficit will grow and rising net-interest costs will accelerate that growth.

Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute 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