Fiscal Follies: The Real Budget Problem and How to Fix It, Part 1

Fall 2003 —
Over the past two and a half years the official U.S. federal budget outlook has deteriorated in spectacular fashion. The federal budget shifted from a surplus of $127 billion in fiscal year 2001 to a projected deficit of about $400 billion in fiscal 2003, which ended on September 30. This decline is due mostly to short-term factors like the economic slowdown and the war on terrorism. More ominously, the Congressional Budget Office's projected baseline budget for 2002-11 changed from a surplus of $5.6 trillion in January 2001, when President George W. Bush took office, to a deficit of $2.3 trillion as of August. The worsening budget projections for later in the decade are due mostly to the 2001 and 2003 tax cuts and to spending increases.

The official figures, moreover, paint far too optimistic a picture of the nation's fiscal health. The official numbers count current surpluses in the Social Security and Medicare trust funds in the budget, even though both face substantial long-term deficits. And the projections of the future make unrealistic assumptions regarding current policy. Making more realistic assumptions about current policy and taking the Social Security and Medicare trust funds "off-budget" reveal large and persistent imbalances between spending and revenues totaling about $8 trillion over the next decade.



Worse, these deficits are projected for the decade that should be the easy time for federal finances. The first baby boomers will become eligible for Social Security in 2008 and for Medicare in 2011. The growing number of new beneficiaries, combined with lengthening life spans, technological changes that boost health care spending, and slow growth of the labor force, will place mounting pressure on federal finances in the decades to come.



Solutions to these difficulties are available, but they will be mostly unpleasant. Policymakers have not completely ignored the problems, but they have not actively sought answers either, and recent policies have made matters worse. Every year of delay makes the problems more difficult and more expensive to resolve.

What Is the Real Budget Outlook?

CBO's baseline budget is intended to be a benchmark against which legislative changes can be measured, not a prediction of likely outcomes. In making its 10-year projections, the CBO makes three assumptions about current policy that we believe make these projections unrealistic. First, although it assumes that Congress will extend some expiring spending programs, CBO assumes that almost all temporary tax provisions will "sunset" (expire) as scheduled in the law. The 2001, 2002, and 2003 tax cuts, for example, are scheduled to sunset at various points before 2011.



Substantial sunsets in the tax code are a recent and dramatic departure from historical practice by federal policymakers intent on manipulating budget rules and hiding the true likely costs of new tax cuts. These tax sunsets, which make it possible to increase the size of annual tax cuts while staying within the budget rules, put fiscal policy on an increasingly unsustainable course, because once a tax cut is in place, Congress will be sorely tempted to extend it past its official sunset. The alternative—not extending it—will be denounced by opponents as a tax increase, a step that policymakers traditionally find distasteful, especially in election years. With President Bush and many congressional leaders already pushing to make the tax cuts permanent, it would be more realistic for the CBO baseline to assume that the tax cuts will be extended.



The second unrealistic assumption involves spending on programs that require annual appropriations decisions by Congress. The baseline assumes that such so-called discretionary spending grows each year only because of inflation. Although judgments may reasonably differ about future spending choices, we believe that current services will be difficult to maintain unless spending keeps pace with population growth too. George W. Bush endorsed the same criterion as a presidential candidate.



The third unrealistic assumption involves the alternative minimum tax (AMT), which runs parallel to the regular income tax system. Although originally designed to raise taxes on wealthy households that aggressively use tax shelters, the AMT will increasingly apply to middle-income households over the next decade, raising their tax bills and plaguing them with mind-boggling, pointless tax complexities. Unlike the ordinary income tax, the AMT is not adjusted for inflation and thus covers ever more taxpayers as prices (and incomes) rise—ensuring that policymakers will come under increasing pressure to cut back the AMT. For that reason, our projection, unlike the CBO baseline, assumes the AMT is adjusted so that the share of taxpayers who face the tax in the future is 3 percent—about the same as today.



Officially, the CBO baseline projects a 10-year deficit of $1.4 trillion for 2004 through 2013, with surpluses rising over time, as figure 1 shows. Adjusting the CBO baseline for our three assumptions regarding current policy tells quite a different story. Extending all expiring tax provisions would cost the federal budget $2.4 trillion. Adjusting the AMT would add another $400 billion. Adjusting discretionary spending implies another $500 billion in outlays.



These changes leave a federal budget with a deficit of $4.6 trillion over the next decade. Numerous uncertainties about what the future holds make it impossible to take these budget figures as exact predictions, but several basic trends are clear. First, the CBO baseline suggests that the budgetary future features rising surpluses within the 10-year window, whereas our adjusted unified budget baseline implies continual deficits through 2013, as shown in figure 1. Second, the differences grow over time. By 2013 the difference between the official projected unified budget and our alternative unified deficit is more than $700 billion each year. Third, our adjustments, which do not include the costs of a Medicare prescription drug benefit or other new initiatives, may themselves understate the severity of the problem.



Finally, all these figures include cash-flow surpluses of $3.2 trillion over the next decade accruing in trust funds for Social Security, Medicare, and government pensions. But—as will come as a surprise to no one—these trust funds, now in surplus, face tremendous long-term shortfalls. In various pieces of legislation between 1983 and 1990, Congress took Social Security off-budget to help clarify the state of the rest of the federal budget. We follow that approach and extend it to Medicare and government pensions. Combining this adjustment with the ones made above results in a 2004–13 projected shortfall in the nonpension portion of the budget of roughly $7.8 trillion. Notably, this shortfall exists in every year through 2013, the end of the budget window.



That the official budget window ends in 2013 itself makes the projections misleadingly optimistic, because the budget outlook deteriorates rapidly thereafter. Indeed, few observers dispute that the long-term forecast involves increasing deficits as a share of the economy.



Some have lately claimed that a previously unrecognized "pot of gold" in future revenue from tax-deferred retirement accounts will be large enough to eliminate most or all of the long-term budget shortfalls. But the underlying calculations of the long-term budget shortfalls already include almost all the projected revenue from withdrawals from tax-deferred accounts. As a result, incorporating the new projections has trivial effects on the long-run budget outlook.