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CBO report: a thriller, with a bad ending

Congressional Budget Office's long-term budget outlook reads like a very scary document. Unfortunately, it's also too optimistic.

By Len BurmanGuest blogger / June 25, 2011

A worker emerges from one of the warren of offices making up the Congressional Budget Office in Washington, D.C., in this 1999 file photo. Every couple years, the CBO publishes its long-term budget outlook, which these days makes for hair-raising reading.

Andy Nelson / The Christian Science Monitor / File

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Every couple years, the Congressional Budget Office publishes a very scary document, The Long-Term Budget Outlook. As in previous reports, the conclusion is that a continuation of current policies would lead to an unsustainable increase in the national debt.

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Here’s how you read the report. CBO simulates two scenarios. One is called “extended baseline,” in which all of the Bush tax cuts expire on schedule after 2012, the AMT engulfs the middle class in a web of higher taxes and mind-numbing complexity, and payments to providers under Medicare are slashed. While all of these things are technically scheduled to occur under current law, none is likely. Congress recently extended the Bush tax cuts, the AMT “patch” (which protects most middle class people from the dread tax), and the Medicare “doc fix,” and is likely to do so again.

The “alternative fiscal scenario” assumes that federal tax revenues return to their historical levels (18.4% of GDP) and health care spending continues to grow at roughly its historical rate (2 percentage points faster than GDP). The alternative scenario should really be labeled “current policy,” and it’s pretty bleak, as shown in the chart above (from the cover of the CBO report). Within 10 years, debt will exceed 100% of GDP. By 2037, it would be more than double the size of the economy.

That scenario, as dreadful as it is, is wildly over-optimistic, because it doesn’t account for the effect of rising debt levels on interest rates and the economy. In recent years, CBO has gotten more forceful in explaining this point. I’ll quote from the summary:

CBO’s projections in most of this report understate the severity of the long-term budget problem because they do not incorporate the negative effects that additional federal debt would have on the economy, nor do they include the impact of higher tax rates on people’s incentives to work and save. In particular, large budget deficits and growing debt 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. Taking those effects into account, CBO estimates that under the extended-baseline scenario, real (inflation-adjusted) gross national product (GNP) would be reduced slightly by 2025 and by as much as 2 percent by 2035, compared with what it would be under the stable economic environment that underlies most of the projections in this report. Under the alternative fiscal scenario, real GNP would be 2 percent to 6 percent lower in 2025, and 7 percent to 18 percent lower in 2035, than under a stable economic environment.

Rising levels of debt also would have other negative consequences that are not incorporated in those estimated effects on output:

  • Higher levels of debt imply higher interest payments on that debt, which would eventually require either higher taxes or a reduction in government benefits and services.
  • Rising debt would increasingly restrict policymakers’ ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, the effects of such developments on the economy and people’s well-being could be worse.
  • Growing debt also would increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget and the government would thereby lose its ability to borrow at affordable rates. Such a crisis would confront policymakers with extremely difficult choices. To restore investors’ confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.