In 1974, Congress created the Congressional Budget Office (CBO). The CBO was given the responsibility of providing Congress with impartial economic analysis as it makes decisions about the federal government’s budget. One of the most widely discussed reports the CBO issues is the Budget and Economic Outlook. The report provides forecasts of future federal budget deficits and changes in the federal government’s debt that the budget deficits will cause. The CBO’s budget and debt forecasts rely on the agency’s forecasts of future economic conditions and assumes that Congress will make no changes to current laws regarding taxing and spending. (We discuss this assumption further below.)
On February 15, the CBO issued its latest forecasts. The forecasts showed a deterioration in the federal government’s financial situation compared with the forecasts the CBO had issued in May 2022. (You can find the full report here.) Last year, the CBO forecast that the federal government’s cumulative budget deficit from 2023 through 2032 would be $15.7 trillion. The CBO is now forecasting the cumulative deficit over the same period will be $18.8 trillion. The three main reason for the increase in the forecast deficits are:
1. Congress has increased spending—particularly on benefits for military veterans.
2) Cost-of-living adjustments for Social Security and other government programs have increased as a result of higher inflation.
3) Interest rates on Treasury debt have increased as a result of higher inflation.
The CBO forecasts that federal debt held by the public will increase from 98 percent of GDP in 2023 to 118 percent in 2033 and eventually to 198 percent in 2053. Note that economists prefer to measure the size of the debt relative to GDP rather than in as absolute dollar amounts for two main reasons: First, measuring debt relative to GDP makes it easier to see how debt has changed over time in relation to the growth of the economy. Second, the size of debt relative to GDP makes it easier to gauge the burden that the debt imposes on the economy. When debt grows more slowly than the economy, as measured by GDP, crowding effects are likely to be relatively small. We discuss crowding out in Macroeconomics, Chapter 10, Section 10.2 and Chapter 16, Section 16. 5 (Economics, Chapter 20, Section 20.2 and Chapter 26, Section 26.5). The two most important factors driving increases in the ratio of debt to GDP are increased spending on Social Security, Medicare, and Medicaid, and increased interest payments on the debt.
The following figure is reproduced from the CBO report. It shows the ratio of debt to GDP with actual values for the period 1900-2022 and projected values for the period 2023-2053. Note that the only other time the ratio of debt to GDP rose above 100 percent was in 1945 and 1946 as a result of the large increases in federal government spending required to fight World War II.
The increased deficits and debt over the next 10 years are being driven by government spending increasing as a percentage of GDP, while government revenues (which are mainly taxes) are roughly stable as a percentage of GDP. The following figure from the report shows actual federal outlays and revenues as a percentage of GDP for the period 1973-2022 and projected outlays and revenues for the period 2023-2033. Note that from 1973 to 2022, outlays averaged 21.0 percent of GDP and revenues averaged 17.4 percent of GDP, resulting in an average deficit of 3.6 percent of GDP. By 2033, outlays are forecast to rise to 24.9 percent of GDP–well above the 1973-2022 average–whereas revenues are forecast to be only 18.1 percent, for a forecast deficit of 6.8 percent of GDP.
The increase in outlays is driven primarily by increases in mandatory spending, mainly spending on Social Security, Medicare, Medicaid, and veterans’ benefits and increases in interest payments on the debt. The CBO’s forecast assumes that discretionary spending will gradually decline over the next 10 years as percentage of GDP. Discretionary spending includes federal spending on defense and all other government programs apart from those, like Social Security, where spending is mandated by law.
To avoid the persistent deficits, and increasing debt that results, Congress would need to do one (or a combination) of the following:
1. Reduce the currently scheduled increases in mandatory spending (in political discussions this alternative is referred to as entitlement reform because entitlements is another name for manadatory spending).
2. Decrease discretionary spending, the largest component of which is defense spending.
3. Increases taxes.
There doesn’t appear to be majority support in Congress for taking any of these steps.
The CBO’s latest forecast seems gloomy, but may actually understate the likely future increases in the federal budget deficit and federal debt. The CBO’s forecast assumes that future outlays and taxes will occur as indicated in current law. For example, the forecast assumes that many of the tax cuts Congress passed in 2017 will expire in 2025 as stated in current law. Many political observers doubt that Congress will allow the tax cuts to expire as scheduled because to do so would result in increases in individual income taxes for most people. (Here is a recent article in the Washington Post that discusses this point. A subscription may be required to access the full article.) The CBO also assumes that defense spending will not increase beyond what is indicated by current law. Many political observers believe that, in fact, Congress may feel compelled to substantially increase defense spending as a result of Russia’s invasion of Ukraine in February 2022 and the potential military threat posed by China.
The CBO forecast also assumes that the U.S. economy won’t experience a recession between 2023 and 2033, which is possible but unlikely. If the economy does experience a recession, federal outlays for unemployment insurance and other programs will increase and federal personal and corporate income tax revenues will fall. The CBO’s forecast also assumes that the interest rate on the 10-year Treasury note will be under 4 percent and that the federal funds rate will be under 3 percent (interest rates on short-term Treasury debt move closely with changes in the federal funds rate). If interest rates turn out to be higher than these forecasts, the federal government’s interest payments will increase, further increasing the deficit and the debt.
In short, the federal government is clearly facing the most difficult budgetary situation since World War II.