Notes Numbers in the text and tables of this report may not add up to totals because of rounding. Unless otherwise specified, all of the years referred to are federal fiscal years. Spreadsheets showing historical values for the variables of the cyclically adjusted and standardized budgets are available by clicking here:

This report offers alternative measures of the budget that adjust for cyclical and other factors. It is one of a series of reports that the Congressional Budget Office (CBO) issues each year to fulfill the requirement of section 202(e) of the Congressional Budget Act of 1974 for CBO to submit to the Committees on the Budget periodic reports about fiscal policy and to provide baseline projections of the federal budget. Most recently, in response to that requirement, CBO issued The Budget and Economic Outlook: Fiscal Years 2006 to 2015 (January 2005).

Frank Russek wrote this report, with assistance from Adam Gordon, under the supervision of Robert Dennis. Loretta Lettner edited the report, John Skeen proofread it, and Christian Spoor prepared it for publication. Annette Kalicki produced the electronic version for CBO's Web site.

Douglas Holtz-Eakin
Director
February 2005

Summary

In January 2005, the Congressional Budget Office (CBO) released its baseline projections of federal revenues, outlays, surpluses, and deficits for the next 10 years.⁽¹⁾ According to CBO's current projections, if the policies assumed in its January baseline were to continue, the total budget deficit would decline from $412 billion in 2004 to $368 billion in 2005 and $295 billion in 2006.⁽²⁾

The size of the budget surplus or deficit reflects temporary factors, such as the effects of the business cycle or of onetime shifts in the timing of federal tax receipts and spending, and the longer-lasting impact of factors such as tax and spending legislation, changes in the trend growth rate of the economy, and movements in the distribution and proportion of income subject to taxation. To help separate out those factors, this report presents estimates of two adjusted budget measures: the cyclically adjusted surplus or deficit (which attempts to filter out the effects of the business cycle) and the standardized-budget surplus or deficit (which removes other factors in addition to the effects of the business cycle).

The cyclically adjusted budget deficit--the total budget deficit minus the effects of the business cycle--is projected to decline from 3.0 percent of potential gross domestic product (GDP) in 2004 to 2.7 percent in 2005 and 2.1 percent in 2006.⁽³⁾ The standardized deficit, by contrast, shows less year-to-year change in the forecast, moving from 2.6 percent in 2004 to 2.5 percent in 2005 and 2.1 percent in 2006 (see Table 1). CBO's projections of the cyclically adjusted and standardized budgets extend only through 2006 because the economic forecast on which they are based does not attempt to reflect cyclical movements beyond that point. Consequently, projections of the cyclically adjusted budget surplus or deficit beyond 2006 would be very similar to CBO's baseline projections of the total budget surplus or deficit.

Table 1.

CBO estimates that the effects of the business cycle account for roughly 15 percent of the total budget deficit in 2004. Given CBO's baseline projections for the economy and the budget, those effects decline to 11 percent in 2005 and 9 percent in 2006. Those estimates of effects of the business cycle on the deficit show a steady decline from the recent highs of 50 percent in 2002 and 27 percent in 2003. The additional adjustments that underlie the standardized-budget surplus or deficit also become smaller over the next two years. Those adjustments (for timing shifts and other factors) amount to 12 percent of the total deficit in 2004, 5 percent in 2005, and 1 percent in 2006.
 

Why Adjust Measures of the Total Budget Surplus or Deficit?

Despite some limitations, both conceptual and empirical, budget measures that filter out cyclical and other temporary factors are useful in a number of ways. For example, some analysts use those measures to discern underlying trends in government saving. Others use them to determine in a rough way whether the budget is providing a positive or negative influence on the growth of real (inflation-adjusted) aggregate demand in the short run. More generally, those measures provide estimates of the extent to which changes in the budget are caused by movements of the business cycle and thus are likely to prove temporary.

Drops in revenues and increases in outlays occur automatically during a cyclical downturn and then reverse themselves during a cyclical upturn. The cyclically adjusted surplus or deficit is calculated to show the underlying outcome of the federal budget when those automatic movements are removed. (The cyclical contribution--the difference between the total budget surplus or deficit and the cyclically adjusted surplus or deficit--is sometimes used as a measure of the so-called automatic stabilizers, which mitigate the decline of real income in recessions and dampen its growth in booms.)⁽⁴⁾

Policy actions by the Congress and the President, such as tax or spending legislation, create changes in the total budget surplus or deficit that are distinct from the automatic cyclical movements. The cyclically adjusted surplus or deficit includes the effects of those legislated changes.

The cyclically adjusted surplus or deficit also reflects other factors, not directly connected with changes in policy, that alter revenues or spending. For example, it includes changes in receipts from capital gains taxes, which may be caused by movements in the stock market. Changes in capital gains tax receipts are not treated as cyclical and therefore are not removed from the cyclically adjusted budget measure because the link between those receipts and the business cycle is tenuous. Similarly, the measure does not adjust for certain explicit budgetary decisions that can produce temporary changes--sometimes of only a few days' duration--in the timing of tax receipts or government spending. Such actions can be viewed more as accounting decisions than as changes in policy.

CBO calculates a different measure, the standardized-budget surplus or deficit, that attempts to remove those factors as well as the effects of the business cycle. As a result, the standardized-budget surplus or deficit is the more speculative of the two measures presented here.

Federal taxes and spending can affect the economy in many ways beyond the short term and thus may alter the prospects for economic growth in the long run, particularly by changing incentives to work, save, invest, and improve the allocation of resources. (Frequently--as was the case with the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA--both short- and long-term effects are intended.) Summary budget measures such as the cyclically adjusted and standardized-budget surplus or deficit are generally of limited use in identifying the economic effects of changes in incentives. Instead, CBO's estimates of those impacts are incorporated in its economic forecasts.⁽⁵⁾
 

The Cyclically Adjusted Surplus or Deficit

Calculations of cyclically adjusted budget measures attempt to remove the effects of the business cycle on revenues and outlays (that is, the cyclical part of the budget). For example, cyclically adjusted revenues exclude the revenue losses that automatically occur during recessions. Likewise, cyclically adjusted outlays exclude the additional spending that automatically follows a rise in unemployment. The difference between those two measures is the cyclically adjusted surplus or deficit.

CBO's estimates of the cyclical component of revenues and outlays depend on the gap between actual GDP and potential GDP (the level of real output that corresponds to a high level of resource--labor and capital--use). CBO's estimates of potential GDP, and the calculations that lie behind them, can be found at www.cbo.gov. Those estimates of the cyclical component, however, may not capture all of the movement in revenues and outlays that some analysts might view as cyclical. Different estimates of potential GDP would produce different estimates of the size of the cyclically adjusted surplus or deficit.⁽⁶⁾

CBO estimates that the cyclically adjusted deficit will decline from 3.0 percent of potential GDP in 2004 to 2.7 percent in 2005 and 2.1 percent in 2006. Thus, the overall change between 2004 and 2006 is a decrease of 0.9 percent (see Figure 1). As a percentage of potential GDP, the cyclically adjusted deficit in 2006 is the smallest since 2002.

Figure 1.

Source: Congressional Budget Office.

Notes: The shaded vertical bars indicate periods of recession. A recession extends from the peak of a business cycle to its trough.

The data points for 2005 and 2006 are projected.

The effect of the business cycle on the budget surplus or deficit is measured by the cyclical contribution---the difference between the total budget surplus or deficit and the cyclically adjusted surplus or deficit. In 2001, the cyclical contribution amounted to a negligible surplus of 0.1 percent of potential GDP, which indicated that the economy was temporarily augmenting the total budget surplus by a small amount. Since then, however, that cyclical contribution has been negative, by as much as 0.9 percent of potential GDP in 2003, which means that the weak economy has been adding to the total budget deficit. As the economy is projected to improve further and narrow the gap between actual and potential GDP, the cyclical deficit is projected to decline to 0.2 percent of potential GDP by 2006.

In its annual reports on the budget and the economy, CBO presents estimates (or "rules of thumb") of how the budget would respond to changes in certain economic assumptions.⁽⁷⁾ The estimate of the cyclical contribution presented here differs from what would be obtained from using those rules of thumb. The rule-of-thumb estimates attempt to capture the budgetary effects of sustained changes in the rate of growth of GDP and other economic variables, whereas the estimates presented in this report are meant to filter out temporary cyclical fluctuations.
 

The Standardized-Budget Surplus or Deficit

CBO routinely publishes another adjusted budget measure, the standardized-budget surplus or deficit. That measure excludes the effects not only of cyclical fluctuations but also of factors that are short-lived and unlikely to significantly affect real income in the short term.⁽⁸⁾ Those factors include unusually large discrepancies between tax payments and liabilities, swings in collections of capital gains taxes, changes in the inflation component of the government's net interest payments, temporary legislative changes in the timing of revenues and outlays, receipts from the government's sale of assets and from auctions of licenses for the use of the spectrum, and federal outlays for deposit insurance.

A substantial discrepancy between tax payments and liabilities emerged most recently in 2003 when taxpayers did not reduce their estimated and withheld tax payments to correspond with the reductions in their tax liabilities. The discrepancy arose because JGTRRA's reductions in tax rates for all of calendar year 2003 were reflected in lower withholding rates for only about half of the calendar year, implying additional refunds or reductions in final settlements of roughly $20 billion in the spring of 2004. Because those overpayments in fiscal year 2003 (and correspondingly higher refunds in 2004) were temporary, they should have had little impact on people's perception of their income. For that reason, in calculating the standardized budget, CBO treated those overpayments (and similar discrepancies between tax payments and liabilities that occurred in the past) as if they affected only the timing of tax payments and not perceived real income. That adjustment removed the temporary overpayments from revenue totals for 2003 and reduced refunds in 2004 by the same amount.

CBO removes capital gains tax receipts from the standardized budget for two reasons. First, removing those tax receipts avoids the misleading effects that can arise, for example, when a cut in the tax rate on capital gains temporarily encourages the realization of taxable gains by enough to increase revenues. If capital gains taxes were included, that rise in revenues would cause the standardized-budget measure to indicate--incorrectly--that a tax cut could reduce the growth of real income in the short term. Second, although capital gains tax receipts move up and down over the business cycle, those movements are not regular enough to be captured by the cyclical adjustments to revenues.

CBO also removes changes in the inflation component of net interest from its calculation of the standardized budget. That component reflects the effect of inflation on the value of outstanding federal debt and does not add to or subtract from real income.

Legislation sometimes temporarily shifts the timing of receipts or outlays (usually from the end of one fiscal year to the beginning of the next). CBO excludes those small timing shifts from the standardized budget because they are unlikely to significantly alter people's perception of their real income. In addition, CBO excludes receipts from the government's sale of assets and from auctions of licenses to use the electromagnetic spectrum. Those transactions are voluntary exchanges of existing assets that have little or no effect on private net worth or real income growth. Finally, CBO removes outlays for deposit insurance because the impact of those outlays on real income occurred in earlier years (when various thrift institutions failed).⁽⁹⁾

The standardized-budget deficit is projected to change less than the cyclically adjusted budget deficit in both 2005 and 2006. It moves from 2.6 percent of potential GDP in 2004 to 2.5 percent in 2005 and then declines to 2.1 percent in 2006. The difference between the two measures reflects the adjustments to the standardized deficit for factors other than the business cycle. During the 2004-2006 period, the adjustments for those factors change from 0.4 percent of potential GDP to essentially zero, primarily because the adjustments for net refunds in 2004 that resulted from overpayments in 2003 were relatively large, as well as because the inflation component of interest payments declined some in both 2005 and 2006. (Details of the calculations for the standardized budget are provided in the appendix.)
 
 

The standardized-budget deficit registered a small increase of $34 billion, or 0.1 percent of potential gross domestic product (GDP), in 2004, following large increases in both 2002 and 2003 (see Tables A-1 and A-2). Standardized revenues were unchanged as a percentage of potential GDP in 2004. The standardized measure of discretionary spending rose slightly, while standardized mandatory spending did not change relative to potential GDP, and the inflation component of interest payments declined slightly.

Under the assumptions for the Congressional Budget Office's baseline projections, the standardized-budget deficit will reverse its course and decline by 0.5 percent of potential GDP between 2004 and 2006, with most of that change occurring next year. In 2005, a small increase in standardized interest payments (relative to potential GDP) is offset by a slight rise in standardized revenues and a slight decline in standardized discretionary spending. In 2006, the standardized deficit declines by 0.4 percent of potential GDP. Standardized revenues rise by 0.3 percent of potential GDP, while standardized discretionary spending falls by 0.5 percent of potential GDP. Those changes are only partly offset by increases in standardized mandatory spending and interest payments.

The movement of the standardized budget is smaller than that of the cyclically adjusted budget in both 2005 and 2006. The discrepancy results from several adjustments to the standardized budget (see Table A-3). On the revenue side, standardized revenues rise less (relative to potential GDP) than cyclically adjusted revenues in 2005 because of the adjustments for capital gains, timing, and other factors (see Table A-3). Capital gains are projected to rise slightly relative to potential GDP, and removing them from the standardized budget reduces the rise in standardized revenues. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) delayed some corporate tax payments from 2004 to 2005, and adjusting for that timing action transfers some standardized revenues from 2005 into 2004. The other factor is an adjustment to standardized revenues for large net individual tax refunds in 2004 that resulted from overpayments in 2003 because of a midyear enactment of the full-year tax cuts in EGTRRA. In total, such adjustments to standardized revenues do not change in size (relative to potential GDP) between 2005 and 2006.

On the outlay side, the discrepancies between the annual changes in the cyclically adjusted and standard measures (relative to potential GDP) are small and mainly reflect an adjustment for temporary timing-related increases in mandatory spending in 2005, as well as for a downward movement in the inflation component of interest payments in both 2005 and 2006.

Table A-1.

Table A-2.

Table A-3.