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Mr. Chairman, Congressman Spratt, and Members of the Committee, I am pleased to be with you this morning to discuss the budget and economic outlook for fiscal years 2001 to 2010.

Total federal revenues exceeded spending by $124 billion in fiscal year 1999, producing a surplus in the total budget for the second consecutive year. The Congressional Budget Office (CBO) estimates that without legislative changes, that surplus will rise to $176 billion in 2000 (see Summary Table 1). If current policies remain in place, the surplus will continue to increase after 2000, CBO projects; however, the size of that increase depends on the amount of discretionary spending that is assumed.
 

CBO's baseline projections are intended to provide the Congress with estimates of the spending and revenues that will occur if current laws affecting the budget remain unchanged. In the case of mandatory spending and revenues, which are generally governed by permanent laws, the projections incorporate the effects of anticipated changes in the economy, demographics, and other relevant factors.

In the case of discretionary spending, however, which is controlled by annual appropriation acts, no consensus exists about how to define current policy as it applies to future years. Is it best represented by the statutory caps on discretionary budget authority and outlays, which were most recently specified in the Balanced Budget Act of 1997? Or does section 257(c)(1) of the Balanced Budget and Emergency Deficit Control Act of 1985 better depict current policy by specifying that baselines should be adjusted for inflation? Or is current policy for discretionary spending simply the amount that was provided in appropriations for the current year?

Without any definitive answer to those questions, CBO presents three variants of its baseline in this report. Each one reflects a different assumption about discretionary spending.

• The "inflated" variation assumes that budget authority for discretionary programs grows at the rate of inflation each year after 2000.
  
  
• The "freeze" variation pegs discretionary budget authority to the level enacted for the current year, plus amounts already enacted for 2001.
  
  
• The "capped" variation assumes that discretionary spending equals CBO's estimates of the statutory caps through 2002 and grows at the rate of inflation thereafter.

The Congress has used each of those spending paths as a benchmark in some past budget deliberations. Each alternative has limitations, however. As they currently stand, the caps may not be a realistic reference point given recent action on discretionary spending. The inflated baseline, for its part, implicitly earmarks future resources to maintain the real (inflation-adjusted) level of discretionary spending even though there is no explicit statutory basis for such earmarking. And the freeze baseline ignores the effects of pay raises and inflation--costs that could erode the amount of services or programs that the government can deliver. In addition, both the inflated and freeze baselines mechanically repeat funding for programs (such as the decennial census) whose needs are known to be significantly greater or less in future years.

Most of the components of CBO's baseline budget projections--revenues, mandatory spending, and offsetting receipts--are the same no matter which assumption about discretionary spending is used. Net interest costs, however, depend on the amount of projected debt outstanding, which in turn reflects the choice of paths for discretionary outlays. Likewise, projections of the surplus will vary depending on assumptions about the discretionary portion of the budget and the resulting effects on interest costs.

Regardless of the variant, the budgetary picture is a bright one. Between 2001 and 2010, accumulated surpluses are projected to total $3.2 trillion under the inflated baseline and $4.2 trillion under the freeze or capped baseline. On-budget surpluses (which exclude the spending and revenues of Social Security and the Postal Service) total more than $800 billion under the inflated baseline and $1.9 trillion under the other two baselines.

Those surpluses are much larger than the ones that CBO projected last July in The Economic and Budget Outlook: An Update. Comparing capped baselines (which CBO used in that report), the cumulative surplus for the 2000-2009 period is now $879 billion higher, despite legislation enacted since July that reduces that surplus by a total of $127 billion between 2000 and 2009. The effects of new legislation are more than offset by changes in economic and other factors that increase revenues by $651 billion over that period and reduce spending by $355 billion.

Most of the improvement in the budgetary picture results from CBO's updated economic outlook. Real economic growth is forecast to average about 3 percent a year over the next two years, with only a slight rise in the underlying rate of inflation. For the longer term, CBO projects that real growth will average 2.7 percent a year from 2002 through 2010, taking into account the possibility of booms and recessions during that period.
 

THE BUDGET OUTLOOK

The total budget surplus of $176 billion that CBO is projecting for this year results from a $153 billion surplus in off-budget accounts--mainly the Social Security trust funds, whose inflows and outflows are accounted for separately from those of the rest of the government--and a $23 billion surplus in on-budget accounts. That on-budget surplus would be the largest ever in nominal dollars. Measured as a percentage of gross domestic product (GDP), it would be the largest since 1951.

Assuming that current policies do not change, CBO projects growing surpluses over the next decade. The total budget surplus would reach between 3 percent and 5 percent of GDP by 2010 depending on the path of discretionary spending (see Summary Tables 2, 3, and 4). The on-budget surplus would range between 1 percent and 3 percent of GDP.
 

Changes Since July

CBO's current budget outlook is considerably more positive than the one described in its July 1999 report. Since then, CBO estimates, the Congress and the President have enacted legislation that increases projected spending over the 2000-2009 period by about $109 billion and reduces projected revenues by $18 billion, compared with the levels in CBO's July baseline (see Summary Table 5). The majority of that legislative action occurred at the end of the session, when the Congress and the President enacted the District of Columbia appropriation act and nine other acts enacted by reference--four regular appropriation acts (for the Departments of Commerce, Justice, and State; for foreign operations; for the Department of the Interior; and for the Departments of Labor, Health and Human Services, and Education), a miscellaneous appropriation act, and four additional acts. The effects of that legislation, however, have been more than offset by changes in CBO's estimates of future revenues and outlays that have added to projected surpluses.
 

Most of the improvement in the budget outlook since July results from the continuing strength of the economy, which CBO estimates will produce higher revenues. The current revenue projections are more than $500 billion higher over the 10-year period because of changes in CBO's economic forecast. Most of that increase stems from higher projected levels of wage and salary income, which boost receipts from individual income and social insurance taxes.

CBO projects that interest rates will be approximately 1 percentage point higher in 2001 and 2002 than previously forecast and at least 0.3 percentage points higher after that. Such changes boost anticipated interest costs (in the capped baseline) by $56 billion through 2009. At the same time, higher revenue projections and other factors lower the projected costs of servicing the federal debt by as much as $31 billion a year by 2009 and by a total of $138 billion over the 10-year period.

Changes in factors other than legislation and the economic outlook (so-called technical changes) increase the surplus under the capped baseline by $366 billion over 10 years. Technical changes to revenue projections account for $141 billion of that difference--mostly the result of an increase in projected realizations of capital gains in the near term and other effects on social insurance taxes and individual income taxes in later years. Technical changes to outlay projections (other than for debt service) represent a similar amount--nearly all of it resulting from changes to CBO's estimates of Medicare spending. Continued emphasis on improving compliance with program rules and a larger-than-anticipated drop in the use of home health care services have slowed the growth of Medicare spending, prompting CBO to adjust its estimates downward.

Revenue Projections for 2000 Through 2010

CBO estimates that total federal revenues will exceed $1.9 trillion in fiscal year 2000 if current policies remain unchanged--marking the eighth consecutive year in which the growth of revenues has outstripped the growth of gross domestic product. Revenues are expected to grow more slowly than GDP through 2004 and then at about the same rate as GDP through 2010. In that year, revenues are projected to be $2.9 trillion, or about 19.8 percent of GDP.

Although revenues will continue to grow, CBO expects the rate of growth to slow from the rapid pace of the past few years. From 1994 to 1998, revenues rose at an average rate of 8.3 percent a year, much faster than GDP. Consequently, revenues as a percentage of GDP increased from 18.1 percent in 1994 to 19.9 percent in 1998. Although revenue growth slowed to 6.1 percent in 1999, it still exceeded GDP growth and boosted the ratio of receipts to GDP to a postwar high of 20 percent.

In CBO's forecast, receipts will increase slightly faster this year (6.4 percent) than in 1999. They will also grow faster than GDP, pushing the ratio of revenues to GDP to 20.3 percent, which is expected to become the postwar peak. Beginning next year, however, CBO expects receipts to grow by roughly 4 percent a year through 2004. That rate is projected to rise to about 4.5 percent a year between 2005 and 2010. Although GDP will grow faster than receipts during that period, on average, the ratio of receipts to GDP will stay close to its peak, remaining at 19.8 percent.

Individual income tax receipts--bolstered primarily by higher realizations of capital gains, growth in real incomes, and especially rapid growth in income among high-income taxpayers--fueled the rapid rise in revenues of the past few years. Those receipts are also an important contributor to the slower growth of revenues projected for the next few years. Higher realizations of capital gains stemmed largely from the sharp rise in stock prices. Effective tax rates rose because an increasing number of taxpayers fell into the high-income category and were therefore taxed at higher marginal rates. Furthermore, those taxpayers experienced higher-than-average growth in income. None of those sources of rapid growth in revenues are expected to persist indefinitely. As they play smaller roles in boosting receipts, revenue growth is projected to slow.

Outlay Projections for 2000 Through 2010

CBO expects federal spending to total $1.8 trillion in fiscal year 2000. Under current policies, that figure is projected to rise to between $2.2 trillion and $2.5 trillion by 2010, depending on the path assumed for discretionary spending.

Federal spending as a percentage of the economy declines from its current level under all three of CBO's alternatives for discretionary spending. Last year, federal outlays totaled just under 19 percent of GDP. In 2000, they will drop further, to about 18.5 percent. Over the next decade, CBO estimates, outlays will continue to fall slowly, reaching between 15.1 percent and 16.5 percent of GDP in 2010, depending on which assumptions are used.

Within the overall picture, the mix of federal spending has changed significantly over time. Today, the government spends more on entitlement programs and less on discretionary programs as a share of GDP than it did in the past. Spending for entitlements and other mandatory programs (including offsetting receipts) rose from 4.9 percent of GDP in 1962 to 9.9 percent in 1999, while discretionary spending declined from 12.7 percent of GDP to 6.3 percent.

That trend continues in CBO's baseline projections. By 2010, mandatory spending (including offsetting receipts) is expected to reach 10.9 percent of GDP, as discretionary spending falls to between 4.2 percent and 5.3 percent. The growth of mandatory spending--at a projected rate of 5.6 percent a year--will be fueled by the two major health care programs, Medicare and Medicaid, which are projected to grow at average annual rates of 6.9 percent and 8.6 percent, respectively. Those growth rates are faster than the ones experienced in the past three years but slower than those of the early 1990s.

Discretionary spending is projected to increase at various rates from 2000 to 2010: the inflated baseline shows growth averaging 2.7 percent a year; the freeze baseline, 0.3 percent; and the capped baseline, 1.4 percent. Although total discretionary spending was virtually unchanged between 1991 and 1996, nondefense discretionary spending grew by 4.7 percent annually, while defense spending dropped by 3.6 percent annually. Over the following three years, nondefense spending increased by 3.8 percent, on average, and defense spending by 1.2 percent, leading to an average increase of 2.5 percent a year for total discretionary spending.

As a whole, federal outlays (other than net interest outlays) are projected to rise by between 3.5 percent and 4.5 percent a year during the next decade (depending on which variation of the baseline is used). By comparison, total noninterest outlays grew at an annual rate of 3.4 percent over the 1991-1999 period.

Under each of the alternatives for discretionary spending, the Treasury would have enough cash on hand sometime between 2007 and 2009 to retire all of the federal debt held by the public. However, because some outstanding debt will not be available for repurchase, the Treasury would not be able to devote all such funds to that purpose. CBO's baseline simply assumes that the Treasury would invest all of its excess cash at an interest rate equal to the average rate projected for Treasury bills and notes and would receive dividend or interest earnings from those investments.
 

THE ECONOMIC OUTLOOK

In 1999, the U.S. economy continued to expand far beyond expectations--yet without any meaningful acceleration in the underlying rate of inflation. Most analysts expect the economy's growth to remain strong but to slow at least moderately from the 4.3 percent annual rate of the past three years.

Changes Since July

CBO's current economic outlook is more optimistic about the prospects for real growth than the one reported last July. Compared with the July projections, growth of real GDP and labor productivity is significantly higher, inflation as measured by the consumer price index (CPI) is unchanged, and interest rates are slightly higher (see Summary Table 6). Private-sector assessments of the economy's recent behavior reach the same conclusion--that the sustainable trends in the growth of labor productivity and real GDP are higher than previously thought possible.
 

In CBO's current projections, real GDP grows for the next 10 years at an average annual rate that is 0.4 percentage points higher than was projected in July. Several factors account for that increase: 0.2 percentage points stem from a reassessment of how much of the recent surge in productivity will persist; slightly less than 0.1 percentage point results from a change in the projected growth of the labor force; and the rest reflects revisions in the measurement of real GDP.

Compared with real GDP growth, the growth of nominal GDP and the categories of income that are important for predicting revenues (corporate profits and wages and salaries) did not change as much from the July projections. The reason is largely that CBO's current projection of the growth of the GDP price index is lower. Furthermore, revisions to the historical data--along with revised outlooks for depreciation, net investment income from abroad, and corporate debt-service costs--have also reduced the projected growth of those income categories relative to the growth of GDP.

Recent Economic Performance

The economy has performed exceptionally well for several years, combining rapid growth and very low unemployment with declining inflation. Since 1996, the growth of real GDP has averaged better than 4 percent, compared with an average of about 3 percent since 1973. Because of those four years of rapid growth, the unemployment rate has fallen to 4.1 percent, its lowest level since January 1970. CPI inflation, excluding food and energy prices, had been running at about 3 percent per year earlier in the decade but was roughly 2 percent over the past year.

Much of the recent good news can be attributed to a surge in productivity growth, which has allowed the economy to grow faster without raising the rate of inflation. Low import and (until recently) oil prices, plus a number of other favorable but probably transitory developments, have also helped suppress inflation. However, domestic demand grew even faster than productivity--boosting employment, tightening labor markets, and raising concerns that recent growth rates may not be sustainable without sparking a rise in inflation.

The Forecast for 2000 and 2001

The economy retains considerable forward momentum, but at some point, a slowdown from the recent blistering pace seems inevitable. If tight labor markets push up labor costs, the best news about price inflation may be in the past. Unless a faster rise in labor costs was offset by continued increases in productivity growth, consumer prices could move upward. Recovery in foreign economies could add to those inflationary pressures by boosting commodity prices and by strengthening foreign currencies relative to the dollar, which would raise import prices.

The Federal Reserve has already responded to the threat of accelerating inflation by increasing the federal funds rate by 0.75 percentage points since June. Although those rate hikes may diminish the risk of inflation in the near term, financial markets seem convinced that further increases will occur this year.

For the next two years, CBO forecasts real GDP growth of about 3 percent, on average, and a slight rise in the underlying rate of inflation. That outlook would not cause the unemployment rate to change much in 2000 or 2001 from its current low level. The core CPI inflation rate (excluding food and energy prices) is expected to edge up slightly over the next two years from its recent pace of 2.1 percent.

In CBO's forecast, short-term interest rates average 5.4 percent in 2000 and 5.6 percent in 2001. The forecast assumes that the Federal Reserve will boost the federal funds rate by 0.5 percentage points during the first half of 2000 (in early January, financial markets expected at least that large an increase). Thus, the interest rate on three-month Treasury bills is forecast to reach 5.6 percent by midyear and remain there through 2001. The rate on 10-year Treasury notes is forecast to average 6.3 percent in 2000 and 6.4 percent in 2001.

Projections for 2002 Through 2010

CBO projects that real GDP will grow at an average annual rate of 2.8 percent during the 2000-2010 period. That growth compares with the slightly higher growth of 3.1 percent for potential output. Since the current estimated level of real GDP exceeds its potential level, actual GDP must grow at a slower pace than potential GDP to close the gap.

CPI inflation averages 2.5 percent a year after 2001 in CBO's projections, and the unemployment rate averages 5.0 percent. Short- and long-term interest rates are projected to average 4.8 percent and 5.7 percent, respectively, during that period.
 

UNCERTAINTY OF THE PROJECTIONS

CBO's baseline projections represent the midrange of possible outcomes for the economy and the budget, assuming that current policies are not changed. Actual budgetary outcomes, however, could be considerably different from those projections. Economic performance and other assumptions that deviate from CBO's baseline will surely lead to results that diverge from the numbers presented in this report. Policy changes will also occur that will alter outlays and revenues; CBO's projections do not attempt to take such changes into account.

Experience shows that although CBO's projection of the surplus for the coming fiscal year is likely to be within 1 percent of GDP in most cases, discrepancies can become more substantial over a five-year horizon. CBO's 10-year projections have only been made since 1992, so it is too soon to assess their accuracy. But 10-year projections are likely to be less accurate than five-year projections.

Many observers believe that a major structural change has taken place in the economy, and that belief influences CBO's projections. However, any transition to a "new economy" would have occurred only in the past few years, which means that little data about it are available from which to make projections for the next decade. Moreover, those data are insufficient to say for sure whether a structural shift has occurred or whether the economy has merely deviated temporarily from its underlying trends, as it has many times in the past. Under those circumstances, projecting the economy and the budget is even more uncertain than usual.

To illustrate the possible effects of differences from the baseline assumptions, CBO has produced budget projections under two alternative scenarios that make different assumptions. One (the optimistic scenario) assumes that the robust performance of the past few years will continue indefinitely and that Medicare and Medicaid spending will grow at a rate 1 percentage point slower than in the baseline. The other (the pessimistic scenario) assumes that the economy has simply experienced a temporary divergence from stable, long-term trends and will soon return to those trends--including even faster growth in Medicare and Medicaid. The projections that result from those two scenarios suggest a very wide range of possible outcomes for the budget: for example, the total surplus or deficit in 2010 could deviate from the baseline projections by $700 billion to $800 billion.

Under the assumptions of the optimistic scenario, the budget outlook would improve dramatically. If discretionary spending grew at the rate of inflation but there was no other action to cut taxes or increase spending, the annual on-budget surplus under that scenario would exceed $800 billion by the end of the decade, and the total budget surplus would exceed $1.1 trillion. Projected surpluses that large would imply that the federal government was holding huge amounts of nonfederal assets (more than $4 trillion). If discretionary spending was held to the lower levels implied by the statutory caps through 2002 or was frozen at the level enacted for 2000, surpluses would be even larger.

Under the pessimistic scenario, the on-budget surpluses that CBO is projecting in its baseline would never emerge. Instead, the on-budget deficit would rise to more than $290 billion a year by the end of the decade. The total budget deficit would be smaller; if discretionary spending was constrained for the whole decade to the level enacted for 2000, that deficit would stay under $100 billion.
 

CONCLUSION

The budgetary picture is bright. Projected surpluses are much larger than the ones that CBO projected last July. The improved picture largely results from CBO's updated economic outlook. But actual budgetary outcomes could be considerably different from the projections. Economic performance and other assumptions that differ from CBO's baseline will lead to results that diverge from the projections. Policy changes will also occur that will alter outlays and revenues; CBO's projections do not attempt to account for such changes.

Although the improved budget outlook over the next 10 years brightens the long-term outlook, problems lie not far beyond the 10-year horizon. Between this year and 2030, the number of retirees will grow by 80 percent, but the number of workers will increase by only about 10 percent. Ultimately, it is not the size of the balances in the trust funds that will limit the ability to meet long-term obligations but the size of the economy.