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In January 2003, the Congressional Budget Office (CBO) released its baseline projections of federal revenues, outlays, surpluses, and deficits for the next 10 years.(1) The total budget surplus of $236 billion recorded in 2000 had become a deficit of $158 billion in 2002.(2) According to CBO's January projections, if the policies assumed in that report were to continue, the deficit would grow to $199 billion in 2003 before falling somewhat to $145 billion in 2004. (Since then, CBO has raised its estimates of the total budget deficit by $47 billion for 2003 and by $55 billion for 2004. However, this analysis is based on the January estimates.) The size of the budget surplus or deficit reflects temporary factors, such as the effects of the business cycle or of one-time shifts in the timing of federal spending and tax receipts, as well as the longer-lasting impact of factors such as tax and spending legislation and changes in the trend growth rate of the economy. To help separate out those factors, this report presents estimates of two adjusted budget measures. Those measures are the cyclically adjusted surplus or deficit (which filters out the effects of the business cycle) and the standardized-budget surplus or deficit (which removes other factors as well as the effects of the business cycle). By CBO's calculations of those measures, the effects of the business cycle are estimated to account for roughly one-third of the decline in the total budget surplus between 2000 and 2003. Roughly half of the total drop can be attributed to recent legislative actions--primarily enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Job Creation and Worker Assistance Act of 2002 (JCWAA), together with increases in discretionary spending. The decline in the budget deficit projected for 2004 stems mainly from the growth of revenues. That projected growth reflects some cyclical improvement and a rise in effective tax rates attributable to a combination of "bracket creep," an increase in taxable income as a share of gross domestic product (GDP), and the expiration of certain corporate income tax provisions enacted in JCWAA.(3) The calculations in this analysis rest on the assumptions used in CBO's
economic and budget projections as published in January 2003. They do not
reflect any updates to those projections, nor do they include the effect
of the President's budgetary proposals for 2004.
Why Adjust Measures of the Total Surplus or Deficit?Despite some limitations, both conceptual and empirical, budget measures that separate 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 imparting a positive or negative impulse to the growth of real (inflation-adjusted) income in the short run. More generally, those measures provide estimates of the extent to which changes in the budget are caused by normal 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 shows the underlying outcome of the federal budget when those automatic movements are removed. (The cyclical deficit--the difference between the total budget deficit and the cyclically adjusted deficit--is often viewed as a measure of the so-called automatic stabilizers, which help to sustain the growth of real income through automatic changes in revenues and outlays.) Policy actions by the Congress and the President, such as legislated tax cuts or increases in spending during recessions, also affect budgetary outcomes. Those actions create changes in the total budget surplus or deficit that are separate from the automatic cyclical movements. The cyclically adjusted surplus or deficit includes the effects of those legislated changes. It also reflects other factors, not directly connected with changes in policy, that alter revenues or spending. For example, as has happened in recent years, declines in the stock market can cause revenue shortfalls because receipts from capital gains taxes fall. (Movements in capital gains tax receipts are not treated as cyclical, and thus are not removed from the cyclically adjusted budget measure, because the linkage between those receipts and the business cycle is usually tenuous.) Similarly, explicit budgetary decisions can produce temporary changes--sometimes of only a few days--in the timing of tax receipts or government spending; but such actions can be viewed more as accounting decisions than as changes in policy. CBO calculates another measure, the standardized-budget surplus or deficit, that attempts to adjust for those factors as well as for the effects of the business cycle. To calculate that measure, CBO must judge whether each factor is likely to have a significant effect on the growth of real income in the short run. As a result, the standardized-budget surplus or deficit is the more speculative of the two measures presented here. Although the standardized-budget measure considers only short-run effects
on real income, federal taxes and spending can affect the economy in many
ways and may alter the prospects for economic growth in the longer run
by changing incentives to work, save, and invest. (Frequently--as in the
case of EGTRRA's enactment--both short- and longer-term effects are intended.)
Summary budget measures such as the cyclically adjusted and standardized
budgets are generally of limited use in identifying the economic effects
of changes in incentives.(4)
CBO's estimates of those impacts are incorporated in its economic forecasts.(5)
The Cyclically Adjusted Surplus or DeficitCalculations 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 loss of revenues that automatically occurs during recessions.(6) Likewise, cyclically adjusted outlays exclude the additional spending that follows from a rise in unemployment. The difference between those two measures is the cyclically adjusted surplus or deficit. The calculation of the cyclically adjusted budget could be refined to adjust for other factors as well. For example, shifts in capital gains tax revenues that arise from economic fluctuations could be removed, although that calculation is complicated by the difficulty of separating the cyclical and legislative components of changes in capital gains realizations. Factors such as legislated shifts in the timing of outlays or tax payments are usually not considered cyclical but could also be removed from a cyclically adjusted measure. Such factors are taken into account in CBO's standardized-budget measure. Between 2000 and 2003, CBO estimates, the cyclically adjusted budget balance will move from a surplus of 1.5 percent of potential GDP to a deficit of 1.4 percent (see Table 1). That decline accounts for roughly two-thirds of the change in the total budget balance from the surplus of $236 billion recorded for 2000 to the deficit of $199 billion projected in January for 2003. The remaining one-third of that drop is attributable to the business cycle. In sum, the cyclical surplus--the difference between the total budget
surplus and the cyclically adjusted surplus--was 1.0 percent of potential
GDP in 2000. Since then, that measure has moved steadily into the red.
The cyclical deficit is expected to reach 0.5 percent of potential GDP
this year and then shrink a bit between 2003 and 2004.
The Standardized-Budget Surplus or DeficitCBO 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 certain more-or-less-temporary factors that are unlikely to have significant effects on real income in the short run.(7) 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, and temporary legislative changes in the timing of revenues and outlays. A substantial discrepancy between tax payments and liabilities emerged in 2001, when taxpayers did not sufficiently reduce their estimated and withheld tax payments even though their tax liabilities had declined because of such factors as stock market losses and smaller-than-expected year-end bonuses. CBO estimates that those temporary tax overpayments in 2001 (and the corresponding increase in refunds in 2002) totaled about $25 billion for individuals.(8) Because those overpayments are temporary, they should have little impact on people's perceptions of their income, especially for individuals whose financial liquidity is not constraining their actions--a group that accounts for perhaps 70 percent of total consumption.(9) For that reason, in calculating the standardized budget, CBO treated 70 percent of those overpayments (and 70 percent of similar discrepancies between tax payments and liabilities in the past) as if they affected only the timing of tax payments and not perceived real income. That adjustment removes most of the temporary overpayments from revenue totals for 2001 and reduces refunds in 2002 by the same amount. CBO removes capital gains tax receipts from the standardized budget for two reasons. First, although such receipts probably move up and down as a result of business-cycle effects, those movements are not captured by the cyclical adjustments to revenues. Second, 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. That rise in revenues causes the standardized-budget measure to indicate--incorrectly--that a tax cut implies budgetary restraint on the growth of real income in the short term. CBO also removes changes in the inflation component of net interest from its calculation of the standardized budget because the component effectively adjusts the value of outstanding federal debt for the effects of inflation and does not increase real income. Legislation enacted by the Congress and the President sometimes temporarily shifts the timing of receipts or outlays (usually from the end of one fiscal year to the beginning of the next one). Those small timing shifts are excluded from the standardized budget because they are unlikely to significantly alter people's perception of their real income. In addition, the standardized budget excludes receipts from the government's sale of assets and from auctions of licenses to use the electromagnetic spectrum, as well as federal outlays for deposit insurance. The effects of asset sales and spectrum auctions are removed because those transactions are voluntary exchanges of existing assets that have little or no effect on private net worth or real income growth. CBO removes outlays for deposit insurance because the impact of those outlays on real income occurred in earlier years, when various thrift institutions failed.(10) The standardized-budget surplus is projected to decline by a total of
2.4 percent of potential GDP between 2000 and 2003--somewhat less than
the decline in the cyclically adjusted surplus over the same period (see
Table 1). For both measures, the declines stem mainly
from the effects on revenues of the tax cuts enacted during those years
and from additional discretionary spending. Because the other adjustments
to the standardized budget become much smaller in 2003, the difference
between that measure and the cyclically adjusted budget also diminishes.
(See the appendix for more details of the standardized-budget surplus and its components through 2004.)
The Effects of Recent Tax and Spending LegislationThe estimated effects of legislation enacted since January 2001 account for roughly half of the projected decline in the total budget surplus between 2000 and 2003. (By comparison, roughly one-third of the drop is attributable to the estimated effects of the business cycle over that period.) Although CBO projects that the effects of legislation since January 2001 will increase the total budget deficit somewhat in 2004, those effects will be more than offset by the impact of the business cycle and by factors that raise effective tax rates (and thus revenues). Legislation accounts for most of the decline in the cyclically adjusted
and standardized-budget surpluses. Laws enacted since January 2001 have
lowered those surpluses by 0.5 percent of potential GDP for 2001, 1.8 percent
for 2002, and 2.3 percent for both 2003 and 2004 (see Table
1). Most of those changes stem from the effects of EGTRRA, from higher
appropriations for defense, and from the tax cuts and additional spending
enacted in JCWAA.
Following a decline in the standardized-budget surplus in 2001 of 0.3 percent of potential gross domestic product (GDP), the standardized budget registered a record shift in 2002--from a surplus of 0.8 percent of potential GDP the year before to a deficit of 1.5 percent (see Table A-1). That shift was the largest single-year decline in the standardized-budget surplus, surpassing the previous large declines of 2.0 percent of potential GDP in 1976 and 1.9 percent in 1983.(11) Revenues accounted for more than half of the drop, with recent legislation responsible for about half of the revenue decline and the rest attributable to a decline in the federal effective tax rate that is not captured by the cyclical and other adjustments used to calculate standardized-budget revenues. The remainder of the decline in the standardized-budget surplus in 2002 came from increases in discretionary and mandatory spending, which amounted to 0.5 percent and 0.4 percent of potential GDP, respectively (see Tables A-2 and A-3). In large part, those increases were caused by emergency appropriations enacted in the wake of the September 11 terrorist attacks and by additional spending for unemployed workers provided in the Job Creation and Worker Assistance Act.
In contrast to the increases in the standardized-budget deficit in 2001 and 2002, CBO's January 2003 projections suggest some movement toward a smaller deficit this year and next. In 2003, that change in direction in the projections mainly results from an estimated decline (from 1.3 percent of potential GDP to 0.9 percent) in inflation-adjusted interest payments and some increase in standardized-budget revenues (as a percentage of potential GDP) that does not show up in the rounded numbers. Those changes more than offset increases in mandatory and discretionary outlays. In 2004, the standardized-budget deficit under CBO's January assumptions is expected to shrink from 1.3 percent of potential GDP to 0.9 percent. Most of that projected decline is due to an increase in revenues, although there are also slight declines (as a share of potential GDP) in discretionary outlays and inflation-adjusted interest payments. The increase in standardized-budget revenues comes from both personal and corporate income tax receipts.
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