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In August 2003, the Congressional Budget Office (CBO) released its updated baseline projections of federal revenues, outlays, surpluses, and deficits for the next 10 years.(1) After recording surpluses of $236 billion in 2000 and $127 billion in 2001, the budget balance switched to a deficit of $158 billion in 2002. According to CBO's updated projections, if the policies assumed in its August 2003 report were to continue, the total budget deficit would grow to $401 billion in 2003 and to $480 billion in 2004.(2) (By comparison, CBO's March 2003 baseline projections showed deficits of $246 billion for 2003 and $200 billion for 2004.)(3) The size of the budget surplus 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 (which filters out the effects of the business cycle) and the standardized-budget surplus (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 15 percent of the total budget deficit in 2003 and for 12 percent in 2004. Those percentages are down from the recent high of 30 percent in 2002, but the cyclical component of the total budget deficit is not projected to change much between 2002 and 2004 as a percentage of potential gross domestic product (GDP). On that basis, the effects of the business cycle are expected to remain close to their 2002 mark of 0.5 percent of potential GDP. The cyclically adjusted budget deficit--the total budget deficit minus the effects of the business cycle--is projected to rise from 1.1 percent of potential GDP in 2002 to 3.1 percent in 2003 and 3.7 percent in 2004. The standardized deficit shows similar, but somewhat smaller, increases. CBO's projections of the cyclically adjusted and standardized budgets extend only through 2004 because the economic forecast on which they are based does not attempt to reflect cyclical movements beyond that point.
Why Adjust Measures of the Total Budget Surplus?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 providing a positive or negative influence on 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 is calculated to show 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 sustain the growth of real income in recessions and dampen growth in booms, through automatic changes in revenues and outlays.) Policy actions by the Congress and the President, such as legislated tax cuts or spending increases, also affect budgetary outcomes. Those actions create changes in the total budget surplus that are distinct from the automatic cyclical movements. The cyclically adjusted surplus 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 reductions in revenue 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, thestandardized-budget surplus, 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 significantly affect the growth of real income in the short run. As a result, the standardized-budget surplus 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 is the case with enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)--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) Instead, CBO's estimates of those impacts are incorporated in its economic forecasts.(5)
The Cyclically Adjusted SurplusCalculations 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 automatically from a rise in unemployment. The difference between those two measures is the cyclically adjusted surplus. 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. CBO estimates that the cyclically adjusted deficit will increase from 1.1 percent of potential GDP in 2002 to 3.1 percent in 2003 and to 3.7 percent in 2004 (see Table 1). That overall change (2.6 percent of potential GDP) is the same as the increase registered between 2000 and 2002 (see Figure 1). Most of the projected growth in the cyclically adjusted deficit occurs in 2003 rather than in 2004. The effect of the business cycle on the budget surplus is measured by the change in the cyclical surplus--the difference between the total budget surplus and the cyclically adjusted surplus. In 2000, the cyclical surplus amounted to 1.0 percent of potential GDP, which indicated that the economy was temporarily augmenting the total budget surplus. After registering a small surplus in 2001, however, that temporary surplus component became a deficit of 0.5 percent of potential GDP in 2002, which meant that the economy was then temporarily adding to the total budget deficit. There has been little further change in 2003, and not much change is expected between 2003 and 2004. Thus, the cyclical component of the budget is not a significant factor in explaining the change in the budget deficit as a share of potential GDP between 2002 and 2004.
The Standardized-Budget SurplusCBO routinely publishes another adjusted budget measure, the standardized-budget surplus. That measure excludes the effects not only of cyclical fluctuations, but also of factors that are clearly short-lived and that are unlikely to significantly affect 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 fiscal year 2003, when taxpayers did not sufficiently reduce their estimated and withheld tax payments even though their tax liabilities had declined substantially. The discrepancy arose because JGTRRA's reductions in tax rates for all of 2003 were reflected in lower withholding rates for about half of the calendar year, implying additional refunds of roughly $25 billion in the spring of 2004. Because those overpayments in fiscal year 2003 (and correspondingly higher refunds in 2004) 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.(8) 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 2003 and reduces refunds in 2004 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 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.(9) The standardized-budget deficit is projected to increase by 1.7 percent of potential GDP in 2003 and by only 0.2 percent in 2004. Thus, the overall increase between 2002 and 2004 is somewhat less than the projected increase in the cyclically adjusted deficit (see Table 1). The difference between the two measures reflects the adjustments to the standardized deficit for factors other than the business cycle. Although the size of those other adjustments changed little between 2000 and 2002, the projected change between 2002 and 2004 amounts to 0.7 percent of potential GDP. It largely comprises timing adjustments to offset legislated shifts in revenues from one fiscal year to the next as well as some increase in the adjustment for the inflation component of interest payments.
The Effects of Recent Tax and Spending LegislationThe estimated effects of legislation enacted since January 2001 account for the projected increase in the total budget deficit between 2002 and 2004. Although CBO projects that, in 2004 alone, the effects of that legislation will increase the total budget deficit by 1.2 percent of potential GDP, the overall increase in the total budget deficit between 2003 and 2004 is expected to be only 0.5 percent of potential GDP, or less than half of the increase from legislation. Thus, more than half of the effects of legislation are offset by the impact of factors that otherwise would have resulted in smaller deficits (primarily because of faster growth of personal and corporate tax revenues that stems from a small cyclical rebound in the corporate profits share of GDP and an increase in effective tax rates). For the 2002-2004 period, legislation accounts for more than all of the increase in both the cyclically adjusted and standardized-budget deficits. Laws enacted since January 2001 have lowered those surpluses (as well as the actual budget balance) by 0.5 percent of potential GDP for 2001, 1.8 percent for 2002, 3.3 percent for 2003, and 4.5 percent for 2004 (see Table 1). Between 2002 and 2004, half of the estimated effect of legislation results from JGTRRA, and most of the rest comes from greater discretionary spending, primarily defense appropriations. EGTRRA and JCWAA together have little net effect on the increase in the various deficit measures between 2002 and 2004.
The standardized budget registered a record shift as a percentage of potential gross domestic product (GDP) in 2002--from a surplus of 1.0 percent in 2001 to a deficit of 1.5 percent (see Table A-1). That shift surpassed the previous large declines of 2.1 percent of potential GDP in 1976 and 1.9 percent in 1983.(10) Revenues accounted for more than half of the drop, with recent legislation responsible for roughly half of the revenue decline and the rest attributable to a fall in the federal effective tax rate (total revenues as a percentage of potential GDP) 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 after the September 11 terrorist attacks and by additional spending for unemployed workers provided in the Job Creation and Worker Assistance Act of 2002. In contrast with the Congressional Budget Office's (CBO's) March 2003 estimates, which showed some reductions in the standardized-budget deficit as a percentage of potential GDP in 2003 and 2004, CBO's updated projections show a continued increase in the standardized-budget deficit, rising to 3.2 percent of potential GDP in 2003 and to 3.4 percent in 2004. During that two-year period, standardized-budget revenues fall by 1.2 percent of potential GDP, roughly half of which reflects the effects of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Standardized-budget outlays rise by 0.7 percent of potential GDP, which is somewhat less than the increase attributable to legislation for discretionary spending (see Table 1). Although recent legislation accounts for almost all of the increase in the standardized-budget deficit in 2003, other factors offset most of the effects of that legislation on the increase in the standardized-budget deficit in 2004. Those other factors mainly include the revenue effects of influences not captured by CBO's cyclical and other adjustments to the standardized budget, such as growing taxes from pension fund distributions, a small amount of real bracket creep, an increase in the effective tax rate on corporate profits to more-historical norms, increases in taxable income as a share of potential GDP, and rapid growth in unemployment insurance receipts as states replenish their depleted trust funds. As a result of those factors, standardized-budget revenues do not fall in 2004 relative to potential GDP, despite the effects of JGTRRA. Instead, the small increase in the standardized-budget deficit in 2004 is the result of increases in discretionary and mandatory spending, which more than offset a decline in inflation-adjusted interest payments.
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