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In March 2004, the Congressional Budget Office (CBO) released its most recent 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 March baseline were to continue, the total budget deficit would grow to $477 billion in 2004 but then would decline to $363 billion in 2005.(2) 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 attempts to filter 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 6 percent of the total budget deficit in 2004, down from the recent highs of 34 percent in 2002 and 18 percent in 2003. By 2005, CBO expects gross domestic product (GDP) to be somewhat above its long-term potential, and consequently, business-cycle effects will actually help reduce the deficit in that year by about 3 percent. The cyclically adjusted budget deficit--the total budget deficit minus the effects of the business cycle--is projected to grow from 2.8 percent of potential GDP in 2003 to 3.9 percent in 2004 and then decrease to 3.1 percent in 2005. The standardized deficit shows similar but slightly smaller changes. CBO's projections of the cyclically adjusted and standardized budgets extend only through 2005 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 2005 would be very similar to CBO's baseline projections. The calculations reported here refer directly to CBO's budget baseline. However, cyclically adjusted budget projections under other tax and spending assumptions, such as the President's budgetary proposals, can be approximated by using the cyclical adjustments calculated here. Applying CBO's cyclical adjustments to CBO's estimates of the President's budget (without macroeconomic feedbacks) would reduce the estimated deficit in 2004 by about $30 billion and increase it in 2005 by about $10 billion.
Why Adjust Measures of the Total Budget 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 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 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 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 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, movements in the stock market can cause changes in revenue because receipts from capital gains taxes change. 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 significantly affect 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-term 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, or EGTRRA, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA--both short- and longer-term effects are intended.) Summary budget measures such as the cyclically adjusted and standardized budget surpluses or deficits 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.(3)
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. 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 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 output consistent with stable inflation). 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. For example, different estimates of potential GDP would produce different estimates of the size of the cyclically adjusted surplus or deficit.(4) The calculation of the cyclically adjusted surplus or deficit 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 2.8 percent of potential GDP in 2003 to 3.9 percent in 2004 and then decrease to 3.1 percent in 2005 (see Table 1). Thus, the change this year is largely offset by the change next year, producing a small overall change between 2003 and 2005--an increase of 0.3 percent (see Figure 1). 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 2000, the cyclical contribution 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 deficits of 0.5 percent of potential GDP in 2002 and 0.6 percent in 2003, which meant that the weak economy was then temporarily adding to the total budget deficit. Following a projected cyclical deficit of 0.3 percent of potential GDP in 2004, a small cyclical surplus will emerge again in 2005, CBO estimates. In its January 2004 report on the budget and the economy, CBO presented estimates of how the budget responds to certain economic changes (the "rules of thumb").(5) 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 based on temporary cyclical fluctuations.
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 factors that are clearly short-lived and that are unlikely to affect real income significantly in the short run.(6) 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 or reductions in final settlements of roughly $45 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 perception 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. 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 would, if capital gains were included, cause 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.(7) The standardized-budget deficit is projected to increase by 0.7 percent of potential GDP in 2004 and then to decrease by 0.6 percent of potential GDP in 2005. Thus, the overall change between 2003 and 2005 is small and not substantially different from that projected for the cyclically adjusted deficit (see Table 1). The small difference between the two measures reflects the adjustments to the standardized deficit for factors other than the business cycle. During the 2003-2004 period, the adjustments for those factors change from -0.2 to 0.2 percent of potential GDP, largely because of adjustments for tax overpayments and subsequently large net refunds. In 2005, such adjustments are less than 0.1 percent of potential GDP.
The standardized-budget deficit increased by 1.6 percent of potential GDP in 2003, following a record increase of 2.5 percent of potential GDP in 2002 (see Tables A-1 through A-5). Most of the increase in 2003 was attributable to a decline in revenues, and nearly half of that decline resulted from the effects of JGTRRA. (The effects of EGTRRA and of the Job Creation and Worker Assistance Act of 2002, or JCWAA, were roughly offsetting.) The rest of the increase in the standardized-budget deficit in 2003 resulted from increases in spending. CBO estimates that the standardized-budget deficit will register another increase in 2004: from 3.0 percent to 3.7 percent of potential GDP. Roughly half of that increase is attributable to a rise in standardized revenues, which is more than explained by the effects of JGTRRA. Most of the increase in standardized outlays reflects growth in discretionary spending. The worsening of the standardized budget from 2001 through 2004 is projected to turn around in 2005 as the standardized deficit decreases from 3.7 percent of potential GDP to 3.1 percent. Virtually all of that turnaround is attributable to an increase in standardized revenues, a reversal of the downward trend observed in recent years. That increase in standardized revenues occurs mainly because of the expiration of some provisions of JGTRRA that had temporarily advanced, extended, or raised the size of several personal tax reductions, as well as the expiration of some business tax incentives enacted in EGTRRA and JCWAA.
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