Congressional Budget Office
Director's Blog

This morning I testified before the House Ways and Means Committee about the ways to reduce the economic cost of a cap-and-trade program for greenhouse-gas emissions by increasing firms’ flexibility in the timing of their emission reductions. Accumulating evidence about the pace and potential extent of global warming has heightened the interest of policymakers in cost-effective ways to achieve substantial reductions in emissions. Many analysts agree that that putting a price on carbon emissions—rather than dictating specific technologies or changes in behavior—would lead households and firms to reduce emissions where and how it was least costly to do so.

Allowing flexibility about when emissions were reduced would further lower costs, because changes in weather and fuel markets lead the cost of emissions reduction to vary from year-to-year. This flexibility in timing can be achieved without lowering the benefits of emissions reductions because climate change depends not on the amount of greenhouse gases released in a given year but on their buildup in the atmosphere over decades. Analysts have developed a number of options for increasing timing flexibility; this morning I made five key points about these options:

• First, permitting firms to “bank” allowances—to save allowances for use in the future—has helped lower compliance costs in existing cap-and-trade programs. However, existing cap-and-trade programs that use banking have still experienced substantial volatility in allowance prices.
• Second, permitting firms to borrow future allowances as well as to bank them could further lower compliance costs. Existing cap-and-trade programs typically preclude borrowing, in part because of concerns that firms that borrow allowances might be unable to pay them back later.
• Third, permitting firms to purchase allowances from a public “reserve pool”– composed of allowances that were borrowed from future years or that supplemented the initial supply—could partially substitute for borrowing by individual firms.  The effectiveness of the reserve pool in realizing cost savings would depend on the size of the pool and the threshold price at which firms could purchase the reserve allowances.
• Fourth, setting a floor and ceiling for the price of allowances would also lower firms’ compliance costs, but it would not ensure a particular level of emissions in the end.
• Finally, a “managed-price” approach would allow for substantial cost savings by eliminating short-term volatility in the price of allowances while accommodating longer-term shifts in prices that would be necessary to keep emissions within a long-term cap. In a managed-price arrangement, firms could purchase allowances from the government each year at a price specified by regulators; in this respect, the policy would be similar to a tax. However, the policy is like a cap-and-trade program in other key respects: Policymakers could choose to distribute some allowances to firms for free; they could allow firms to comply by purchasing “offsets,” or credits for emission reductions made in sectors not covered by the cap; and cumulative emissions over a period of several decades would be capped. To implement this approach, regulators would establish a path of rising prices for allowances with the goal of complying with the cumulative cap that legislators had set; that path would be adjusted periodically based on new information about emissions and future compliance costs.

In short: timing flexibility can be a useful tool in meeting emissions targets as efficiently as possible. The more flexibility that is granted regarding the timing of emissions reductions, the less short-term volatility in the price of emissions and the lower the cost of meeting any given emissions target.

The CBO’s budget projections released last Friday are based in part on our economic forecast. In this blog entry, I want to discuss how our projection of real (that is, inflation-adjusted) GDP, one of the most important economic factors in the budget projections, compares with two other forecasts—the Blue Chip forecast (an average of about 50 private-sector forecasters), and the Administration’s forecast.

Often, it is useful to focus on growth rates, as we did in our report here. However, the effect of GDP projections on the budget—and especially on tax revenue—can be seen more clearly by comparing levels of projected GDP. As the figure below shows:

• CBO’s projection of real GDP is lower than that of the Administration throughout the next 10 years, and,
• CBO’s projection is stronger than the Blue Chip consensus of private forecasters in 2010 and beyond (although slightly weaker in 2009). A difference remains even though CBO’s projection of growth slows a bit after 2015 (the slope of the line flattens slightly), while the Blue Chip’s projection does not.

Comparison of CBO, Administration, and Blue Chip Medium-Term Projections: Levels of Real GDP, 2005 to 2019 (Billions of 2000 dollars)

Sources: Congressional Budget Office; Office of Management and Budget; Department of Commerce, Bureau of Economic Analysis; and Aspen Publishers, Inc., Blue Chip Economic Indicators (March 10, 2009).

For the differences in 2009, much of the story is behind us: real GDP fell at an annual rate of 6.2 percent in the fourth quarter of 2008 and now seems likely to be falling at a similar rate in the first quarter of this year. CBO’s forecast was completed a month and a half after the Administration’s forecast and a few weeks after the March Blue Chip survey. Economic news during that time—weaker employment, exports, and orders for manufacturers, and downward revisions to GDP growth in the fourth quarter of 2008 and to employment growth in December and January—caused many economists to sharply reduce their estimates for the level of economic activity in the first part of this year.

But, like the Blue Chip consensus, CBO projects the beginning of an upturn late this year (as shown in the figure below), reflecting in part the effects of the recent economic stimulus legislation (the American Recovery and Reinvestment Act) and very aggressive actions by the Fed and the Treasury.

The Gap Between Actual and Potential Output (Percentage of potential GDP)

Note: The gap is the difference between real (inflation-adjusted) gross domestic product and its estimated potential level (which corresponds to a high level of resource—labor and capital—use).

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

For the next few years, CBO projects faster growth than the Blue Chip, as the economy grows back toward CBO’s estimate of potential GDP (which corresponds to a high level of use of labor and capital resources). Still, the CBO forecast assumes that the gap between actual and potential output closes more slowly than in previous recoveries because of a persistent drag from financial markets, households’ loss of wealth, the overhang of vacant houses, and weak economic growth overseas. Therefore, CBO projects that the economy does not return to its potential level until 2014.

In the 2015-2019 period, the projected rate of real GDP growth averages 2.4 percent.  That rate is lower than during the period from 2010 to 2014, largely because there is no longer any gap to close between actual and potential GDP.

Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation.  Over the postwar period, the labor force grew at an average annual rate of 1.6 percent; by contrast, we project it to grow only 0.4 percent per year in the period from 2015 through 2019.  As a result, potential GDP grew 3.4 percent per year on average in the postwar period, but CBO expects that it will grow by only 2.4 percent annually (allowing for a tad more productivity growth) in the 2015-2019 period.  That demographic trend is reflected also in the Social Security Administration’s projections of the labor force, available here. CBO published its own analysis of demographic trends; while the numbers have changed a little with new information since then, the general story remains the same.

To be sure, all economic forecasts are subject to considerable uncertainty, as we emphasized in our report.  But I hope that this discussion of the logic behind the latest CBO forecast is helpful to readers of that report.

We have just released our latest projections for the budget and economic outlook, updating the projections published in early January 2009. In addition, we have reviewed the President’s budgetary proposals contained in the February publication A New Era of Responsibility: Renewing America’s Promise, and our report summarizes our preliminary analysis of that budget plan.  For a detailed discussion of the economic forecast underlying the report click here.

Our updated budget projections indicate that:

• Largely as a result of the enactment of recent legislation and the continuing turmoil in financial markets, CBO’s baseline projections of the deficit have risen by more than $400 billion in both 2009 and 2010 and by smaller amounts thereafter. Those projections assume that current laws and policies remain in place. Under that assumption, CBO now estimates that the deficit will total almost $1.7 trillion (12 percent of GDP) this year and $1.1 trillion (8 percent of GDP) next year—the largest deficits as a share of GDP since 1945. Deficits would shrink to about 2 percent of GDP by 2012 and remain in that vicinity through 2019.
• Under current laws and policies, outlays are projected to decline from 27.4 percent of GDP in 2009 to about 22 percent in 2012 and subsequent years, as spending related to the current recession phases out, problems in the financial markets fade, and discretionary spending–under the assumptions of the baseline–declines as a share of GDP.
• At the same time, under current laws and policies, revenues are estimated to rise from 15.5 percent of GDP in 2009 to about 20 percent in 2012 and subsequent years. Much of that projected increase in revenues results from the growing impact of the alternative minimum tax (AMT) and, even more significant, the scheduled expiration in December 2010 of provisions enacted in the recent economic stimulus legislation and tax legislation in 2001 and 2003.

Our analysis of the President’s budget proposals indicates that:

• As estimated by CBO and the Joint Committee on Taxation, the President’s proposals would add $4.8 trillion to the baseline deficits over the 2010–2019 period. CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.
• The cumulative deficit from 2010 to 2019 under the President’s proposals would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41 percent of GDP in 2008 to 57 percent in 2009 and then to 82 percent of GDP by 2019 (compared with 56 percent of GDP in that year under baseline assumptions).
• Proposed changes in tax policy would reduce revenues by an estimated $2.1 trillion over the next 10 years. Proposed changes in spending programs would add $1.7 trillion (excluding debt service) to outlays over the next 10 years. Interest costs associated with greater borrowing would add another $1.0 trillion to deficits over the 2010–2019 period.
• Our estimates of deficits under the President’s budget exceed those anticipated by the Administration by $2.3 trillion over the 2010-2019 period. The differences arise largely because of differing projections of baseline revenues and outlays. CBO’s projection of baseline deficits exceeds the Administration’s estimate (prepared on a comparable basis) by $1.6 trillion.

Our current assessment of economic developments indicates that:

• Although the economy is likely to continue to deteriorate for some time, the enactment of the American Recovery and Reinvestment Act and very aggressive actions by the Federal Reserve and the Treasury are projected to help end the recession in the fall of 2009. In CBO’s forecast, on a fourth-quarter-to-fourth-quarter basis, real (inflation-adjusted) GDP falls by 1.5 percent in 2009 before growing by 4.1 percent in both 2010 and 2011.
• For the next two years, CBO anticipates that economic output will average about 7 percent below its potential—the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer—making the current recession the most severe since World War II. In this forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years.

CBO released a cost estimate yesterday for H.R. 1256, the Family Smoking and Tobacco Control Act. This bill would authorize the Food and Drug Administration (FDA) to regulate tobacco products and require the agency to assess fees on manufacturers and importers of tobacco products to cover the cost of these new regulatory activities.

The effect of these activities on the use of tobacco products is uncertain, in part because ongoing initiatives to reduce the use of tobacco products are expected to continue under current law. In particular, public health efforts by federal, state, and local governments and by private entities have contributed to a substantial reduction in underage smoking in recent years. For example, the recent increase in the federal excise tax on cigarettes, from $0.39 to $1.01 per pack, as a result of the Children’s Health Insurance Program Reauthorization Act is likely to contribute to a continuing decline in smoking. 

H.R. 1256 would affect the use of tobacco products through a combination of regulatory and economic factors. The regulatory changes with the largest potential to reduce smoking include: restricting access to tobacco by youths, requiring an increase in the size of warning labels on certain tobacco packaging (and authorizing the Secretary of HHS to mandate further changes to enhance warning labels), limiting certain marketing and advertising activities (especially those that target youths), and requiring FDA’s permission before manufacturers can market tobacco products that suggest reduced health risks or exposure to particular substances. In addition, tobacco consumption would decline because the assessment of new fees on manufacturers and importers of tobacco products would probably result in higher prices for tobacco products. CBO expects that consumption of tobacco products in the United States would further decline as a result of enacting H. R. 1256.  By 2019, CBO projects a decline of 11 percent among underage tobacco users and about 2 percent among adult users, as a result of this legislation.

CBO anticipates that FDA’s regulation of tobacco products would lead to a decline in smoking among pregnant women, which would slightly decrease federal spending for Medicaid.  A decline in smoking could affect health care spending for many other medical conditions, and CBO continues to examine the impact of smoking-related legislation on public and private payers. Counterintuitively, a reduction in smoking might add to the government’s costs in many cases by enabling some people to live longer and to incur health care costs over longer periods. In those cases, government spending for Social Security, Medicare, and other retirement and mandatory spending programs, would increase.

Global climate change poses one of the nation’s most significant long-term policy challenges. While the potential damage from climate change is large, the potential cost of avoiding it is also large. Policymakers could help minimize that cost by using either a tax, or a well-designed cap and trade program, to motivate reductions in emissions. As many analysts have noted however, either a tax or a cap would cause prices of goods and services to increase, with larger increases for goods that entail greater emissions, such as home heating. Those price increases are essential to the success of the program, but they would represent a larger share of income for lower-income households than for higher-income households. Terry Dinan of our Microeconomic Studies Division discussed CBO’s analysis of the distributional consequences of cap-and-trade programs for CO2 emissions yesterday in a testimony before the Ways and Means Subcommittee on Income Security and Family Support.

I’ve highlighted some of the key points of Terry’s discussion below. To read her full testimony, click here.

• One approach that lawmakers could use to cushion the effects of those higher prices under a cap-and-trade program is to sell some allowances and give the revenue back to households. If, for example, the government sold all of the allowances and used the proceeds to provide the same lump-sum rebate to each household in the U.S., low-income households would actually be made better off under a cap-and-trade policy (though this rebate would not fully compensate higher-income households for their increased expenditures).
• If lawmakers wanted to use a more targeted approach for offsetting costs incurred by low-income households, they could choose from a variety of different strategies, including using existing transfer programs or providing rebates through the income tax system.  However, no single existing system would be likely to reach all such households.
• Delivering rebates through a combination of the income tax system and existing transfer programs would do a better job of reaching low-income households than would relying on either approach by itself. Using multiple systems to reach all households poses other challenges: it is not easy to coordinate among existing programs to avoid compensating the same household twice.
• In choosing among options for using proceeds from the sale of emissions allowances, potentially tens or hundreds of billions of dollars per year, policymakers could face a trade-off between providing targeted assistance to low- and moderate-income households and offsetting some of the adverse effects on the economic activity caused by the price increases.

The Subcommittee on Health of the House Committee on Energy and Commerce invited me to testify this morning about the opportunities and challenges that the Congress faces in trying to make the health care system more efficient—so that it can continue to improve Americans’ health but do so at a lower cost. In my remarks I emphasized serveral points:

Evidence suggests that a substantial share of our national spending on health care contributes little if anything to overall health.  Policymakers could seek to improve efficiency by changing the ways that public programs pay for health care services or by encouraging such changes in private health plans. In both sectors, those changes could in turn exert a strong influence on the delivery of care.

Reducing unnecessary spending without also affecting services that do improve health is challenging, but many analysts think that providing stronger incentives to control costs and generating and disseminating more information about the effectiveness of care could be  important steps.  More information is needed about which treatments work best for which patients and about what quality of care different doctors, hospitals, and other providers deliver. But absent stronger incentives to improve value and efficiency, the effect of information alone will generally be limited. Many analysts would agree that payment systems should move away from a fee-for-service design and should instead provide stronger incentives to control costs and ensure reward value. Many analysts would also agree that the current unlimited tax exclusion for employment-based health insurance dampens incentives for cost control. Those incentives could be changed by restructuring the tax exclusion in ways that would encourage workers to join health plans with higher cost-sharing requirements and tighter management of benefits.

Despite broad support among analysts for moving in these directions, there is substantial uncertainty about the effects of many specific policies. In particular, many policies in these areas might not yield substantial savings within a 10-year window. There are a number of reasons for this. In some cases, savings materialize slowly over time because an initiative is phased in.  In other cases, initiatives that will generate savings—such as prevention efforts or disease management—have substantial costs to implement. In some cases, initiatives cause reductions in national health spending that the federal budget does not capture. In yet other cases, new structures for health care delivery improve health but do not provide incentives to reduce costs. And in other cases, limited evidence about effects on efficiency is available.

At the request of Senator Grassley and Congressman Camp, today CBO released a year-by-year estimate of the economic effects of the American Recovery and Reinvestment Act of 2009 (ARRA) as enacted on February 17, 2009. This is our first such analysis of the ARRA legislation as enacted. (In CBO’s letter to Senator Gregg, Senator Grassley, and Congressman Camp on February 11, 2009, we estimated an average of the effects of the House- and Senate-passed versions of H.R. 1 because the final language had yet been agreed upon; those numbers differ only very slightly from the estimates provided in today’s document).

We estimate that the legislation will raise gross domestic product (GDP) and increase employment in the short run—by adding to aggregate demand and boosting the utilization of labor and capital.  In contrast, we expect that the legislation will reduce output slightly in the long run because the resulting increase in government debt will tend to “crowd out” private investment and thereby reduce the stock of productive private capital.  That crowding-out effect will be diminished to the extent that some of the funding in the legislation will go for activities that could add to the nation’s long-term output. 

Today’s letter provides finer detail on how CBO estimated the short-run effects of the legislation. Different provisions in the law differ in both the magnitude and timing of their effects on aggregate demand. To simplify its analysis of the overall effects, CBO grouped the various provisions into a number of more general categories, and each category was assumed to have a range of effects on the economy that could by summarized by “multipliers”—the cumulative effect on output of a one-time increase in spending, or reduction in taxes, of one dollar. For example, a one-time increase in federal purchases of goods and services of $1.00 in the second quarter of this year would raise GDP by $1.00 to $2.50 in total over several quarters, with most of that effect in the first two quarters and little effect beyond a year. The multipliers are applied to outlays when they occur and to changes in taxes or transfer payments when they affect disposable income. Table 1 in today’s letter shows the categories to which CBO assigned the major provisions of ARRA. (In some cases, when different elements of a single provision were estimated to have different multipliers, the total cost of a provision was divided among more than one category. In those cases, the provision is shown in the table in the category to which most of its budgetary cost applied.)

Thanks to Ben Page and Robert Arnold of CBO’s Macroeconomic Analysis Division for their fine work on this analysis.