Congressional Budget Office
Director's Blog

On Wednesday I spoke at a conference on the health care system hosted by the Institute of Medicine. My presentation dealt with health care costs and the federal budget. The central challenge is straightforward and stark: The rising costs of health care will put tremendous pressure on the federal budget during the next few decades and beyond.

In CBO’s judgment, the health legislation enacted earlier this year does not substantially diminish that pressure. In fact, CBO estimated that the health legislation will increase the federal budgetary commitment to health care (which CBO defines as the sum of net federal outlays for health programs and tax preferences for health care) by nearly $400 billion during the 2010-2019 period. Looking further ahead, CBO estimated that the legislation would reduce the federal budgetary commitment to health care in the following decade—if the provisions of the legislation remain unchanged throughout that entire period. CBO also estimated that the legislation will reduce budget deficits by about $140 billion during the 2010-2019 period and by an amount in a broad range around one-half percent of gross domestic product (GDP) during the following decade—again, under the assumption that the legislation remains in force as enacted.

The projected reductions in budget deficits and in the federal budgetary commitment to health care during the decade beyond the 10-year budget window are steps in the direction of sustainable fiscal policy. However, they are small steps relative to the length of the journey that will be needed to achieve sustainability. If the tax cuts enacted in 2001 and 2003 are extended, the alternative minimum tax is indexed for inflation, and no other changes are made to current laws regarding taxes and spending, the budget deficit in 2020 would be about 6 percent of GDP and rising. Because federal health care programs make up a large share of the federal budget, putting that budget on a sustainable path would almost certainly require a significant reduction in the growth of federal spending on health care relative to the amounts projected under current law (including this year’s health legislation).

In considering the opportunities for achieving that reduction in spending growth, there are grounds for both optimism and pessimism. On the upside, there is considerable agreement that a substantial share of current spending on health care contributes little if anything to people’s health, and providers and health analysts are making significant efforts to make the health system more efficient. On the downside, it is not clear what specific policies the federal government can adopt to generate fundamental changes in the health system; that is, it is not clear what specific policies would translate the potential for significant cost savings into reality. Moreover, efforts to reduce costs substantially would increase the risk that people would not get some health care they need or would like to receive.

The United States Navy and Marine Corps operate a fleet of more than 1,100 tactical fighter aircraft that provide air-to-air and air-to-ground combat capabilities. Those aircraft include Hornets (F/A-18A, B, C, and D), Super Hornets (F/A-18E and F), and Harriers (AV-8B); within the next few years, a new and more advanced aircraft—the F-35 Joint Strike Fighter (JSF)—will start being added to the fleet. Although current plans call for the purchase of about 700 new fighter aircraft over the next 15 years, the Department of the Navy is projecting that purchases planned for the next 5 to 10 years will be unable to keep pace with the retirement of today’s Hornets as they reach the limit of their service life. In a report released today, CBO compares four alternatives for maintaining the Navy’s and Marine Corps’ fighter inventories.

The alternatives discussed in the report consist of different combinations of three approaches.  One approach involves extending the service life of Hornets by up to 600 flight hours (roughly two additional years) beyond the current 8,000-hour limit by modifying and inspecting those aircraft in the high-flight-hour (HFH) program (comprising a series of structural repairs and more-frequent inspections). A second approach would implement a service-life extension program (SLEP) of more-extensive modifications, which would enable Hornets to reach 10,000 flight hours, and the third would purchase more Super Hornets than current plans call for. Some HFH modifications have already been done, and Super Hornets are still in production—but research and planning for the Hornet SLEP is not expected to be complete until 2014 (the Navy has indicated that it may begin SLEP modifications on some aircraft as early as 2012).

Of the four alternatives that CBO analyzed, the first two are limited to extending the service life of existing Hornets. They are generally consistent with various plans the Navy has proposed or is considering:

• Alternative 1: Execute the HFH program on the 509 Hornets suitable for those modifications;
• Alternative 2: Execute the HFH program on 220 Hornets and the more-extensive SLEP on 289 Hornets.

The third and fourth alternatives would combine some service-life extensions for Hornets with changes in planned purchases of new aircraft:

• Alternative 3: Implement the HFH program in the same way that Alternative 1 would, but also increase purchases of Super Hornets by 126 aircraft (beyond the planned total of 515) and decrease purchases of Joint Strike Fighters by 93 aircraft between 2018 and 2023;
• Alternative 4: Modify 509 aircraft through the HFH process and purchase 126 additional Super Hornets, as in Alternative 3, but do not reduce purchases of JSF aircraft.

CBO measured the increase in inventory offered by those alternatives and the funding that each would require relative to a base case under which the service life of Hornets would not be extended and additional aircraft would not be purchased. CBO found that Alternative 1 would increase the Navy’s and Marine Corps’ fighter inventory by an average of 66 aircraft over the 2011–2025 period; Alternative 2 would add an average of 106 aircraft to the inventory; Alternative 3—an average of 128; and alternative 4—an average of 148.

Relative to the cost of the base case in which none of the three approaches are undertaken, the cost of Alternative 1 would be about $2.2 billion higher (in fiscal year 2010 dollars). Alternative 1 has the lowest total cost of the alternatives examined by CBO, but it provides the smallest increase in inventory.

Alternative 2 would provide the largest increase in inventory that can be achieved with the HFH and SLEP modifications currently being considered—but at a cost of about $7.7 billion, it would be more than twice as costly as Alternative 1 when measured per increment of additional service.

Alternative 3 would provide larger increases in inventory than would Alternatives 1 and 2. Moreover, each additional Super Hornet provided under Alternative 3 would offer improved performance (a more-capable radar, longer range, and the ability to carry more weapons) than would a SLEP Hornet. The reduction in JSF purchases would result in fewer of the most advanced aircraft after 2020. At about $3.8 billion to $4.8 billion higher than the cost of the base case, the total cost of Alternative 3 would fall between the costs of Alternatives 1 and 2. In the near term, however, the cost would be substantially higher than for Alternatives 1 or 2 because the savings from reducing JSF purchases would not offset the cost of new Super Hornet purchases until after 2017.

Alternative 4 would provide the largest increase in inventory before 2025 and would also provide increased inventory well beyond 2025, because additional purchases of Super Hornets would not be offset by fewer purchases of JSFs. The advantages of new aircraft provided in Alternative 4 would come at a cost of $12 billion to $13 billion more than under the base case (nearly all of which would be incurred in the next five years). Alternative 4 would be the most expensive per increment of additional service provided between 2011 and 2025.

CBO did not evaluate whether the inventories that would be realized under the various alternatives would be sufficient to meet the Navy’s and Marine Corps’ operational needs. Further, if additional delays were experienced with the JSF program, the inventories realized under all four alternatives would be lower, and any corresponding shortfall would be larger.

This report was prepared by David Arthur of CBO’s National Security Division.

Early last week, I wrote that CBO is providing basic budget and economic analysis for the National Commission on Fiscal Responsibility and Reform. That blog posting summarized the presentations that Assistant Director Peter Fontaine and Deputy Director Robert Sunshine had made to some members of the commission regarding discretionary spending (that is, spending that is governed by the annual appropriation process) and mandatory spending (that is, spending for programs like Social Security and Medicare that are not governed by the appropriation process ).

Last Wednesday was my turn. Following a presentation by Thomas Barthold, the chief of staff for the Joint Committee on Taxation, I discussed three aspects of tax policy:

• The effect of taxes on economic activity through effects on labor supply, saving, the allocation of capital, the composition of spending, and other decisions;
• The burden of taxation and who bears that burden; and
• The revenue collected through taxes.

I used the picture shown here to illustrate the daunting magnitude of the imbalance between federal revenues and federal spending that CBO projects for 2020. Under current law, spending would be more than 10 percent bigger than revenues, as depicted in the two bars on the left. Alternatively, if the 2001 and 2003 tax cuts were extended, the alternative minimum tax (AMT) was indexed to inflation, and no other changes were made to the federal budget, spending would be nearly one-third bigger than revenues. Under this alternative scenario, the budget could be balanced in 2020 by raising revenues by about one-third and leaving the path of spending unchanged, by cutting spending by about one-quarter and leaving the path of revenues unchanged, or by making less dramatic changes in both revenues and spending.

Federal Spending and Revenues in 2020

In thinking about possible changes to the tax system and how they might affect the nation’s economy, it is important to consider not only how much revenue is raised, but also how it is raised. Among the questions one might consider, here are five key ones:

• How broad should the base be for the personal income tax?
• What should the personal income tax rates be?
• What should payroll tax rates be, and how much income should be subject those taxes?
• How broad should the base be for the corporate income tax?
• Should the government impose taxes on things that are not taxed today—in place of or in addition to other taxes?

In addressing those questions, policymakers will need to consider that, in collecting resources for the government’s activities, taxes affect the behavior of people and businesses. A tax essentially raises the price of doing something and thereby lowers the relative price of doing something else; for example, the income tax raises the price of working relative to taking leisure, and it raises the price of saving relative to current spending. Higher marginal tax rates change prices by more than lower marginal tax rates, and thereby affect behavior more. Also, households generally bear the economic cost or burden of the taxes that they pay directly (such as individual income taxes and the employees’ share of payroll taxes); they also ultimately bear the burden of taxes paid by businesses (such as the corporate profits tax and the employers’ share of payroll taxes).

Under the American Recovery and Reinvestment Act of 2009 (ARRA), also known as the economic stimulus package, certain recipients of funds appropriated in ARRA (most grant and loan recipients, contractors, and subcontractors) are required to report the number of jobs they created or retained with ARRA funding after the end of each calendar quarter. The law also requires CBO to comment on those reported numbers. Today CBO released a report to satisfy that requirement.

CBO’s Estimates of ARRA’s Impact on Employment and Economic Output

Looking at recorded spending to date as well as estimates of the other effects of ARRA on spending and revenues, CBO has estimated the law’s impact on employment and economic output using evidence about the effects of previous similar policies on the economy and using various mathematical models that represent the workings of the economy. On that basis, CBO estimates that in the first quarter of calendar year 2010, ARRA’s policies:

• Raised the level of real (inflation-adjusted) gross domestic product (GDP) by between 1.7 percent and 4.2 percent,
• Lowered the unemployment rate by between 0.7 percentage points and 1.5 percentage points,
• Increased the number of people employed by between 1.2 million and 2.8 million, and 
• Increased the number of full-time-equivalent (FTE) jobs by 1.8 million to 4.1 million compared with what those amounts would have been otherwise. (Increases in FTE jobs include shifts from part-time to full-time work or overtime and are thus generally larger than increases in the number of employed workers.)

The effects of ARRA on output and employment are expected to increase further during calendar year 2010 but then diminish in 2011 and fade away by the end of 2012.

Data on actual output and employment during the period since ARRA’s enactment are not as helpful in determining ARRA’s economic effects as might be supposed, because isolating those effects would require knowing what path the economy would have taken in the absence of the law. Because that path cannot be observed, there is no way to be certain about how the economy would have performed if the legislation had not been enacted, and data on its actual performance add only limited information about ARRA’s impact.

Limitations of Recipients’ Estimates

CBO’s estimates differ substantially from the reports filed by recipients of ARRA funding. Those recipients reported that ARRA funded nearly 700,000 FTE jobs during the first quarter of 2010. Such reports, however, do not provide a comprehensive estimate of the law’s impact on employment in the United States. That impact may be higher or lower than the reported number for several reasons (in addition to any issues about the quality of the data in the reports):

• Some of the reported jobs might have existed in the absence of the stimulus package, with employees working on the same activities or other activities. 
• The reports filed by recipients measure only the jobs created by employers who received ARRA funding directly or by their immediate subcontractors (so-called primary and secondary recipients), not by lower-level subcontractors.
• The reports do not attempt to measure the number of jobs that may have been created or retained indirectly as greater income for recipients and their employees boosted demand for products and services. 
• The recipients’ reports cover only certain appropriations made in ARRA, which encompass about one-sixth of the total amount spent by the government or conveyed through tax reductions in ARRA during the first quarter; the reports do not measure the effects of other provisions of the stimulus package, such as tax cuts and transfer payments (including unemployment insurance payments) to individuals.

Consequently, estimating the law’s overall effects on employment requires a more comprehensive analysis than the recipients’ reports provide.

The report was prepared by Ben Page of CBO’s Macroeconomic Analysis Division.

The Navy is required by law to submit a report to the Congress each year that projects the service’s shipbuilding requirements, procurement plans, inventories, and costs over the coming 30 years. Since 2006, CBO has been performing an independent analysis of the Navy’s latest shipbuilding plan at the request of the Subcommittee on Seapower and Expeditionary Forces of the House Armed Services Committee. Today CBO released its latest report that summarizes the ship requirements and purchases described in the Navy’s 2011 plan and estimates their implications for the Navy’s funding needs and ship inventories through 2040.

The Navy’s report—issued in February and covering fiscal years 2011 to 2040—contains some significant changes in its long-term goals for shipbuilding. The new plan appears to increase the required size of the fleet compared with earlier plans, while reducing the number of ships to be purchased—and thus the costs for ship construction—over the next three decades. Despite those reductions, the total costs of carrying out the 2011 plan would be much higher than the funding levels that the Navy has received in recent years, according to analysis by CBO. Specifically,

• Language in the 2011 shipbuilding plan and in related briefings by the Navy implies that the service’s requirement for battle force ships (aircraft carriers, submarines, surface combatants, amphibious ships, and some logistics and support ships) now totals 322 or 323—up from 313 in the Navy’s three previous long-term plans. The battle force fleet currently numbers 286 ships.
• The 2011 plan calls for buying a total of 276 ships over the 2011–2040 period: 198 combat ships and 78 logistics and support ships. That construction plan is insufficient to achieve a 322- or 323-ship fleet. In comparison, the previous shipbuilding plan (for 2009) envisioned buying 40 more combat ships and 20 fewer support ships over 30 years.
• If the Navy receives the same amount of funding for ship construction in the next 30 years as it has over the past three decades—an average of about $15 billion a year in 2010 dollars—it will not be able to afford the purchases in the 2011 plan.
• The Navy estimates that the construction of the new ships in the 2011 plan will cost an average of about $16 billion per year. Expenditures for other activities that are typically funded from the Navy’s budget accounts for ship construction—such as refueling nuclear-powered aircraft carriers and outfitting new ships with various small pieces of equipment after the ships have been built or delivered—will add about $2 billion to the Navy’s average annual shipbuilding costs under the 2011 plan, in CBO’s estimation, bringing the average cost to a total of $18 billion per year.
• Using its own models and assumptions, CBO estimates that the average total cost to implement the Navy’s plan will come to $21 billion per year. about 18 percent higher than the Navy’s estimates overall. That figure masks considerable variation over time, however: CBO’s estimates are 4 percent higher than the Navy’s for the first 10 years of the plan, 13 percent higher for the following decade, and 37 percent higher for the final 10 years of the plan. Those differences result partly from different estimating methods and different assumptions about the design and capabilities of future ships. The estimates also diverge because CBO accounted for the fact that costs of labor and materials have traditionally grown much faster in the shipbuilding industry than in the economy as a whole, whereas the Navy does not appear to have done so. That difference becomes more pronounced over time.

This study was prepared by Eric Labs of CBO’s National Security Division.

Over the past several years, the nation has experienced its most severe financial crisis since the Great Depression of the 1930s. To stabilize financial markets and institutions, the Federal Reserve System used its traditional policy tools to reduce short-term interest rates and increase the availability of funds to banks, and created a variety of nontraditional credit programs to help restore liquidity and confidence to the financial sector. In doing so, it more than doubled the size of its asset portfolio to over $2 trillion and assumed more risk of losses than it normally takes on.

In a study prepared at the request of the Ranking Member of the Senate Budget Committee, CBO describes the various actions by the Federal Reserve and how those actions are likely to affect the federal budget in coming years. The report also presents estimates of the risk-adjusted (or fair-value) subsidies that the Federal Reserve provided to financial institutions through its emergency programs. Unlike the cash treatment of the Federal Reserve in the budget, fair-value subsidies include the cost of the risk that the central bank has assumed. Thus, those subsidies are a more comprehensive measure of the cost of the central bank’s actions.

The Federal Reserve’s activities during the crisis have had a striking impact on the amount and types of assets that it holds. In July 2007, before the financial crisis began, the Federal Reserve held about $900 billion in assets; U.S. Treasury securities accounted for about $790 billion of that amount. The central bank had acquired those securities during its normal operations in conducting monetary policy—the process of influencing the level of short-term interest rates and consequently the pace of U.S. economic activity. By the end of 2008, the value of the Federal Reserve’s assets had grown to about $2.3 trillion; of that amount, loans and other support extended to financial institutions made up $1.7 trillion. At the end of 2009, the amount of direct loans and other support to financial institutions, though still quite high by historical standards, had fallen markedly to about $280 billion, but holdings of mortgage-related securities had risen to just over $1 trillion. There was also a marked shift in the composition of the central bank’s liabilities. Before the crisis, the major liability on the Federal Reserve’s balance sheet was the amount of currency in circulation—about $814 billion as of July 2007. At the end of 2009, the amount of reserves that banks held with the Federal Reserve was the central bank’s largest liability, at more than $1 trillion.

The amount and composition of the Fed’s assets and liabilities are major determinants of its impact on the federal budget. That impact is measured by the central bank’s cash remittances to the Treasury, which are recorded as revenues in the budget. (The amount that is remitted is based on the Federal Reserve System’s income from all of its various activities minus the costs of generating that income, dividend payments to banks that are members of the Federal Reserve System, and changes in the amount of the surplus that it holds on its books.) For fiscal years 2000 through 2008, annual remittances by the Federal Reserve ranged between $19 billion and $34 billion.

CBO projects that the Federal Reserve’s actions to stabilize the financial system will boost its remittances to the Treasury during the next several years. That increase reflects the Federal Reserve’s larger portfolio of riskier assets, most of which are likely to earn a great deal more than the amount the system must pay in interest on reserves and its other liabilities. CBO projects that remittances will grow from about $34 billion in fiscal year 2009 to more than $70 billion in fiscal years 2010 and 2011.

However, that estimated effect on the budget fails to account for the cost of the risks to taxpayers from those actions. When the Federal Reserve invests in a risky security, it increases its expected net earnings because the return it anticipates on that security exceeds the interest rate it pays on the debt used to fund the purchase. Nevertheless, when the riskiness of such securities is fully accounted for, the investment may be projected to produce no net gain or even a loss. If the Federal Reserve purchases the security at a fair-market price, equivalent to what private investors would have paid, then the purchase creates no economic gain or loss for taxpayers; the price compensates the central bank for the risk it has assumed. By contrast, if the Federal Reserve purchases a risky security for more than the amount that private investors would have paid, it gives a subsidy to the seller of the security, creating an economic loss, or cost, for taxpayers.

The economic cost of the Federal Reserve System’s actions to stabilize the financial markets—which incorporates the risks to taxpayers—can be estimated using “fair-value” subsidies. In CBO’s estimation, the “fair-value” subsidies conferred by the Federal Reserve System’s actions to stabilize the financial markets totaled about $21 billion at the time those actions were taken. The gains or losses that will ultimately be realized from the Federal Reserve’s activities will almost certainly deviate from CBO’s estimates of the fair-value subsidies those actions provided. Fair-value subsidies are forward-looking estimates that are based on averages over many possible future outcomes, whereas realized gains or losses reflect a particular outcome.

It bears emphasizing that CBO’s fair-value estimates address the costs but not the benefits of the Federal Reserve’s actions. In CBO’s judgment, if the Federal Reserve had not strategically provided credit and enhanced liquidity, the financial crisis probably would have been deeper and more protracted and the damage to the rest of the economy more severe. Measuring the benefits of the Federal Reserve’s interventions in avoiding those worse outcomes is much more difficult than estimating the subsidy costs of the interventions, and CBO has not attempted to do so. It is likely, though, that the benefits of the Federal Reserve’s actions to stabilize the financial system exceeded the relatively small costs of the fair-value subsidies.

The report was prepared by Kim Kowalewski and Wendy Kiska of CBO’s Macroeconomic Analysis Division, and Deborah Lucas, Associate Director for Financial Analysis.

CBO and the staff of the Joint Committee on Taxation (JCT) have prepared an estimate of the budgetary effects of H.R. 4213, the American Jobs and Closing Tax Loopholes Act, as posted on the Web site of the Committee on Ways and Means on May 20, 2010. CBO and JCT estimate that the legislation would increase budget deficits by about $123 billion for fiscal years 2010 and 2011, by about $141 billion over the 2010-2015 period, and by about $134 billion over the 2010-2020 period.

The legislation would reduce federal revenues by about $23 billion in 2010 and 2011, but would lead to a net increase in revenues totaling about $40 billion over the 2010-2020 period. The revenue effects are the net result of provisions that both increase and decrease revenues. Revenue reductions would result mainly from the extension for one year of various tax provisions that expired at the end of 2009, including the tax credit for research and experimentation expenses, and the 15-year straight-line cost recovery method allowed for specified leasehold, restaurant, and retail improvements. Revenue increases would result from a number of provisions including taxing so-called “carried interest,” altering various rules that corporations use to calculate their foreign tax credits and foreign-source income, and modifying the employment tax treatment of income earned by individuals in professional service businesses.

The legislation would increase outlays by $174 billion over the 2010-2020 period, mostly between 2010 and 2015. The bill would extend benefits under the unemployment insurance program, at a total cost of about $47 billion, and it would extend (for an additional six months) the increase in the federal share of Medicaid costs that was originally enacted in the American Recovery and Reinvestment Act of 2009, at a cost of about $24 billion. The legislation would also amend the system for payments to physicians under Medicare, at an estimated cost of $63 billion over the 2010-2020 period.

Under the new system for Medicare payments to physicians, payment rates would increase by 1.3 percent on June 1, 2010, and by another 1.0 percent on January 1, 2011; under current law, those payment rates would fall by about 21 percent on June 1 and by another 6 percent on January 1, 2011. During 2012 and 2013, a new formula would increase or freeze payment rates to physicians depending on the type of service performed and on whether they participate in a new practice arrangement established by the Patient Protection and Affordable Care Act passed earlier this year. Payment rates would be reduced by about 35 percent in 2014 to approximately the levels they would have been without the changes made between 2010 and 2013. For years after 2014, CBO estimates that payment rates would decline by an average of about 2 percent per year, keeping spending close to the amounts expected under current law in those years.
 

CBO has a panel of economic advisers that includes many distinguished economists (some of whom are former CBO directors). We host periodic meetings of the advisers at our office and solicit the advisers’ views between meetings via email exchanges and phone calls. Through these interactions, we benefit from the advisers’ understanding of cutting-edge research, current economic conditions and the economic outlook, and economic policy. As a result of the advisers’ comments, the quality of CBO’s economic analysis is greatly enhanced. The advisers for 2010 are:

Henry J. Aaron, Ph.D.
Senior Fellow, Economic Studies
The Bruce and Virginia MacLaury Chair
Brookings Institution

Richard Berner, Ph.D.
Managing Director
Chief U.S. Economist
Morgan Stanley

Dan L. Crippen, Ph.D.
Economic Consultant

Steven J. Davis, Ph.D.
William H. Abbott Professor of International Business and Economics
Booth School of Business
University of Chicago

Janice C. Eberly, Ph.D.
John L. and Helen Kellogg Professor of Finance
Kellogg School of Management
Northwestern University

Kristin J. Forbes, Ph.D.
Jerome and Dorothy Lemelson Professor of Management and Global Economics
Sloan School of Management
Massachusetts Institute of Technology

Robert E. Hall, Ph.D.
Robert and Carole McNeil Joint Professor of Economics and Senior Fellow
Hoover Institution
Stanford University

Jan Hatzius, Ph.D.
Chief U.S. Economist
Goldman Sachs & Co.

Douglas Holtz-Eakin, Ph.D.
President
American Action Forum

Simon Johnson, Ph.D.
Robert A. Kurtz Professor of Entrepreneurship
Sloan School of Management, MIT
Senior Fellow
Peterson Institute for International Economics

Lawrence Katz, Ph.D.
Elisabeth Allison Professor of Economics
Harvard University

Anil Kashyap, Ph.D.
Edward Eagle Brown Professor of Economics and Finance
Booth School of Business
University of Chicago

N. Gregory Mankiw, Ph.D.
Robert M. Beren Professor of Economics
Harvard University

Laurence H. Meyer, Ph.D.
Distinguished Scholar
Center for Strategic and International Studies
Vice Chairman
Macroeconomic Advisers

Rudolph G. Penner, Ph.D.
Senior Fellow
Arjay and Frances Miller Chair in Public Policy
Urban Institute

Adam S. Posen, Ph.D.
Senior Fellow
Peterson Institute for International Economics
Member
Monetary Policy Committee of the Bank of England

James Poterba, Ph.D.
Mitsui Professor of Economics
Massachusetts Institute of Technology
President and CEO
National Bureau of Economic Research

Carmen M. Reinhart, Ph.D.
Professor of Economics and Director of the Center for International Economics
University of Maryland

Alice Rivlin, Ph.D.
Senior Fellow
Brookings Institution

Stephen P. Zeldes, Ph.D.
Benjamin M. Rosen Professor of Finance and Economics
Graduate School of Business
Columbia University

This afternoon I spoke at a Brookings conference on climate and energy policy. CBO has done a great deal of work in this area, applying the research done by outside experts as well as our own analysis and modeling to help the Congress understand the likely budgetary and economic effects of alternative policy approaches and specific legislative proposals being considered. In my comments today I focused on one particular issue—efforts to reduce emissions of greenhouse gases—and what CBO sees as the lessons of economic analysis for those efforts. (These slides capture the key points that I made today; all of CBO’s work on climate change is available here and relevant links are noted throughout this blog post.) CBO’s analysis focuses on how economic principles would apply to emission-reduction efforts, but following its standard practice, CBO does not make recommendations regarding specific policies. 

Lesson #1: To reduce greenhouse-gas emissions at the lowest social cost, the government should put a price on emissions.

Putting a price on emissions—for example, by taxing them or creating a cap-and-trade system—would create incentives for conservation, substitution in production, and technological innovation—the changes needed to reduce emissions. In addition, a price-based approach would allow firms and households to reduce emissions in the lowest-cost way. However, achieving cost-effective emission reductions would probably require other policies as well, because price signals do not always work effectively and because government has a key role to play in funding basic research and in other areas.

Lesson #2: To reduce greenhouse-gas emissions at the lowest social cost, the price should rise gradually over time and should avoid unnecessary volatility.

Gradual reductions in emissions are important because it takes time for research to be conducted and technology to be designed, tested, refined, and disseminated widely; time for patterns of production and consumption to change; and time for business and household capital to wear out and be replaced with different sorts of capital. Unnecessary volatility in the price of emissions would make a given amount of emissions reduction more costly, because it would force too many reductions when the cost of cutting emissions was relatively high and motivate too few when the cost was relatively low.

Lesson #3: To reduce greenhouse-gas emissions at the lowest social cost, the scope of emissions that are priced should be as broad as possible.

Market-based methods of reducing emissions would be most cost-effective if the largest number of producers and consumers are involved. That does not mean that everyone needs to be under exactly the same system or face exactly the same price: As long as the prices faced by different producers and consumers were similar, the outcome would be fairly efficient. This issue arises in several contexts in climate policy—in designing one system for the entire economy or different systems for different parts of the economy, in considering approaches for international coordination, and in addressing so-called “offsets” (reductions in emissions from activities not subject to limits).

Lesson #4: An efficient system for reducing greenhouse gas emissions would probably lower overall GDP, employment, and households’ purchasing power by a modest amount relative to what would occur otherwise (and leaving aside the economic effects of slowing climate change).

Although estimates are very uncertain, most experts project that the long-term loss in gross domestic product (GDP) from a policy like the American Clean Energy and Security Act of 2009 (ACESA) would be a few percent, which is roughly equal to normal growth in GDP over just a few years. Employment would probably also fall slightly as production shifted away from industries related to the production of carbon-based energy and energy-intensive goods and services, and toward the production of alternative and lower-emission energy sources, goods that use energy more efficiently, and non-energy-intensive goods and services; workers would follow those shifts in demand, but that would take time and entail costs. The reduction in households’ purchasing power would occur because resources would be devoted to achieving a goal not included in measured income. CBO estimated that the loss in purchasing power from the primary cap-and-trade program that would be established by ACESA would rise from about 0.1 percent of GDP in 2015 to about 0.8 percent of GDP in 2050.

Lesson #5: The details of policies to reduce greenhouse gas emissions would have significant effects on how workers in different industries and households at different income levels would be affected by those policies.

Policies can be designed to cushion the effects on certain industries. Of course, the protection of those firms and workers would have costs, because the resources that would be given away through those channels would not be available to be given to other people. A policy that reduced emissions would affect households at different income levels differently, depending crucially on how the revenues collected under the policy were returned to households. The amount of revenue involved could be large: CBO estimated that the value of allowances under ACESA would total nearly $900 billion during the next decade.

At the request of Congressional budget leaders, CBO is providing basic budget and economic analysis and estimates for the National Commission on Fiscal Responsibility and Reform. That bipartisan commission is composed of 18 members, six appointed by the President and the other 12, all Members of Congress, appointed by the Congressional leaders of both parties. The commission is charged with formulating recommendations designed to balance the federal budget, excluding interest payments on the debt, by 2015, and to “meaningfully improve” the nation’s long-run fiscal outlook. The commission is to vote on a final report by December 1, 2010.

The Chairmen and Ranking Republican Members of the House and Senate Budget Committees all serve as commission members. In order to ensure that the commission has an objective, nonpartisan source of budget information for use in its deliberations, the two Budget Committee Chairmen—Representative John M. Spratt, Jr. and Senator Kent Conrad—and the two Ranking Members—Representative Paul Ryan and Senator Judd Gregg—formally asked CBO to provide the commission with projections regarding the current budget outlook, as well as estimates and information that may be needed to assess the impact of alternative policy options.  In order to assist the Members of Congress in their deliberations on the commission, we have agreed to do so to the extent feasible while meeting our other responsibilities to the Congress.

As part of that effort, CBO’s Assistant Director for Budget Analysis, Peter Fontaine, recently briefed some of the members of the commission on historical trends and CBO’s projections related to discretionary spending (that is, spending that is governed by the annual appropriation process). Deputy Director Robert Sunshine briefed commission members on historical trends and CBO’s projections related to mandatory spending (that is, spending for programs like Social Security and Medicare that are not governed by the appropriation process ).

In CBO’s baseline projections, which are intended to reflect current laws and policies, new funding from annual appropriations is assumed to keep pace with inflation. Under that baseline, discretionary spending would fall from 9.4 percent of gross domestic product (GDP) in 2010 to 6.7 percent of GDP in 2020, which is lower than the level seen in any year since 2001. In contrast, if appropriations were frozen at the 2010 level, total discretionary spending would fall to about 5 percent of GDP by 2020, the lowest share in more than 50 years. By comparison, in recent years discretionary spending has been rising significantly faster than inflation and somewhat faster (on average) than GDP: It grew at an average annual rate of 7.5 percent from 1999 through 2008 and by another 9 percent in 2009; it will grow by roughly 11 percent in 2010.

Mandatory spending has risen from 6 percent of GDP in 1970 to more than 10 percent in 2007; CBO projects that it will exceed 13 percent of GDP by 2020 if current laws remain in place. About 80 percent of the mandatory spending in 2020 will be for Social Security, Medicare, Medicaid, and health insurance subsidies provided under the new health care legislation. Another 8 percent will be for the government’s retirement programs for civilian and military employees and for veterans’ benefits. Overall, the bulk of mandatory spending is for programs serving the older members of the population. The projected growth in mandatory spending over the next decade is, in roughly equal parts, attributable to (1) cost-of-living and other automatic adjustments to benefit payments, (2) changes in program participation, largely because of the aging of the baby-boom generation, and (3) other changes in benefits, particularly rising health care costs and increases in benefits that are linked by formula to wages.