Congressional Budget Office
Director's Blog

I testified this morning to the Senate Budget Committee about the economic outlook and CBO’s analysis of the potential impact on the economy of various fiscal policy options. You can read a summary of my testimony (the full version, which is rather long, is also available), or you can glance at the slides I used, which are below.

Policymakers cannot reverse all of the effects of the housing and credit boom, the subsequent bust and financial crisis, and the deep recession. However, in CBO’s judgment, there are both monetary and fiscal policy options that, if applied at a sufficient scale, would increase output and employment during the next few years. But there would be a price to pay: Those same fiscal policy options would increase federal debt, which is already larger relative to the size of the economy than it has been in more than 50 years—and is headed higher. If policymakers wanted to achieve both stimulus and sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it relative to baseline projections after a few years.

To assist policymakers in their decisions, CBO has quantified the effects of some alternative fiscal policy options. In a report last January, we analyzed a diverse set of temporary policies and reported their two-year effects on the economy per dollar of budgetary cost, what one might call the “bang for the buck.” The overall effects of those policies would depend also on the scale at which they were implemented; making a significant difference in an economy with an annual output of nearly $15 trillion would involve a considerable budgetary cost.

In brief, CBO found the following: A temporary increase in aid to the unemployed would have the largest effect on the economy per dollar of budgetary cost. A temporary reduction in payroll taxes paid by employers would also have a large bang-for-the-buck, as it would both increase demand for goods and services and provide a direct incentive for additional hiring. Temporary expensing of business investment and providing aid to states would have smaller effects, and yet smaller effects would arise from a temporary increase in infrastructure investment and a temporary across-the-board reduction in income taxes.

Today’s testimony went on to address the effects of another set of fiscal policy options. At the request of the Chairman of the Senate Budget Committee, we have now estimated the short-term and longer-term effects of extending the 2001 and 2003 tax cuts, extending higher exemption amounts for the alternative minimum tax, and reinstating the estate tax as it stood in 2009 (adjusted for inflation). The methodology for this analysis was quite similar to the methodology that CBO follows in analyzing the President’s budget each spring; we used several different models and made different assumptions about people’s behavior.

We examined four alternative approaches to extending the tax cuts: a “full permanent extension” that would extend all of the provisions permanently; a “partial permanent extension” that would extend permanently all of the provisions except those applying only to high-income taxpayers; a “full extension through 2012” that would extend all provisions but only through 2012; and a “partial extension through 2012” that would extend through 2012 all provisions except those applying only to high-income taxpayers. As shown in the following figure, all four of the options would raise national income, output, and employment during the next two years, relative to what would occur under current law. That would occur because, all else being equal, lower tax payments increase demand for goods and services and thereby boost economic activity.

Ranges of Effects of Four Tax Policy Options on Real GNP in 2011 and 2012

But the effects of those policy options on the economy in the longer term would be very different from their effects during the next two years. The averages of the estimates across different models and assumptions indicate that all four of the options would probably reduce income relative to what would otherwise occur in 2020 (see the figure below). Those effects are largely the net result of two competing forces: All else being equal, lower tax revenues increase budget deficits and thereby government borrowing, which reduces economic growth by crowding out investment. At the same time, lower tax rates boost growth by increasing people’s saving and work effort.

Effects of Four Tax Policy Options on Real GNP in 2020

Beyond 2020, and again relative to what would occur under current law, the reductions in income from all four of the policy options would become larger. Either a full or a partial extension of the tax cuts through 2012 would reduce income by much less than would a full or partial permanent extension.

In sum, and as CBO has reported before: Permanently or temporarily extending all or part of the expiring income tax cuts would boost income and employment in the next few years relative to what would occur under current law. However, even a temporary extension would add to federal debt and reduce future income if it was not accompanied by other changes in policy. A permanent extension of all of those tax cuts without future increases in taxes or reductions in federal spending would roughly double the projected budget deficit in 2020; a permanent extension of those cuts except for certain provisions that would apply only to high-income taxpayers would increase the budget deficit by roughly three-quarters to four-fifths as much. As a result, if policymakers then wanted to balance the budget in 2020, the required increases in taxes or reductions in spending would amount to a substantial share of the budget—and without significant changes of that sort, federal debt would be on an unsustainable path that would ultimately reduce national income. Similarly, even temporary increases in government spending would add to federal debt and reduce future income, and permanent large increases in spending that were not accompanied by other spending reductions or tax increases would put federal debt on an unsustainable path. Compared with the options examined here for extending the expiring tax cuts, various other options for temporarily reducing taxes or increasing government spending would provide a bigger boost to the economy per dollar of cost to the federal government.

In September 2008, the federal government took control of Fannie Mae and Freddie Mac—two government sponsored enterprises (GSEs) that provide credit guarantees on more than half of the outstanding residential mortgages in the United States. Although they are not legally federal agencies, the government operates them to fulfill the public purpose of supporting the housing and mortgage markets. Therefore, CBO believes that it is appropriate to include the GSEs’ financial transactions in the federal budget.

In its August 2010 baseline projections, CBO included an estimated $53 billion in costs for new mortgage guarantees that Fannie Mae and Freddie Mac will make over the 2011–2020 period. That estimate was made using a so-called “fair-value” basis of accounting, which differs from the way most federal credit programs are reflected in the budget. In a letter sent today to Congressman Barney Frank, CBO discusses that estimate and compares it with the budgetary impact that would be estimated using the procedures specified in the Federal Credit Reform Act of 1990 (FCRA), which governs the accounting for most federal direct loans and loan guarantees. CBO estimates that on a FCRA basis, Fannie Mae’s and Freddie Mac’s new mortgage guarantees made over the 2011–2020 period would generate total budgetary savings of $44 billion.

Both types of estimates use an accrual basis of accounting (the estimates represent the lifetime cost of credit commitments at the time when a federal loan or guarantee is provided) and are based on the same projected cash flows—but the estimates are very different because they involve the use of different discount rates to convert the expected future cash flows into one number representing the present value of those transactions. FCRA estimates are based on Treasury rates (which are generally viewed as risk-free), whereas fair-value estimates employ discount rates that are adjusted to match the risk of the specific credit obligation. Because it fully accounts for such risk, the fair value of a federal loan guarantee represents the amount that would have to be paid to induce a private entity to assume that liability in an orderly market.

The fair-value approach thus provides a more comprehensive measure of cost because it recognizes the cost to taxpayers when the government assumes financial risk. FCRA accounting, by omitting part of the cost of risk, makes a federal direct loan or loan guarantee appear to be less costly than an economically equivalent grant program. However, using the fair-value approach to account for the budgetary cost of the GSEs has the drawback that it reduces the comparability of the GSEs’ cost with that of other federal mortgage guarantee programs, such as those operated by the Federal Housing Administration.

The Administration takes a different approach to showing the impact of Fannie Mae and Freddie Mac on the federal budget. It treats the GSEs as separate from the federal government, and records the cash transactions between those two GSEs and the federal government. That is, it shows the payments the government makes to those entities when it purchases preferred stock, less the dividends Fannie Mae and Freddie Mac pay to the government. CBO estimates that those cash transactions will result in net receipts to the government of $8 billion over the 2011–2020 period, reflecting additional costs for more cash infusions from the Treasury in the near term (2011 and 2012) and dividend payments from the GSEs to the Treasury that will exceed cash infusions in subsequent years. That budgetary treatment, however, does not reflect the governmental nature of the GSEs’ activities, nor does it capture the full cost of the risks associated with them.
 

I’m speaking this afternoon to the Washington Policy Seminar sponsored by the Macroeconomic Advisers forecasting firm.  My presentation draws on several reports that CBO has released over the course of this year and emphasizes these points:

• CBO and most private forecasters expect that the economic recovery will proceed at a modest pace during the next few years. For example, in the forecast that we completed in early July, the unemployment rate remains above 8 percent until 2012. In addition, the economic data released since we finished that forecast have been weaker than we had expected, so if we were to construct a new forecast today, we would project slightly slower growth in the near term.
• Weak economic growth has serious social consequences. About 9½ percent of the labor force is officially unemployed, but many other people are underemployed or have left the labor force. The increase in unemployment is not uniform across demographic groups or regions, with larger run-ups for less-educated workers, men, and people living in certain states. The incidence of unemployment lasting longer than 26 weeks has been the highest by far in the past 60 years. As discussed in our April issue brief, the short-term and long-term impact on people of losing a job during a recession can be very significant.
• Some observers have argued that there is not much that policymakers can do about the weakness of the recovery. That is not our view at CBO. Although there are no magic cures, we do think there are both monetary and fiscal policy options that, if applied at a sufficient scale, would increase output and employment during the next few years (but not overnight). Such options would have costs though—in particular, expansionary fiscal policy would increase federal budget deficits and debt relative to current baseline projections, which are already quite worrisome.
• One key question I’ve been asked in the debate about fiscal policy: What sorts of fiscal policies would actually encourage greater economic activity and more employment? Fiscal policy can affect behavior through several channels: by changing direct demand for goods and services, changing people’s current and/or expected income, changing the payoff from extra work effort and saving, changing the cost of investment, and so on. Predicting the effects of particular policies is difficult, and estimates are quite uncertain.
• In January of this year, we published a study titled Policies for Increasing Economic Growth and Employment in 2010 and 2011. We studied temporary policy changes to be enacted in early 2010, because most observers were interested in the question of how to provide a short-term boost to the economy without significantly worsening the medium- and long-term budget situation. In most cases, permanent changes would generate larger short-term stimulus but would have substantially larger medium- and long-term budget and economic costs. We estimated the “bang for the buck” of different policies; of course, the effect on the economy would also depend on the scale of the policies. This graph summarizes our estimates:

Cumulative Effects of Policy Options on Employment in 2010 and 2011, Range of Low to High Estimates

• The other key question I’ve been asked: How can short-term fiscal stimulus be reconciled with the imperative—and it is a critical imperative—to put fiscal policy on a sustainable medium-term and long-term path? As I said to the Fiscal Commission at the end of June, there is no intrinsic contradiction between providing additional fiscal stimulus today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential.
• If taxes were cut or government spending were increased permanently that would worsen the already worrisome fiscal outlook, as shown in the graph below.  Even if changes were temporary, the additional debt accumulated during that temporary period would weigh on the budget and the economy in the future. Achieving both stimulus and sustainability would require a combination of policies. If policymakers wanted to avoid worsening the large medium-term and long-term imbalance between federal spending and revenue, any policies that widened budget deficits in the near-term would need to be accompanied by specific policies to reduce spending or increase revenue over time.

Rising Burden of Federal Debt Held by the Public

• In summary, the economic recovery will probably proceed at a modest pace—leaving total output well below its sustainable level, and the unemployment rate well above its sustainable level, for a number of years. In CBO’s judgment, the available monetary and fiscal tools, if applied at sufficient scale, would improve economic conditions during the next few years—though with costs and risks in the medium and long term. Policymakers need to address those trade-offs.
   

Four years ago, Medicare began providing outpatient prescription drug benefits for senior citizens and people with disabilities. Known as Part D, the program uses private plans to provide coverage for prescription drugs to enrollees. Those plans negotiate payment rates with pharmacies and rebates from drug manufacturers while competing for enrollees. Such competition provides incentives for plans to control their costs; one important way in which plans seek to control costs is by encouraging the use of generic drugs. A CBO study released today assesses how successful plans have been in encouraging the use of generic drugs and the potential for savings from the additional use of such drugs.

In 2007, total payments to plans and pharmacies from the Part D program and its enrollees were about $60 billion. The total number of prescriptions filled was about 1 billion, of which 65 percent were filled with generic drugs, 5 percent were filled with multiple-source brand-name drugs (brand-name drugs that are also available in generic versions), and 30 percent were filled with single-source brand-name drugs (brand-name drugs for which no chemically equivalent generic versions are available). Even though a majority of prescriptions were filled with generic drugs, their lower prices meant that those prescriptions accounted for only 25 percent of total prescription drug costs.

Potential Savings from Generic Substitution. To control their costs, plans encourage enrollees to switch from brand-name drugs to their less expensive generic equivalents, a practice known as generic substitution. CBO estimates that:

• Dispensing generic drugs rather than their brand-name counterparts reduced total prescription drug costs in 2007 by about $33 billion, meaning that total payments to plans and pharmacies from the Part D program and its enrollees would have been about $93 billion—or 55 percent higher—if no generics had been available.
• The potential for additional savings from increased generic substitution is comparatively small, totaling less than $1 billion.

Potential Savings from Therapeutic Substitution. In one form of a practice known as therapeutic substitution, plans can also encourage enrollees to switch from a brand-name drug to the generic form of a different drug that is in the same therapeutic class (that is, a drug designed to treat the same medical condition). To assess the potential for such savings, CBO examined seven therapeutic classes identified by the Medicare program as providing opportunities for such substitution. CBO finds that:

• If all of the single-source brand-name prescriptions in those seven classes had been switched to generic drugs from the same class, prescription drug costs would have been reduced by $4 billion in 2007.
• Savings from therapeutic substitution to generic drugs could have been much higher than $4 billion to the extent that other classes of drugs also would have presented options for substitution. The seven classes that CBO evaluated represented only about 15 percent of the cost of single-source brand-name drugs under Part D. However, the potential savings could have been lower than $4 billion because in many cases it would have been medically inappropriate to switch to a generic form of a therapeutically similar drug.

Policymakers would face several challenges in developing tools to achieve any additional savings from the expanded use of generic drugs—particularly in the case of therapeutic substitution. About half of Part D spending is on behalf of enrollees who have lower incomes and thus qualify for additional subsidies. Policies that used financial incentives to steer enrollees toward certain drugs might not be effective for that population because Medicare pays nearly all of their costs.

This study was prepared by Julie Somers of CBO’s Microeconomic Studies Division.
 

Over the past two decades, the adult population in the United States has, on average, become much heavier. From 1987 to 2007, the fraction of adults who were overweight or obese increased from 44 percent to 63 percent; almost two-thirds of the adult population now falls into one of those categories. The share of obese adults rose particularly rapidly, more than doubling from 13 percent to 28 percent. That sharp increase in the fraction of adults who are overweight or obese poses an important public health challenge. Those adults are more likely to develop serious illnesses, including coronary heart disease, diabetes, and hypertension. As a result, that trend also affects spending on health care.

A CBO issue brief released this afternoon examines changes over time in the distribution of adults among four categories of body weight: underweight, normal, overweight, and obese. Those categories are defined in federal guidelines using a measure known as the body-mass index—a measure that standardizes weight for height. CBO analyzes how past changes in the weight distribution have affected health care spending per adult and projects how future changes might affect spending going forward.

According to CBO’s analysis of survey data, health care spending per adult grew substantially in all weight categories between 1987 and 2007, but the rate of growth was much more rapid among the obese (defined as those with a body-mass index greater than or equal to 30). Spending per capita for obese adults exceeded spending for adults of normal weight by about 8 percent in 1987 and by about 38 percent in 2007. That increasing gap in spending between the two groups probably reflects a combination of factors, including changes in the average health status of the obese population and technological advances that offer new, costly treatments for conditions that are particularly common among obese individuals.

A relatively simple set of calculations using survey data indicates that if the distribution of adults by weight between 1987 and 2007 had changed only to reflect demographic changes, such as the aging of the population, then health care spending per adult in 2007 would have been roughly 3 percent below the actual 2007 amount. Similar calculations for three different scenarios show the potential effects of different trends in adults’ body weight on future health care spending. In all cases, CBO assumes per capita health care spending will continue to grow faster for adults whose weight is in the above-normal categories. CBO’s assumptions and findings for the scenarios are as follows:

• First, CBO assumed that there will be no future changes in the distribution of adults by body weight, and the prevalence of obesity will remain at the 2007 rate of 28 percent. If so, per capita spending on health care for adults would rise by 65 percent—from $4,550 in 2007 to $7,500 in 2020—largely as a result of rapidly increasing health care spending for all adults regardless of weight. (All dollar figures are in 2009 dollars.)
• Alternatively, CBO assumed a rising prevalence of obesity, matching recent trends. In that scenario, the prevalence of obesity would rise to 37 percent by 2020, and per capita spending would increase to $7,760—about 3 percent higher than spending in the first scenario.
• CBO also assessed the impact of a possible reversal in recent trends. In that scenario, the prevalence of obesity among adults would drop to 20 percent by 2020. Per capita spending would increase to $7,230—about 4 percent lower than spending in the first scenario.

Because lower rates of obesity are associated with better health and lower health care spending per capita, there is considerable interest in devising policies that would reduce the fraction of the population that is obese. However, the literature to date suggests that the challenges in reducing the prevalence of obesity are significant. How reducing obesity would affect both total (rather than per capita) spending for health care and the federal budget over time is not clear, for reasons discussed in the brief.

This issue brief was prepared by Noelia Duchovny of CBO’s Health and Human Resources Division and Colin Baker (formerly of CBO).

The federal government incurred a deficit of nearly $1.3 trillion in the first 11 months of fiscal year 2010, CBO estimates in its latest Monthly Budget Review—a total that is about $100 billion less than the shortfall recorded through August of last year. Outlays are about 2 percent less than they were in the first 11 months of 2009, whereas revenues have increased by 1 1/2 percent.

CBO recently released its latest annual budget estimates for 2010 and beyond in the Budget and Economic Outlook: An Update. CBO estimates that the deficit for 2010 will be about $70 billion below last year’s total, but will still exceed $1.3 trillion. Relative to the size of the economy, this year’s deficit is expected to be the second-largest shortfall in the past 65 years: At 9.1 percent of gross domestic product (GDP), that deficit will be exceeded only by last year’s deficit of 9.9 percent of GDP.

By CBO’s estimate, spending through August was $77 billion (or about 2 percent) less than during the same period last year. That decline includes a net reduction in outlays of about $373 billion for three items related to the financial crisis: the costs of the TARP (a reduction of $274 billion from 2009), payments to Fannie Mae and Freddie Mac (a drop of $42 billion), and federal deposit insurance (a decline of $57 billion). Excluding those three programs, outlays through August increased by $296 billion (or 10 percent) relative to spending in the same period last year. Slightly more than one-third of that increase stemmed from provisions in the American Recovery and Reinvestment Act (ARRA), the majority of which was for the State Fiscal Stabilization Fund and other Department of Education programs, additional unemployment benefits, refundable tax credits, and the federal share of Medicaid assistance.

Several major entitlement programs accounted for another one-third of the overall increase in spending. Social Security benefits increased by $34 billion (or 6 percent) and Medicare expenditures rose by $19 billion (or 5 percent). Excluding spending under ARRA, outlays for unemployment benefits were $35 billion higher and Medicaid spending was $12 billion higher than in the previous year. Outlays for net interest on the public debt were $24 billion (or 13 percent) higher than during the same period last year. Most of that growth reflects adjustments to the value of inflation-indexed securities.

Total receipts for the first 11 months were $29 billion (or 1 1/2 percent) higher than in the same period last year.  Higher net corporate income taxes and receipts from the Federal Reserve have been partially offset by declines in individual income and payroll taxes. Corporate income taxes rose by $32 billion (or 30 percent) primarily because of higher taxable profits stemming from improved economic conditions and lower depreciation charges. With an increase of $41 billion, receipts from the Federal Reserve were more than double the amount received in the comparable period in 2009. The Federal Reserve’s higher remittances stem from a much larger portfolio and a shift to riskier and thus higher-yielding investments.

In contrast, combined receipts from individual income and payroll taxes declined by about $47 billion (or 3 percent) compared with receipts in the same period last year. Withheld income and payroll taxes fell by about $19 billion (or 1 percent), and nonwithheld receipts fell by about $37 billion (or 12 percent). In both instances, the declines occurred earlier in this fiscal year and were largely attributable to lower collections from tax liabilities incurred in 2009.

The Monthly Budget Review was prepared by Elizabeth Cove Delisle and Daniel Hoople of CBO's Budget Analysis Division, and by Barbara Edwards and Joshua Shakin of our Tax Analysis Division.
 

I am delighted to announce that, for the second year in a row, CBO has been recognized by the Partnership for Public Service as one of the "Best Places to Work in the Federal Government."  We were ranked third among 34 agencies in the small agency category.

The Partnership says that its goal is "to ensure our government has the right talent with the right skills to meet the extraordinary challenges it faces."  To do this, it uses survey results to gauge employee satisfaction in a variety of categories.  You can see the results for all participating federal agencies at www.bestplacestowork.org.

I think these ratings are a collective accomplishment of everyone at CBO:  It is the way that we work together, treat each other as colleagues, and care about each other as people, that creates the special environment at CBO.  I feel very lucky to be here, and I am glad that so many other people at CBO seem to feel that way too.