Macroeconomic Effects of Alternative Budgetary Paths

Federal debt held by the public now exceeds 70 percent of the nation’s annual output (gross domestic product, or GDP) and stands at a higher percentage than in any year since 1950. Under an assumption whereby current laws generally remain unchanged, federal debt will be 77 percent of GDP in 2023, CBO projects. Such a large amount of federal debt will reduce the nation’s output and income below what would occur if the debt was smaller, and it raises the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates). Moreover, the aging of the population and rising health care costs will tend to push debt even higher in the following decades.

In addition, those projections of debt under current law incorporate scheduled changes in policies that will serve to restrain the growth of debt. For example, under current law, some significant tax provisions will expire at the end of this year or in later years, increasing revenues; automatic spending cuts included in the Budget Control Act of 2011 and modified in the American Taxpayer Relief Act of 2012 will go into effect on March 1, 2013; and Medicare’s payment rates for physicians’ services will fall in January 2014. If future legislation prevented those changes from taking effect and did not make other policy changes with offsetting budgetary effects, federal debt would be considerably higher than the amount projected under current law.

To aid lawmakers in assessing the macroeconomic effects of possible changes in tax and spending policies, this report describes the effects of three alternative budgetary paths: one with deficits that are greater than those projected under current law and two with deficits that are smaller. Those paths are purely illustrative and do not represent recommendations by CBO.

In evaluating policy changes that would change projected budget deficits, lawmakers would undoubtedly weigh other considerations besides the macroeconomic effects—taking into account, for example, views about the proper size of the federal government and the best allocation of its resources. Lawmakers would also be concerned about the distributional implications of proposed changes—that is, who would bear the burden of any cuts in spending or increases in taxes (or who would benefit from spending increases or tax cuts), and who would gain or lose from changes in economic conditions. Such considerations are outside the scope of this analysis but have been addressed by CBO in other reports.

What Budgetary Paths Did CBO Analyze?

CBO analyzed three budgetary paths that would alter cumulative primary deficits (that is, deficits excluding interest costs) from 2014 to 2023 relative to those under current law—an increase of $2 trillion (Path 1), a decrease of $2 trillion (Path 2), and a decrease of $4 trillion (Path 3). In each case, the budgetary changes would begin in 2014 and increase steadily over time.

The changes in primary deficits that occurred under the three paths would induce changes in debt service (the interest the government pays on its debt). They would also affect the economy, which would have further budgetary consequences (mostly through the rate of economic growth and interest rates). As a result, CBO estimates, the changes in total deficits and in federal debt held by the public from 2014 through 2023 would be as follows:

• Path 1: A $2 Trillion Increase in Primary Deficits. With economic effects and debt service included, the cumulative increase in the deficit would total $2.5 trillion and debt would reach 87 percent of GDP in 2023, compared with, respectively, 73 percent at the end of 2012 and 77 percent projected for fiscal year 2023 under current law.
• Path 2: A $2 Trillion Reduction in Primary Deficits. The total cumulative decrease in the deficit would amount to $2.4 trillion and debt would drop to 67 percent of GDP in fiscal year 2023.
• Path 3: A $4 Trillion Reduction in Primary Deficits. The total cumulative decrease in the deficit would amount to $4.8 trillion and debt would drop to 58 percent of GDP in fiscal year 2023.

For the sake of simplicity and to avoid any presumption about what particular policies might be chosen to reduce the deficit, CBO has not specified fiscal policies underlying the three illustrative paths. As a result, the projected outcomes under the three paths reflect no direct changes to the incentives to work and save that exist under current law; for example, marginal tax rates (the rates that apply to an additional dollar of a taxpayer’s income) are assumed to be the same as those under current law. Therefore, the estimated macroeconomic effects presented in this report arise solely from the differences in deficits, and not from any effects of different tax policies or benefit programs that would directly alter people’s incentives to work and save.

In fact, changing budget deficits significantly relative to what would occur under current law without altering incentives to work and save would be very difficult. If policies that raised or lowered deficits affected those incentives, then the overall economic impact of those policies would depend on both the changes in federal borrowing and the changes in incentives. In addition, the short-run economic impact of deficits would differ depending on how the specific tax and spending policies affected aggregate demand.

How Would Such Budgetary Paths Affect the Economy?

In assessing the effects of the budgetary paths on total economic output, CBO focused on changes in gross national product (GNP). Unlike the more commonly cited GDP, GNP excludes foreigners’ earnings on investments in the domestic economy but includes U.S. residents’ earnings overseas; changes in GNP are therefore a better measure of the effects of policies on U.S. residents’ income than are changes in GDP.

Relative to projections under current law, CBO estimates, policies that led to larger deficits by raising spending or cutting taxes would boost GNP from 2014 to 2016, and policies that reduced deficits by cutting spending or raising taxes would lower GNP in those years—reflecting the short-term impact of tax and spending policies on the demand for goods and services. By contrast, sustained higher deficits would lead to lower GNP beginning in 2017, and sustained lower deficits would lead to higher GNP beginning then—reflecting the impact of deficits on national saving and domestic investment (and without accounting for any changes to households’ incentives to work or save stemming from changes to tax policies or benefit programs).

As shown in the figure below, compared with the agency’s baseline projections (reflecting current law), the illustrative paths would have differing effects on GNP at the end of next year and after a decade:

• Path 1: A $2 Trillion Increase in Primary Deficits. Real (inflation-adjusted) GNP would be higher, by 0.3 percent, in the fourth quarter of 2014 and lower, by 0.9 percent, in 2023 than it would be under current law.
• Path 2: A $2 Trillion Reduction in Primary Deficits. Real GNP would be lower, by 0.3 percent, in the fourth quarter of 2014 and higher, by 0.9 percent, in 2023 than it would be under current law.
• Path 3: A $4 trillion Reduction in Primary Deficits. Real GNP would be lower, by 0.6 percent, in the fourth quarter of 2014 and higher, by 1.7 percent, in 2023 than it would be under current law.

Those findings represent CBO’s central estimates, but to reflect the high degree of uncertainty involved, the agency also estimated a range of effects encompassing a broad span of economists’ views about the relevant economic relationships.

Of course, policy changes of many other sizes and different patterns over time are possible, as are combinations of policies. For example, if policymakers wanted to raise GNP in the near term relative to projections under current law, as well as raise GNP in later years relative to that same benchmark, they could enact a combination of policies that increased deficits during the next few years and decreased them by a greater cumulative amount thereafter (ultimately leading to less debt than would arise under current law). That approach, however, would allow more federal debt to accumulate over the next few years and might raise doubts about whether long-term deficit reduction would actually take place. Households, businesses, state and local governments, and participants in the financial markets would be more likely to believe that the deficit reduction would truly take effect in the future if the future policy changes were specific and widely supported.