FRBSF Economic Letter
2001-10; April 13, 2001
Uncertainties in Projecting Federal Budget Surpluses
In January 2001, the non-partisan U.S. Congressional Budget Office (2001a)
issued updated federal budget projections for fiscal years 2002 through
2011. According to the CBO's baseline projections, the federal government
will accumulate $5.6 trillion in total surpluses over the coming decade.
Slightly less than half of this total ($2.5 trillion) is expected to come
from so-called "off-budget" programs, the most important of
which is Social Security. The remainder of the surplus ($3.1 trillion)
is expected to come from "on-budget" sources, as mounting federal
tax revenues continue to exceed spending on the rest of the government's
programs. In the absence of new legislation, the projected budget surpluses
are large enough to pay off all of the publicly held federal debt that
is available for redemption by the year 2006.
The emergence of these large projected surpluses has sparked a vigorous
political debate over how the funds should be used—whether for tax cuts,
paying down debt, or new spending. Participants in the debate often adopt
the CBO's baseline numbers as the starting point for their proposed budget
plans. When thinking about these issues, it is important to keep in mind
that ten-year budget projections are subject to considerable uncertainty.
This Economic Letter discusses the nature of this uncertainty and
presents some alternative projections constructed by the CBO to help illustrate
the range of possible budget scenarios that might be observed over the
The baseline projection
The CBO's baseline budget projections are constructed according to statutory
rules set forth mainly in the Deficit Control Act of 1985 and the Congressional
Budget Act of 1974. When projecting federal tax revenues and mandatory
federal spending, the rules instruct the CBO to assume that existing tax
and spending policies are continued in the future. The CBO then estimates
how future economic conditions, demographics, and other relevant factors
will affect the stream of revenues and spending under the existing policies.
In the case of discretionary spending (which is subject to annual appropriation
decisions), the rules instruct the CBO to assume that nominal discretionary
spending grows at the rate of inflation. The baseline projections are
not intended to be forecasts of future legislation; the CBO recognizes
that the actual tax and spending policies signed into law will usually
differ from those used to construct the baseline. During the last three
fiscal years, for example, nominal discretionary spending grew at an average
annual rate of 6%—more than twice the rate assumed in the CBO's baseline
projections for those years. Rather than serving as a forecast, the baseline
projections are intended to provide lawmakers with a neutral reference
point for assessing policy options going forward.
Sources of uncertainty
The uncertainties in the CBO's budget projections arise from two sources.
First, as mentioned above, new legislation may alter paths of revenues
and spending from those assumed by the CBO. Second, forecasting the performance
of the U.S. economy and its impact on the federal budget is an extremely
complex process—one that involves numerous macroeconomic and technical
factors that are themselves very difficult to predict. Examples of such
factors include the trend growth rate of U.S. labor productivity (which
influences the average earnings of workers), the rate of inflation (which
determines cost-of-living adjustments for various federal spending programs),
and the level of capital gains realizations from transactions in stocks
and bonds (which affects capital gains tax revenue). The CBO's baseline
projections are constructed using assumptions for these factors that appear
reasonable given the available data. In some cases, the assumptions are
based on extrapolations of recent trends.
The CBO updates its projections twice a year, incorporating the latest
data and any changes to economic and demographic assumptions. In recent
years, the projections have undergone a series of rather large revisions.
During this time, stronger than expected real GDP growth, low unemployment,
and a soaring stock market combined to produce a tremendous increase in
taxable income. In addition, lower than expected inflation led to an overestimate
of federal spending on programs with automatic cost-of-living adjustments
(such as Social Security). As of result of these developments, previously
anticipated deficits turned into large and growing surpluses (for additional
details, see Walsh 1999 and Kliesen and Thornton 2001).
The CBO's analysis of its own track record (see U.S. Congressional Budget
Office 2001a, Chapter 5) shows that errors in estimating federal tax revenues
have generally exceeded errors in estimating federal spending. This is
due to the greater sensitivity of tax revenues to changes in economic
conditions. The short-term outlook for revenues is particularly uncertain
when the economy may be close to a business cycle turning point. Historically,
the CBO has tended to overestimate actual tax revenues during recessions
(as the tax base contracts) and underestimate actual tax revenues during
booms (as the tax base expands). Over the long term, revenue projections
are less sensitive to business cycle factors because recessions and booms
tend to average out. However, the long-term outlook is particularly uncertain
if the economy may have undergone a permanent structural change that renders
past data less relevant. Since 1995, for example, the U.S. economy has
experienced a surge in capital investment linked to computers and information
technology. The growth rate of labor productivity has picked up while
inflation has declined.
In light of these developments, many economists and policymakers believe
that technological advancements have created a "new economy"
which can grow faster than before without leading to inflationary pressure.
From 1974 through 1995, the trend growth rate of U.S. labor productivity
was about 1.5% per year. Beginning in 1996, however, labor productivity
accelerated to an average growth rate of about 2.9% per year. The CBO's
baseline projection assumes that most of this acceleration is permanent
and that the remainder is due to temporary business cycle factors. Over
the next ten years, the CBO assumes that trend productivity growth will
be about 2.7% per year.
The CBO's January 2001 baseline takes into account the recent pronounced
slowdown of the U.S. economy. The CBO anticipates that real GDP will grow
by only 2.4% during 2001—a full percentage point below the growth rate
of 3.4% anticipated only six months earlier in July 2000. According to
the CBO analysis, a recession of average severity would not significantly
alter its ten-year baseline projection. This is because the baseline already
allows for the possibility that an average recession will occur sometime
during the next decade. The calculations also show that subtracting 0.1
percentage point from projected real GDP growth in every year from 2001
through 2011 would reduce the cumulative ten-year surplus by only 4%,
or $245 billion.
To provide a better idea of the uncertainty surrounding the baseline
projection, the CBO has constructed some alternative budget scenarios
based on different (but still reasonable) assumptions about the future
course of the U.S. economy and the cost of federal health care programs.
The "optimistic" scenario assumes that: (1) trend productivity
growth over the next decade is 3.2% rather than 2.7%, (2) the recent increase
in personal tax liabilities as a share of personal taxable income (due
largely to higher capital gains realizations and a swift rise in income
among people in the highest tax brackets) continues for another five years,
and (3) spending on Medicare and Medicaid grows more slowly than in the
The "pessimistic" scenario assumes that: (1) trend productivity
growth over the next decade reverts to 1.5%, i.e., the rate observed from
1974 through 1995, (2) the recent increase in personal tax liabilities
as a share of personal taxable income dissipates over the next five years,
and (3) spending on Medicare and Medicaid grows faster than in the baseline
All three budget scenarios are plotted in Figure
1, together with the 40-year historical record of deficits or surpluses
as a percentage of GDP. The long-run trend shown in the figure is constructed
using a statistical technique that fits a smooth line through the central
tendency of the data. This procedure helps to isolate movements in the
data that are attributable to permanent shifts in policy or permanent
changes in the structure of the economy, as opposed to temporary business
cycle factors. The trend component of the deficit-to-GDP ratio reversed
course and started shrinking in 1986. Since then, the federal government's
budget position has continued to improve, particularly during the late
1990s when a budget surplus was recorded for the first time since 1969.
The ten-year total budget surplus under the optimistic scenario would
be $8.9 trillion versus $5.6 trillion under the baseline. The on-budget
(or non-Social Security) portion of the surplus would reach $6.2 trillion.
This is two times larger than the corresponding baseline figure of $3.1
trillion. According to the CBO's computations, budget surpluses of this
magnitude would completely wipe out the federal government's net indebtedness
and lead to an accumulation of government-owned assets by 2011 that is
unprecedented in U.S. history.
Under the pessimistic scenario, the ten-year total budget surplus would
be only $1.6 trillion—less than one-third of the baseline figure of $5.6
trillion. On-budget surpluses would vanish after 2003 and turn into a
series of gradually rising deficits. In 2011, the projected on-budget
deficit would be $143 billion or about 1% of projected GDP. This figure
is relatively small in comparison to the average deficit-to-GDP ratio
of 4% recorded during the 1980s, however. Despite the pessimistic assumptions,
the government's off-budget programs would continue to generate rising
surpluses that would more than offset the on-budget deficits. In the absence
of new legislation, the total surpluses would be large enough to reduce
the federal government's net indebtedness by more than 50% over the ten-year
The divergence between the optimistic and pessimistic budget trajectories
in Figure 1 shows that the degree of uncertainty surrounding the baseline
widens as the projection horizon lengthens. This is because small differences
in assumed growth rates can lead to large swings in the size of the surplus
when growth rates are compounded over many years. A more sophisticated
assessment of budget uncertainty conducted recently by the CBO helps to
reinforce this point (see U.S. Congressional Budget Office, 2001b, Table
5). For fiscal year 2001, the CBO estimates that there is a 90% probability
that the actual budget surplus will be within $131 billion of the baseline
projection. Five years into future, for fiscal year 2006, the 90% probability
range surrounding the baseline expands to a whopping $600 billion.
Projecting the status of the federal government's budget position over
the next decade is a difficult and challenging task. The process involves
the application of economic theory, statistical analysis, and a large
amount of judgment. Despite the considerable uncertainties involved, the
CBO's ten-year projections are a crucial input to federal budget deliberations
because they provide lawmakers with a set of quantitative boundaries for
evaluating any new spending or revenue policies.
Kevin J. Lansing
Hodrick, Robert J., and Edward C. Prescott. 1997. "Postwar U.S.
Business Cycles: An Empirical Investigation." Journal of Money,
Credit, and Banking 29, pp. 1-16.
Kliesen, Kevin L., and Daniel L. Thornton. 2001. "The Expected Federal
Budget Surplus: How Much Confidence Should the Public and Policymakers
Place in the Projections?" Federal Reserve Bank of St. Louis Economic
Review (March/April) pp. 11-24. http://www.stls.frb.org/docs/publications/review/01//03/0103kk.pdf
(accessed April 2, 2001).
U.S. Congressional Budget Office. 2001a. The Budget and Economic Outlook:
Fiscal Years 2002-2011. (January.) Washington DC: Government Printing
Office. http://www.cbo.gov/ (accessed
April 2, 2001).
U.S. Congressional Budget Office. 2001b. "Uncertainties in Projecting
Budget Surpluses: A Discussion of Data and Methods." (February 28.)
Washington DC: Government Printing Office. http://www.cbo.gov/otherdoc.html
(accessed April 2, 2001).
Walsh, Carl E. 1999. "Projecting Budget Surpluses." FRBSF
Economic Letter 99-27 (September 10). http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-27.html.
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