Baseline Budget Projections Under Alternative Assumptions

Order Code RS22045

Updated February 24, 2006

CRS Report for Congress

Received through the CRS Web

Baseline Budget Projections Under

Alternative Assumptions

Gregg A. Esenwein

Specialist in Public Finance

Government and Finance Division

Marc Labonte

Analyst in Macroeconomics

Government and Finance Division

Summary

The Congressional Budget Office (CBO) estimates a baseline budget based on

simple rules prescribed by law. Statute requires CBO to project a baseline of revenues

and outlays under current law over the next 10 years. Arguably, a “better guess” of the

probable path of the federal budget under current policy might be achieved by modifying

three assumptions in the CBO baseline. First, that discretionary spending will remain

constant as a share of GDP rather than growing at the rate of inflation. Second, that

recent tax reductions will be extended rather than allowed to expire. Third, that the

alternative minimum tax (AMT) relief will be extended rather than allowing the AMT

to “take back” the reductions in regular income tax. Modifying these baseline

assumptions and accounting for the additional debt service required to finance these

policies yield an estimate that the federal budget deficit is likely to be $5 trillion more

over the FY2007 through FY2016 period than that shown by the baseline projection.

The effects of the alternative assumptions grow over time: by 2016, the alternative

baseline deficit is $861 billion, compared to an official baseline surplus of $67 billion.

This report will be updated periodically.

The Congressional Budget Office (CBO) produces baseline projections of the budget

semi-annually so that policymakers have a common starting point from which to debate

policy changes.1 The purpose of the baseline is to project revenues and outlays under

current law over the next 10 years. It does not include legislative changes even if

Congress is actively considering them. The CBO defines the baseline projection as:

1

For the latest baseline projection, see CBO, The Budget and Economic Outlook: Fiscal Years

2007 to 2016, Jan. 2006.

Congressional Research Service ˜ The Library of Congress

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a benchmark for measuring the budgetary effects of proposed changes in federal

revenues or spending.... By statute, CBO’s baseline projections must estimate the

future paths of federal spending and revenues under current law and policies. The

baseline is therefore not intended to be a prediction of future budgetary outcomes;

instead, it is meant to serve as a neutral benchmark that lawmakers can use to measure

the effects of proposed changes to spending and taxes. So for that reason and others,

actual budgetary outcomes are almost certain to differ from CBO’s baseline

projections.2

The CBO baseline tends to be misunderstood and, hence, misused. Headlines such

as “CBO predicts that the national debt will be paid off by 2008” or “Changes in the

baseline projections prove policy change was unaffordable” are examples that reflect a

misunderstanding of the baseline. As implied in the CBO quote, the baseline is not a

“best guess” of future policy outcomes.

CBO baseline projections rarely provide a good indication of the realized path of

federal spending and revenues. Critics have argued that using the CBO baseline as a

predictor of future budgetary outcomes is inappropriate because several of the underlying

assumptions or rules followed by CBO in making the budget baseline are not as realistic

as they could be. Applying alternative assumptions to the baseline, they say, could

significantly change the projected path of the federal budget. The CBO baseline treatment

of discretionary spending, expiring tax provisions, and the alternative minimum tax

(AMT) are three assumptions that have been cited as reasons not to use the baseline to

forecast future budgetary outcomes.3

Discretionary Spending

Discretionary spending presents a special problem for budget estimates. Unlike

entitlements, there are few legal determinants of its levels; instead, it is determined

annually at the “discretion” of legislators. In its baseline projections, CBO is required to

assume that overall discretionary spending will stay constant in inflation-adjusted terms.

This has two implications. First, although discretionary spending is assumed to keep up

with inflation, there is no adjustment for expected population growth. Under the baseline,

therefore, future discretionary spending can buy the same amount of roads or military

equipment or government services, but there will be fewer of them per person.

Second, since the economy, as measured by gross domestic product (GDP), is

assumed to grow in real terms over the next 10 years, but real discretionary spending is

assumed to remain constant, discretionary spending would fall as a percentage of GDP.

This implies that as society becomes wealthier, it will not want to spend any of its

additional wealth on government-provided discretionary goods and services. Although

there are undoubtedly some government-provided goods and services on which people

2

CBO, The Budget and Economic Outlook: Fiscal Years 2006 to 2015, Jan. 2005.

[http://www.cbo.gov/showdoc.cfm?index=6060&sequence=0]. Instructions for creating the

baseline estimates are contained in the Budget Enforcement Act (BEA), as amended.

3

There are other issues surrounding the accuracy of baselines that are not included in this report,

including the accuracy of economic projections and the treatment of unfunded liabilities. For a

discussion of these issues, see CRS Report RL31414, Baseline Budget Projections: A Discussion

of Issues, by Marc Labonte.

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may not wish to spend their additional wealth, it is not obvious why this would be true of

total discretionary spending, as implied by the baseline.

Does recent history suggest what growth rate is most realistic for discretionary

spending? At least for non-defense discretionary spending, assuming spending would stay

constant as a percentage of GDP is the only assumption that would not consistently

underpredict spending levels historically. The baseline assumption that discretionary

spending will stay constant in inflation-adjusted terms would reduce total discretionary

spending as a share of GDP to its lowest level in the modern budget era.

Since 1962, non-defense discretionary spending has fluctuated between 3.2% and

5.6% of GDP, and has been increasing faster than GDP since 1999. Defense spending fell

as a share of GDP after the cold war, but has been rising since 2001. If, as is likely based

on historical standards, discretionary spending increases at the growth rate of GDP (in

other words, stays constant as a percentage of GDP), then total federal outlays will be

significantly higher than those levels contained in the baseline. CBO estimates that under

this policy alternative, discretionary outlays will be $1.4 trillion larger than the baseline

outlays over the FY2007 through FY2016 period, and the divergence grows over time.

Absent other policy changes, higher discretionary spending would be deficit financed,

which would increase future interest payments on the national debt by $234 billion over

the next 10 years.

Extending Expiring Tax Provisions

On the revenue side there are also assumptions made in the baseline projection that

arguably do not reflect what most observers consider to be current policy. For example,

some federal tax provisions, especially many tax credits, have expiration dates. CBO is

required to assume in its baseline projection that all tax measures (unless earmarked to

a trust fund) will expire as scheduled, since that represents current policy according to the

law. But most of these expiring provisions have proven very durable, having been

routinely extended. Some examples of expiring tax provisions include credits or

deductions for clean-fuel vehicles, qualified zone academy bonds, welfare-to-work,

medical savings accounts, research and experimentation, and economic development

empowerment zones.

In addition, the tax reductions contained in the Economic Growth and Tax Relief

Reconciliation Act (EGTRRA, P.L. 107-16) and the Jobs and Growth Tax Relief

Reconciliation Act (JGTRRA, P.L. 108-27) are scheduled to expire after 2010.4 (The

reduction in taxes on capital gains and dividend income from JGTRRA is scheduled to

expire after 2008.) However, it was not the intention of the tax cuts’ authors that they be

temporary, and there has been strong congressional and Administration support for

making these tax cuts permanent or at least extending them. The CBO baseline

projections do not include the revenue effects of extending or making these tax cuts

permanent.

These omissions greatly inflate the revenue take of the government in the out years.

CBO estimates that extending the EGTRRA and JGTRRA tax cuts — excluding an

4

See CRS Report RS21992, Extending the 2001, 2003, and 2004 Tax Cuts, by Gregg Esenwein.

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extension of expiring alternative minimum tax reform — would reduce federal revenues

by $1.6 trillion over the FY2007 through FY2016 period, mostly after 2010. Extending

the expiring tax provisions, such as the deduction for medical savings accounts and

welfare-to-work tax credit, would reduce federal revenues by another $406 billion over

the same period. The total reduction of $2 trillion would also engender increased debt

service expenditures of $324 billion. Hence, extending the expiring tax cuts and tax

provisions would add $2.3 trillion to the deficit over the next 10 years.

The Alternative Minimum Tax

And this figure does not take into account the revenue loss associated with extending

relief from the alternative minimum tax (AMT) for individuals that expired at the end of

2005.5 The AMT was originally enacted in 1969 to make sure that certain high-income

taxpayers were not able to escape their “fair share” of the federal income tax through the

use of special deductions, exemptions, and credits.

However, because of the recent reductions in the regular income tax and the fact that

the AMT is not indexed for inflation, there will be a significant increase in the number

of middle to upper-middle income taxpayers affected by the AMT in the near future. In

1999, about 1 million taxpayers were affected by the AMT, but estimates indicate that by

2013, if the major tax reductions contained in the EGTRRA are made permanent, then

41 million taxpayers will be subject to the AMT.

To counteract the effects of the AMT, Congress increased the AMT basic exemption

and allowed certain personal tax credits to offset AMT tax liability. However, to

minimize the revenue loss, these changes have been enacted for one or two years at a time

and expired at the end of 2005. Allowing the AMT exemption increase to expire at the

end of 2005 means that, in the out years, the AMT will “take back” much of the regular

income tax relief provided by extending the other expiring provisions.6

Because the revenue estimates of extending the other expiring tax provisions are

based on the AMT exemption increase expiring after 2005, the out year revenue estimates

of these extensions include the AMT take back effect. As a result, they significantly

understate the actual cost of providing the full amount of projected reductions in the

regular income tax. If the increase in the AMT exemption is not extended throughout the

forecast period, then the number of taxpayers subject to the AMT will increase

dramatically.

If Congress decides to provide taxpayers with the full amount of regular income tax

relief from the expiring tax provisions, the AMT would need to be “held harmless.” This

means that the AMT would not be allowed to “take back” the tax reductions provided by

the extensions of the other expiring middle class tax relief provisions. To hold the AMT

harmless would require, at the least, that the AMT exemption increase be extended over

the same time period as the other middle-class tax reductions (i.e., through the 10-year

baseline projection period, FY2007 through FY2016).

5

6

See CRS Report RL30149, The Alternative Minimum Tax for Individuals, by Gregg Esenwein.

See CRS Report RS21817, The Alternative Minimum Tax (AMT): Income-Entry Points and

“Take Back” Effects, by Gregg Esenwein.

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CBO estimates that extending and indexing the higher AMT exemption, which

expired at the end of 2005, so that it does not take back the reductions in the regular

income tax, would reduce revenues by $865 billion over the FY2007 through FY2016

period (assuming extension of the other tax reductions). In addition, debt servicing costs

would add $182 billion in additional interest costs to the deficit.

Effects of Alternative Assumptions on the Baseline

CBO estimates a baseline based on simple rules prescribed by law. Arguably, a

“better guess” of the probable path of the federal budget under current policy might be

achieved by modifying three assumptions in the CBO baseline. First, that discretionary

spending will remain constant as a share of GDP rather than growing at the rate of

inflation. Second, that recent tax reductions will be extended rather than allowed to

expire. Third, that the AMT relief will be extended rather than allowing the AMT to

“take back” the reductions in regular income tax.

The table below shows the effects of these probable policy initiatives on the federal

budget deficit over the 10-year budget projection period. Modifying these baseline

assumptions and accounting for the additional debt service required to finance these

policies means that the federal budget deficit is likely to be $5 trillion higher over the next

10 years than that shown by the baseline projection. The effects of the alternative

assumptions grow over time: by 2016, the alternative baseline deficit would be $895

billion, compared to an official baseline surplus of $67 billion. Rather than return to

surplus as in the official baseline, the deficit would get bigger each year if alternative

assumptions are made.

CBO’s baseline projection is a benchmark and it does not — and is not intended to

— predict the probable path of the federal budget. Therefore, critics say, a projection that

includes alternative assumptions that are likely to occur can provide a better starting point

for policymakers weighing the budgetary effect of different options.

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Effects of Alternative Policy Options on Path of the Federal Budget

(billions of dollars)

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Total

20072016

CBO baseline

surplus/deficit

-270

-259

-241

-222

-114

38

40

57

73

67

-832

Discretionary

Appropriations

constant as % of GDPa

-15

-38

-64

-92

-121

-149

-178

-207

-238

-271

-1,372

Extend EGTRRA/

JGTRRA

-4

-9

-20

-18

-154

-257

-270

-282

-290

-301

-1,606

Other tax extenders

-15

-22

-28

-34

-41

-45

-49

-53

-57

-61

-406

Extend AMTb

-46

-48

-58

-70

-88

-94

-101

-108

-118

-130

-865

Debt Service

-2

-8

-14

-24

-42

-67

-95

-125

-161

-199

-740

Total Modificationsa

-82

-125

-184

-238

-446

-612

-693

-775

-864

-962

-4,989

Modified baseline

surplus/deficit

-352

-384

-425

-460

-560

-574

-653

-718

-791

-895

-5,821

Source: CRS calculations based on CBO data

Notes: See text for details.

a. Supplemental spending is excluded from the constant share of GDP assumption.

b. For the purposes of this table, the cost of extending the AMT tax relief includes the interactive effects

when the AMT relief and the other tax cuts are extended jointly.