CBO Reports Point to Dire Fiscal Situation

June 5, 2012

The Congressional Budget Office (CBO) has released two important documents regarding the federal government’s fiscal situation and its economic effects.  The CBO’s “2012 Long-Term Budget Outlook” can be read here.    The CBO’s “Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013” can be read here.

If the federal fiscal situation does not improve substantially, it can be expected to have a sustained, large negative impact on the economy in general and small businesses in particular.

If current law remains in effect, then the fiscal situation of the federal government would improve (although, as shown below, largely due to tax increases).  This would mean that the automatic budget cuts (called a sequester) would take effect and tax increases scheduled for next year would occur (i.e. the expiration of the Bush era tax cuts, various tax preferences and credits and the AMT fix).  If, as is widely expected, current policies are broadly continued, the fiscal situation will radically deteriorate.  It is, for example, unlikely that current law reducing Medicare payment rates for physicians by 27 percent in January 2013 will remain fully in effect.  It is unlikely that all of the scheduled $399 billion in tax increases will occur as this would amount to about a 13 percent tax hike.

In the chart below, the “extended baseline” scenario is the scenario with the major tax increases and spending cuts that are in current law.  The “extended alternative fiscal scenario” assumes that Congress will change the law to avoid many of the tax increases and spending cuts (both defense and domestic).  Another way of looking at this scenario is that it broadly retains the policies in effect now (2012), as opposed to the baseline which reflects the dramatic changes scheduled to take effect in 2013 under current law.

Source: Congressional Budget Office, CBO Long-Term Budget Outlook, June, 2012

Continuing 2012 policies will cause the federal debt to reach 100 percent of gross domestic product (GDP) by 2023 (11 years from now) and exceed its historical peak of 109 percent by 2026, and it would approach 200 percent in 2037.  In this scenario, federal spending consumes 24 percent of GDP in 2012 and 36 percent in 2037 while revenues stay near historic norms of 18.5 percent.

As seen in Europe today, when a country approaches debt levels of 100 percent of GDP, investors typically begin to demand higher interest rates to compensate for the substantially increased risk of default.  Government interest expense increases, the economy slows, the banking system becomes unstable and the fiscal situation worsens. Other factors are also important, notably the rate of underlying economic growth, the magnitude of unfunded entitlement liabilities, the soundness of the banking system and domestic savings rates. In 2011, according the CIA World Factbook, sovereign debt levels as a percentage of GDP in various countries were: Japan (208), Greece (165 percent), Italy (120), Ireland (107), Portugal (103), France (86), Germany (82), United Kingdom (80), Spain (68), United States (69).  These figures do not include entitlement or pension liabilities.  Click here for the entire list.

NSBA analysis shows that in the U.S., making reasonable assumptions, the present discounted value of federal, state and local unfunded entitlement liabilities, unfunded pension liabilities and government debt is now approximately $80 trillion, or more than five times GDP.

The table to the right shows the impact of current law deficit reduction provisions, sometimes referred to as the 2013 “fiscal cliff.”  Over 80 percent of projected deficit reduction will come from tax increases under current law.

CBO estimates that the combination of policies under current law will reduce the federal budget deficit by $607 billion, or 4.0 percent of GDP, between fiscal years 2012 and 2013.   CBO projects that under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent.  CBO expects the economy to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half.  CBO expects that this would be scored by the National Bureau of Economic Research as a short recession. CBO projects that in the absence of the current law tax increases and spending cuts, GDP would increase about 4.4 percent.