The Congressional Budget Office (CBO) issued its annual update to its long-term budget projections last month. As usual, the report is chock full of useful insights about the state of the nation’s medium and long-term fiscal position, the implications of the budget outlook for the national economy, and the primary policies and programs that influence the long-term forecast.
CBO’s bottom line? The nation is facing very significant budgetary challenges over the next quarter century, and beyond, and health care cost escalation is a primary cause of the problems.
That’s not a universally held view, though. Some commentators on the budget have suggested in recent months that the push for an additional round of deficit reduction, which the president has said repeatedly he favors, is misguided. These commentators have pointed to both the near-term improvement in the budget outlook — CBO now expects the 2013 deficit to fall to about $640 billion, down from $1,087 billion in 2012 — and the recent slowdown in health care cost inflation to suggest that existing policies are working and might be all we need to get our fiscal house in order.
No Room For Complacency
But CBO’s report should leave little doubt that complacency on future federal deficits and debt would be disastrous for the American economy. While it is true that near-term deficits are down compared to the experience of the last four years, that’s not saying much. The deficits of 2009 to 2012 were massive and all out of proportion to the nation’s historical experience. The federal budget deficit exceeded $1 trillion in each of the four preceding 2013, and the four-year total reached $5.1 trillion. By comparison, from 1789 through 2008, the federal government had borrowed a total of $5.8 trillion.
The nation’s outstanding debt — $11.3 trillion at the end of 2012 – now equals 73 percent of GDP. The only other time the nation’s debt has been at such an elevated level relative to the size of the economy was during World War II. And, the deficit in 2013, though down from previous years, will still be 3.9 percent of GDP, according to CBO — far above the 2.5 percent of GDP average in the three decades preceding the deep financial crisis of 2007 to 2009.
An uncertain, and at best brief, respite. CBO expects a brief decline in budget deficits over the next several years as the economy is expected to finally recover from the recession that ended in mid-2009. But the improvement is of short duration and contingent on multiple variables all breaking the right way, including a benign interest rate environment and no foreign policy crises.
But even if the next several years go well — a big if — CBO’s forecast shows that the U.S. is facing unsustainable levels of deficits and debt in the medium and long-term. Specifically, under CBO’s base-case scenario – called the “extended baseline scenario” – annual budget deficits never fall below 3 percent of GDP after 2019 and federal debt held by the public (which excludes federal debt held by federal trust funds) would reach 100 percent of GDP by 2038.
Familiar And Imposing Challenges
The cause of the soaring deficits and debt is familiar: rapid increases in entitlement spending (on top of the five decade run-up that has already occurred), driven by the aging of the population, rapidly rising health care costs, and spending associated with expanded health entitlements under the Patient Protection and Affordable Care Act (PPACA). CBO expects that 54 percent of the federal spending increase on the major entitlements over the next twenty-five years will be attributable to the aging of the U.S. population.
Twenty-eight percent of the increase will be due to “excess cost growth” in health care – meaning cost escalation per capita in excess of GDP growth per capita. The rest of the spending increase is due to the expansion of Medicaid and the new premium credits enacted in the PPACA. When looking at just the health care entitlements, 40 percent of the federal spending increase is due to excess cost growth, 35 percent from population aging, and 26 percent from the PPACA program expansions.
Getting our fiscal house in order will not be easy, according to CBO. Just to keep the debt from rising above today’s already elevated level of 73 percent of GDP, CBO estimates that Congress and the president would need to agree to deficit-reducing changes (tax increases or spending cuts) amounting to about 0.8 percent of GDP every year. Put another way, policymakers would need to agree to new legislation cutting future deficits by an average of $145 billion per year from 2014 to 2038. To bring the debt level down to where it was at the end of 2008 (39 percent of GDP), Congress and the president would need to agree to measures amounting to $350 billion annually over the next quarter century.
… and now for the bad news. Although CBO’s “extended baseline scenario” is plenty dire, it is still, on several levels, optimistic, including with respect to the health care projections. Among other things, the CBO forecast assumes that spending on everything other than Social Security and the health care entitlements will continue falling to very low levels as a percentage of the national economy. In 2013, spending on national defense, the full range of domestic appropriated accounts (like education, the National Institutes of Health, the FBI, etc.), and other small entitlement programs will be about 10 percent of GDP. CBO assumes that spending on this part of the federal budget will fall to 7.1 percent of GDP in 2038, a nearly 30 percent drop.
This projection assumes that the sequester mechanism enacted in the 2011 Budget Control Act will continue to cut spending in this part of the budget over the next eight fiscal years. Implicitly, the agency is also assuming that defense funding will fall to levels far below anything seen in recent history, with the implication that the nation will have a much reduced global presence. On the revenue side, CBO assumes that several tax credit provisions will not be extended, even though Congress has tended to extend all expiring tax provisions in the past.
Unrealistic health spending assumptions. In the health accounts, the CBO forecast assumes that the across-the-board payment rate reductions for facilities contained in the PPACA remains fully in effect through 2029. According to the Medicare actuaries, this policy is likely to force a large percentage of these facilities to withdraw from the Medicare program because of the negative margins the cuts would produce. Consequently, there is widespread skepticism that the permanent payment reductions in the PPACA will survive this decade, much less the following one.
Similarly, the CBO’s forecast assumes that the sustainable growth rate (SGR) mechanism, which will produce deep cuts in physician fees, will remain in effect through 2029 (even though it has been overridden by Congress for many years); that the Independent Payment Advisory Board will intermittently cut Medicare spending further during that same period (even though the administration has yet to nominate anyone to serve on it); that the 2 percent cut in Medicare fees from the sequester will not get overturned; and that the new premium credits payable under the PPACA will remain subject to an overall cap tied to GDP growth. All of these are heroic assumptions on their own, but the assumption that all of them will remain in effect for the next fifteen years is a real stretch, to put it mildly.
This is one reason that CBO continues to put together a second long-range projection, dubbed the “alternative fiscal scenario,” which modifies some of the key assumptions contained in the extended baseline scenario, but not all of them. The alternative scenario assumes the sequester cuts are undone (including for Medicare), that the SGR is overridden, and that the automatic cuts to Medicare payment rates and premium credits contained in the PPACA will end after 2023 (instead of after 2029 in the extended baseline scenario). As shown in the following chart, under this alternative scenario, federal debt would rise very rapidly and almost certainly trigger a fiscal crisis within the next quarter century.
But even this is nowhere near the worst-case scenario. If interest rates rise more rapidly, or if higher defense spending is necessary based on a changing global landscape, or if there is another economic crisis in the next decade, a fiscal crisis could emerge much sooner than 2025 or 2030.
The Costs Of Inaction
Some critics have warned that paying too much attention to deficits and debt risks hurting short-term economic prospects more than is necessary. And it is certainly true, even in CBO’s projections, that aggressive deficit cutting in the near-term would slow economic growth initially. But CBO’s report makes it abundantly clear that there is a direct trade-off between higher deficits today and better economic prospects in the medium and long-run. According to CBO’s modeling, the large deficits projected under the extended baseline scenario would reduce real per capita income by 7 percent in 2038, largely because the reduced investment associated with massive governmental deficits would lower the productivity of the future workforce.
There is great uncertainty surrounding any long-term forecast. That’s true of CBO’s latest projections. But that’s not an excuse for inaction. We have known for some time that the combination of population aging and rising health costs would cause severe strain in federal finances. CBO’s new forecast is emphatic confirmation that the strain we have long anticipated is upon us, and the sooner we take corrective action, the better.
James C. Capretta is a senior fellow at the Ethics and Public Policy Center and a visiting fellow at the American Enterprise Institute.