Congressional Budget Office
Director’s Blog

The labor force in the United States is expected to grow much more slowly in the coming decades for several reasons: a long-term decline in fertility rates, the leveling off of a substantial increase in women’s labor force participation, and the aging and retirement of baby-boomers. CBO projects that the growth of the labor force, which averaged 1.6 percent per year from 1950 to 2007, will slow to about half a percent per year over the next 20 years. Although slower growth in the workforce might affect the U.S. economy and budget in many ways, CBO examined—in a background paper released today—what could happen to the rate of return paid on assets (such as stocks and bonds) and to wages.

Most mainstream economic models predict that the slowdown is likely to make the rate of return on capital—as reflected in the rate of interest on bonds or other borrowing, and the rate of return on stocks—lower than might otherwise be expected, by between 0.8 and 2.6 percentage points. Wages will be higher than would otherwise be the case, although that effect will be much smaller than the increase in wages that is projected to result from productivity growth.

Shifts in wages and rates of return on capital would have budgetary implications, both for the overall federal budget and for individual programs such as Social Security. The lower interest rates that would result from a slowdown in labor force growth would tend to reduce federal interest payments and slow the growth of debt relative to output. Lower interest rates would also reduce the interest income of the Social Security trust fund and increase the actuarial imbalance of the system (because future deficits in the system would be “discounted” at a lower rate of interest), although the accompanying higher wages would tend to increase payroll tax revenues somewhat.

The rate at which the labor supply grows is, however, only one factor influencing wages and rates of return on capital. Therefore, it is not clear whether, on balance, future wages and rates of return will be higher or lower than today’s. For example, budget deficits reduce national saving—the sum of private and government saving—and tend to crowd out investment in productive capital (the stock of office buildings, factories, machines, computers, and other equipment that are set aside to support future production and consumption). That crowding out implies a smaller capital stock and, other things being equal, lower wages and a higher rate of return on capital.

CBO’s 10-year economic projections illustrate some of those offsetting effects. They incorporate lower rates of return from a slackening in labor force growth, but that effect is outweighed by the impact of budget deficits and economic recovery, resulting in a projection that real (inflation-adjusted) interest rates will increase over the 10-year period.

Yesterday I gave a talk over lunch to the National Economists Club.  If I’d known when I was invited how much legislative activity would be occurring this week, I wouldn’t have agreed—but I enjoyed the chance to talk with the group.

My topic was CBO’s outlook for the federal budget and the economy, drawing on our August report The Budget and Economic Outlook: An Update and our June report The Long-Term Budget Outlook.  You can read the slides from my remarks.

CBO estimates that, if current laws remained in place, the federal deficit would shrink significantly—from about 11 percent of GDP this fiscal year to around 3 percent of GDP between 2013 and 2019.  The country has experienced persistent large deficits before; for example, deficits averaged about 4 percent of GDP during the economic expansion of the 1980s. However, the budget challenge facing policymakers during the coming decade will be more acute than the challenge they faced during the 1980s in three important respects:

• First, federal debt held by the public will exceed 50 percent of GDP at the end of this fiscal year, compared with roughly 30 percent when the expansion of the 1980s began.  As a result, further large deficits and increases in the debt will raise more serious economic risks.  Under current law, CBO projects that debt held by the public will reach 68 percent of GDP by 2019, the highest level since 1950, and will be continuing on an upward trajectory.

• Second, the difference between current law (which underlies CBO’s baseline projections) and current policy as perceived by many people (in particular, the personal income tax rates now in effect) is especially large now.  For example, most of the tax cuts enacted in 2001 and 2003 are scheduled to expire at the end of December 2010, and the exemption amount for the alternative minimum tax (AMT) is scheduled to fall back sharply; those provisions of current law are reflected in CBO’s baseline projections, adding to projected revenues.  If, instead, the tax cuts were extended and the AMT exemption was indexed for inflation after 2009, the revenue loss and the resulting increase in interest payments on the federal debt would widen the deficit to more than 6 percent of GDP by 2019.

• Third, the aging of the U.S. population and rising costs for health care are making federal spending on Social Security, Medicare, and Medicaid a much larger burden relative to GDP.  During the expansion of the 1980s, federal spending on those three programs stayed close to 7 percent of GDP; in the 2013 to 2019 period, CBO projects that spending on those programs will rise from just over 10 percent of GDP to a little below 12 percent.  Beyond the 10-year budget window, CBO expects that this share would continue to rise rapidly under current law.

This sobering outlook for the federal budget is likely to weigh on policy decisions for some time.  High deficits in the near term may be an inevitable consequence of the severe economic downturn and the turmoil in the financial markets.  However, continued large deficits and increases in federal debt over time would adversely affect the nation’s economic growth by lowering saving and investment.

Today CBO released a background paper examining whether the demand for assets, such as stocks and bonds, will fall after the retirement of the baby-boomer generation—the segment of the nation’s population born between 1946 and 1964, whose oldest members turned 62 in 2008. Some economists have warned of the possibility of a dramatic decline in demand as baby boomers sell off their assets to finance their retirement; they assert that the sell-off could cause a dramatic decline in prices. An evaluation of the evidence, however, indicates that such a dramatic decline in asset demand and prices is unlikely.

Demand for Assets

In general, retirees sell assets to finance their retirement, whereas young and middle-aged workers buy assets to save for old age. As a population ages, the share of older, retired people selling assets increases relative to the share of younger, working people buying them. In principle, if an unusually large cohort, such as the baby boomers, were to sell its assets to finance retirement, the total demand for assets in the economy could fall substantially over several decades and the prices of those assets could decline as well.

However, empirical evidence about the behavior of earlier groups of retirees suggests that baby boomers will not sell their assets quickly after they retire. Several factors probably explain that evidence. First, retirees generally are cautious about selling assets to finance consumption because they might need those assets in the future: They might live longer than expected, and medical costs, which are likely to rise as people age, could be higher than anticipated. Second, rather than spend all of their assets, retirees might intentionally retain some to make bequests. Third, wealth in the United States is highly concentrated: One-third of the nation’s financial assets is held by the wealthiest 1 percent of the U.S. population. The wealthiest people do not spend significant portions of their assets during retirement and in most cases die leaving bequests.

The demand for assets will be reinforced if baby boomers change the timing of their retirement as a result of the recent financial turmoil. Some baby boomers who have lost or spent a significant portion of their assets may defer retirement, shortening the duration of retirement and reducing the amount of assets needing to be sold to finance consumption. The aggregate effect on asset demand might be small, however, if people delayed retiring for only a year or two.

Foreign demand is likely to help sustain the demand for U.S. assets. A rising demand for U.S. financial assets is anticipated to come from developing countries with emerging economies whose populations are younger or aging less quickly than is the U.S. population. By contrast, the demand for assets by new immigrants to the United States is unlikely to have much effect on overall demand.

Prices of Assets

Although the retirement of the baby boomers is not likely to cause a large decline in aggregate demand for assets, several economic studies suggest that the retirement and aging of baby boomers could cause a temporary decrease in asset prices. That prediction of a temporary decrease is based on the studies’ expectation that the retirement of baby boomers will cause the demand for assets to fall more rapidly than the stock of capital will be reduced, causing asset prices to fall while the capital stock adjusts. Empirical evidence, however, has not revealed much connection between demographic trends and the price changes observed in financial markets.

This paper was prepared by Marika Santoro of CBO’s Macroeconomic Analysis Division.

Today CBO released an evaluation of the accuracy of its economic forecasts by comparing those forecasts with the economy’s actual performance and with the projections of other forecasters. The study examines the two-year ahead forecast accuracy and the five-year ahead forecast accuracy for a variety of macroeconomic variables, such as real GDP, inflation, and interest rates. Thirty-two CBO forecasts, those made early each year from 1976 to 2007, are included in the study.  Such evaluations help guide CBO’s efforts to improve the quality of its forecasts and also assist Members of Congress in their use of CBO’s estimates.

Since publishing its first macroeconomic forecast in 1976, CBO has compiled a forecasting track record that is comparable in quality with that of the Administration and that of the Blue Chip consensus. In particular, the accuracy of CBO’s two-year forecasts between 1982 and 2007 paralleled that of the forecasts published by the Blue Chip consensus and the Administration over the same period. The accuracy of CBO’s five-year projections also generally corresponded to that of other forecasters, although the Administration’s projections of types of income (such as wages and salaries, and profits) as a share of national output had slightly smaller errors. Comparing CBO’s forecasts with those of the Blue Chip consensus suggests that when the agency’s predictions of the economy’s performance missed by the largest margin, those errors probably reflected problems shared by other forecasters in predicting turning points in the business cycle.

CBO’s forecasting record provides a measure of the uncertainty underlying forecasts under normal circumstances. However, the current degree of economic dislocation exceeds that of any previous period in the past half-century, so the uncertainty inherent in current forecasts exceeds the historical average.

Today CBO released a brief that analyzes the effects of changes in the health insurance system on the U.S. labor market. In 2009, about three out of every five nonelderly American are expected to have health insurance that is provided through an employer or other job-related arrangement, such as a plan offered through a labor union. Changes to the health insurance system could affect labor markets by changing the cost of insurance offered through the workplace and by providing new options for obtaining coverage outside the workplace.

In the current system, employment-based plans are popular largely due to three reasons:

• They are subsidized through the tax code: Nearly all payments for employment-based insurance are excluded from taxable compensation and thus are not subject to income and payroll taxes.
• Employers offering coverage usually pay a large share of the premium – partly to encourage broad participation among their employees, so as to limit the potential for “adverse selection.”
• Larger group purchasers can spread administrative costs over a larger number of people, using these economies of scale to reduce costs imbedded in premiums.

Although employers directly pay most of the costs of their workers’ health insurance, the available evidence indicates that active workers—as a group—ultimately bear those costs.

Congress is currently considering proposals that would expand health insurance coverage. Those proposals would affect the labor market because of the close linkage between health insurance and employment. For example:

• Requiring employers to offer health insurance—or pay a fee if they do not—is likely to reduce employment, although the effect would probably be small. Those who would most likely be affected are currently paid close to or at the minimum wage. They would be more vulnerable to job loss because their wages could not be lowered sufficiently to absorb the cost of health insurance (if their firm decides to offer) or the fee (if their firm does not) without bumping into the minimum wage.
• Proposals that imposed surcharges on employers whose workers received subsidies directly from the government could have a larger impact on employment. (Such provisions are sometimes known as free-rider surcharges.) Many of the affected workers would be paid low wages that could not easily adjust to absorb the full cost.
• Providing new subsidies for health insurance that decline in value as a person’s income rises could discourage some people from working more hours.
• Subsidies could be targeted to small businesses, but employers or their workers might respond by taking action to qualify for the subsidies. For example, some firms might reorganize into smaller subsidiaries, and workers might move to smaller firms to take advantage of the new subsidies.
• Increasing the availability of health insurance that is not related to employment could lead more people to retire before age 65 or choose not to work at younger ages. It might also encourage other workers to take jobs that better match their skills—because they would not have to stay in less desirable jobs solely to maintain their health insurance.

The overall impact on labor markets, however, is difficult to predict. Although economic theory and experience provide some guidance as to the effect of specific provisions, large-scale changes to the health insurance system could have more extensive repercussions than had previously been observed and also may contain numerous pieces that would interact—affecting labor markets in significant but potentially offsetting ways.

Today CBO released an updated report on the treatment of federal receipts and expenditures in the National Income and Product Accounts (NIPAs). The Congress, executive branch agencies, and the press generally focus on the accounting of government finances presented in the Budget of the United States Government, which is prepared by the Office of Management and Budget (OMB). The budget is structured to provide information that can assist lawmakers in their policy deliberations, facilitate the management and control of federal activities, and help the Treasury manage its cash balances and determine its borrowing needs.

In contrast, the NIPAs—produced by the Bureau of Economic Analysis (BEA), an agency within the Department of Commerce—are intended to provide a comprehensive measure of activity in the U.S. economy, of which the federal sector is one part. Because the aims of the NIPAs differ from those of the federal budget, the two accounting systems treat some of the government’s transactions very differently, as described in this report. Despite the accounting differences, the government budget numbers reported by the BEA are not all that different from those reported under the OMB framework.

Today CBO released an updated report on the effects of the business cycle on the federal budget.

For example, during recessions, the budget deficit tends to increase because of the automatic stabilizers built into the budget: tax revenue tends to decline and certain forms of government spending, such as outlays for food stamps and unemployment benefits, tend to increase.

A budget measure that filters out cyclical factors is useful in several ways. For example, some analysts use such a measure to discern underlying trends in government saving or dissaving (that is, surpluses or deficits). Others use it to approximate whether the influence of the budget on aggregate demand and on the growth of real (inflation-adjusted) income in the short run is positive or negative. More generally, the measure helps analysts estimate the extent to which changes in the budget are caused by movements of the business cycle and thus are likely to prove temporary. The usefulness of the cyclically adjusted budget measure for such purposes is hampered by large but temporary federal measures, such as the Troubled Asset Relief Program (TARP).

Under CBO’s baseline assumptions, the cyclically adjusted budget deficit will rise sharply in 2009, to 9 percent of potential GDP (from 2.6 percent in 2008), but then decrease in 2010 and 2011 to 4.7 percent and 2.2 percent of potential GDP, respectively. Those deficits are smaller than the unadjusted deficit estimates because the latter include the automatic responses of revenues and outlays to the current recession. CBO expects that economic output will be much farther below its potential level in 2009, 2010, and 2011 than it was in 2008, which is to say that effects of the business cycle will substantially increase the federal budget deficit in those years. According to CBO’s baseline projections, in 2009 and 2010 the cyclical contribution to the budget deficit will climb to roughly 2.1 percent and 2.6 percent of potential GDP and in 2011 it will decrease to 2.2 percent.

Budget Deficits and Surpluses as Percentage of Potential GDP

In preparing its economic forecast published in September 2008, CBO estimated that 40 percent of the tax rebates issued in the spring and summer under the Economic Stimulus Act of 2008 would be spent within six months––raising the growth of consumption in the second and third quarters of 2008 by 2.3 percent and 0.2 percent, respectively, and reducing it by 1.0 percent in the fourth quarter, when the distribution of the rebates was expected to end. However, analysts disagree about the economic impact of tax rebates. One study of the 2001 rebates suggests that as much as two-thirds of those rebates was spent within six months. For the 2008 rebates, some analysts have put the figure as low as 10 percent to 20 percent––in contrast to CBO’s estimate of 40 percent. There is, however, disagreement among analysts about the economic impact of tax rebates. Today CBO released a brief that examines the issue in light of the evidence currently available.

Studies of tax rebates fall into three groups depending on the type of data employed: those based on detailed data about spending by individual households; those based on qualitative answers to surveys in which people were asked what they intended to do or had already done with their rebate check; and those based on national data on income and spending for the country as a whole. By itself, simple observation of aggregate  consumption over time may not detect the effect of rebates; no spike in spending corresponds to the spike in income. For that reason, CBO places more confidence in studies of the first two types, which rely on differences in spending by people who benefit from the tax rebates and those who do not.

The figure below illustrates why careful studies, not casual observation, are necessary.  It shows a counterfactual path for monthly consumption spending, constructed by subtracting from actual spending CBO’s estimate of the effect of the rebates. That estimate (based on an assumption that 40 percent of the rebates was spent) implies that the rebates raised the growth of consumption in the second and third quarters by 2.3 percent and 0.2 percent, respectively, but reduced it by 1.0 percent in the fourth quarter, when the distribution of the rebates ended. However, someone comparing the monthly course of consumption with that of income would be unlikely to detect any effect.

Note: The cumulative area between lines showing consumption with and without the effects of rebates is 40 percent of the area between the lines showing income with and without the rebates. In the figure, it is assumed that the 40 percent of rebates is spent over six months according to this pattern: 15 percentage points in the first month and 5 percentage points in each subsequent month. On the basis of those assumptions, CBO estimates that the rebates added 2.3 percent (at an annual rate) to the growth of consumption in the second quarter of 2008 and 0.2 percent in the third quarter but––because of those effects––reduced the growth of consumption by 1.0 percent in the fourth quarter.

I testified yesterday before the House Budget Committee regarding the state of the U.S. economy. I emphasized the following points:

• In CBO’s judgment, the economy will stop contracting and resume growing during the second half of this year, but the hardships caused by the recession will persist for some time. We now expect that the recovery will be more tepid than we had projected earlier. In particular, the growth in output later this year and next year is likely to be sufficiently weak that the unemployment rate will continue to rise into the second half of next year and peak above 10 percent. Economic growth over time will ultimately bring the unemployment rate back down to the neighborhood of 5 percent seen before this downturn began, but that process is likely to take several years.
• On the positive side, the fiscal stimulus provided by the federal government is now beginning to boost the economy, and financial markets show clear signs of improvement since the fall and winter. However, many factors will likely temper the strength of the recovery: the loss of household wealth, the fragility of financial institutions, persistently weak growth in the rest of the world, a surplus of housing units on the market, and low utilization of manufacturing capacity.
• Even if the economy returns to positive growth this year, the loss in output and income during this downturn will be huge. In CBO’s March forecast, the difference between the economy’s actual and potential output will average 7 percent of GDP (which is equivalent to about a trillion dollars) this year and next, and that gap in output will not close until 2013. CBO’s forecast in August is likely to show even larger shortfalls in output over the next few years. By this measure, the current recession and its aftermath will be the most severe economic downturn of the postwar period.

• The persistence of high unemployment in CBO’s forecast does not stem from a “failure” of fiscal stimulus. We expect that the stimulus legislation will boost GDP a little more than dollar-for-dollar of reduced tax collections and increased outlays. However, as large as the stimulus package is, the contraction in underlying demand is far larger, so the stimulus will offset only part of the contraction.
• Most experts believe that larger budget deficits are appropriate during recessions, because higher spending and lower taxes can bring the levels of resource use and output closer to the economy’s potential. Therefore, the extremely large deficit this year—roughly $1.7 trillion, or nearly 12 percent of GDP, in CBO’s March projection—serves a purpose. However, most experts also believe that persistent large deficits reduce capital accumulation and thereby slow the growth of output and incomes over time. Thus, the large deficits that CBO projects for the years after the economy has returned to full employment are more worrisome. Moreover, the sharp increase in debt this year and next raises the risk that investors might lose confidence in U.S. government debt as a safe haven. This risk heightens the importance of putting the budget on a sustainable path as the economy returns to full employment.

As I discussed yesterday, I participated in two panels at the Milken Institute’s Global Conference in Los Angeles on Monday.  The second panel was about “Infrastructure Projects as Economic Stimulus.” You can view the slides and webcast.

My main observations at this second panel were:

• Some of the infrastructure spending in the stimulus package would pass a cost-benefit test even apart from the recession.  For example, CBO’s analysis of infrastructure investment last year concluded that “additional spending of up to tens of billions of dollars each year on transportation infrastructure projects” could be justified as having benefits that exceed the costs.  We warned that economic returns on specific projects vary widely, so specific investments should be selected carefully.  In addition, we explained that some of the additional spending could be avoided by creating incentives to use existing infrastructure more efficiently—such as congestion pricing, which we analyzed more fully earlier this year.  Still, additional targeted infrastructure investment could be appropriate even in normal times. Moreover, these are not normal times, and it may be appropriate to undertake more immediate infrastructure spending than otherwise in order to put idle resources to use.

• CBO projected that infrastructure spending approved in the stimulus legislation would generate outlays—and thus economic stimulus—only gradually.  For example, we are looking for increases in federal highway spending to be 10 percent of the amount appropriated in the rest of fiscal year 2009, 25 percent in FY 2010, 20 percent in FY 2011, and a declining share thereafter.  Although the sluggishness of this projected spend-out surprised some observers, we explained that the need to draft plans, solicit bids, enter into contracts, and then to undertake the work (during appropriate weather) had led previous increases in budgetary resources for highways to be followed by increases in                                      

            Budgetary Resources and Outlays for Highways 

Source: Congressional Budget Office

outlays with a measurable lag. Lags in other areas of infrastructure spending can be even longer, especially where programs are new or receive significant boosts in funding relative to recent years—descriptions that fit provisions in the stimulus package focused on weatherization and broadband expansion among others.  CBO projects that total infrastructure outlays resulting from the stimulus package will peak in 2010 and 2011 but will remain significant for a number of years.  

Infrastructure Outlays as a Result of the American Recovery and Reinvestment Act



Source: Congressional Budget Office

• Very early data on the use of funds approved in the stimulus package are consistent with this perspective.  For example, the Department of Transportation has reported that $7 billion has been obligated for highway spending but only a few million federal dollars have been spent.