Like all of us, the government's income and spending don't always match. Sometimes the government spends more money than it takes in--a budget deficit. When the opposite occurs, and the government's revenue exceeds expenses, that is known as a budget surplus. Sounds simple, but predicting how long a deficit or surplus will last and which one will occur from year to year has proved to be a complex task for economists.

After running deficits that averaged almost $200 billion a year from 1989 to 1997, the federal government recorded a budget surplus of $69.2 billion in fiscal year 1998--the first surplus in more than 25 years. Over the next two years, as the economy strengthened, the federal surplus nearly quadrupled, rising to just under $240 billion in fiscal year 2000. In May 2001, the Congressional Budget Office (CBO) projected that it expected this trend to continue in the form of federal surpluses totaling just over $5.6 trillion between fiscal years 2002 and 2011.

Unforeseen Obstacles

These CBO projections were based on the assumptions that the economy would continue to grow robustly, with no new tax cuts or increases in government spending. Given that trillions of dollars are involved, even small errors in these assumptions about economic conditions have the potential to become quite large when compounded over a decade. In fact, as late as 1997, the CBO and most private forecasters were projecting large and rising budget deficits over the next decade.

Of course, the CBO could not have foreseen the events of Sept. 11, the subsequent war on terrorism and the 2001 recession. And while budget forecasters might have surmised from the 2000 presidential campaign that, if elected, George W. Bush planned to pursue cuts in marginal tax rates, the rules of the game prevented forecasters from adjusting their budget projections accordingly. In its January 2002 report, the CBO now projects that federal surpluses for fiscal years 2003 to 2012 will add up to about $2.2 trillion, with small deficits projected for 2002 and 2003.

Hitting Full Stride

Government finances typically deteriorate during recessions. When the economy weakens, it slows down the growth of incomes--and, as a result, tax revenues. Meanwhile, expenditures on unemployment insurance and other income-support programs tend to increase. This effect can be compounded during times of war. In 2001, the U.S. economy experienced all of these conditions, and the end result was no surprise: Government surpluses at the federal, state and local levels diminished markedly. Because government budget balances tend to move in tandem with the economy, it seems reasonable to conclude that the fiscal outlook will improve once the turmoil of war and recession passes.

On average, federal budget balances as a percentage of GDP (gross domestic product) fall by about 2 percent during recessions. The deterioration in state and local budget balances as a percentage of GDP is much less--0.3 percent, which is expected given their balanced-budget requirements. Nonetheless, state and local government finances did benefit from strong U.S. economic growth during the late 1980s and early 1990s. During that period, total state and local government receipts grew by an average of 7.5 percent a year, while expenditures were rising by an average of 7.7 percent a year. From 1995 to 2000, the situation reversed: Growth of state and local revenues averaged 5.9 percent a year, while their expenditures increased by 5.7 percent a year. Accordingly, budget surpluses built up. In response, net tax reductions occurred at the state level each year for fiscal years 1995 to 2001.

Down the Stretch

As the economy turned down in late 2000, state and local budgets once again came under increasing pressure. As the growth of tax revenues slowed dramatically, many states--most of which operate under some sort of balanced-budget requirement--were forced to trim planned outlays, raise taxes and/or redirect money from "rainy day" funds.

At the state and local level, policymakers are struggling to cope with large increases in Medicaid spending. From 1987 to 2000, state spending on Medicaid had risen by nearly 12 percent a year, outstripping the percentage growth of all other major expenditures. As a result, Medicaid is now the second-largest expenditure of state governments, just behind spending on elementary and secondary education. An additional uncertainty is the extent to which federal resources will be diverted to state and local governments to implement several of the new initiatives designed to enhance homeland security.

At the federal level, the budget balance may improve this year. During the early phase of an economic expansion, the federal government's budget balance typically increases by approximately 1.3 percent of GDP. In other words, tax revenues typically grow faster than do government expenditures in the early phase of an expansion. Thus, if forecasters are correct in their assessment of how strong the economy will be in 2002, the federal budget could end the year in the black.

This article was adapted from "Government Budget Surpluses Head South," which was written by Kevin L. Kliesen and appeared in the April 2002 issue of The Regional Economist, a St. Louis Fed publication.

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