Where Is the Federal Budget Going?

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It is tax season again, and several reforms to the federal budget have been or are expected to be proposed. It is thus timely to revisit the most current federal budget projections to see where we are and where we are headed.

The table below summarizes the projections made by the Congressional Budget Office (CBO) in January, based on the law at the time. The table includes the projections for the current fiscal year and 10 years out.¹ Fiscal year 2016 is included for reference. All figures are expressed as percentages of gross domestic product (GDP).

As we can see, the federal budget projected for 2017 looks very similar to 2016 under current law. The deficit will be around 3 percent of GDP, and debt held by the public will remain below 80 percent of GDP.²

As we move forward 10 years, we see a slight increase in revenues relative to GDP coupled with a substantial increase in outlays relative to GDP. The end result is a projected increase in the deficit, expected to be about 5 percent of GDP by 2027. The cumulative effect of projected deficits over the next decade implies that debt held by the public will increase to almost 90 percent of GDP.

By far, the biggest contributors to federal coffers are individual income and payroll taxes.³ Relative to GDP, individual income taxes are the only component of total revenue that is expected to increase over the next decade; all others components are expected to remain the same or decrease.

In part, the increase in individual income taxes results from real “bracket creep.” That is, as income increases faster than prices, larger proportions of income are subject to higher tax rates. This is one item that Congress may arguably revise in the future, so it is not unreasonable to expect that revenues will not increase as much as the current projections suggest.

The corporate income tax has received recent attention due to the proposed “border adjustment tax,” which would reduce the corporate income tax rate. What is noteworthy, however, is how little this item contributes: less than 10 percent of overall revenue, or about 1.6 percent of GDP.

On the expenditures side, total outlays are projected to increase significantly over the next decade, exceeding 23 percent of GDP by 2027. Discretionary expenditures are projected to continue declining as a percentage of GDP, due to reductions in both defense and non-defense spending. Current budget proposals suggest that defense spending may instead be substantially increased in the near future, reversing the current downward trend.

About two-thirds of outlays consist of mandatory spending. Social Security and health care are two of the main drivers of the projected increase in total expenditures. Their combined burden is projected to rise from 10.4 percent to 12.9 percent of GDP between 2017 and 2027.

Projections on Social Security spending are fairly reliable, as they depend largely on demographic factors and are unlikely to be changed drastically by innovations to the law. Projections on health care expenditures, on the other hand, should be taken with more reservation, due to uncertainties about both the economic effects of the current system and the extent of revisions to the law.

The interest on the debt is another important contributor to the growing deficit. The projected increase follows from higher expected interest rates. However, there are many good reasons why we shouldn’t expect nominal interest rates to return to their historical average.⁴ If such is the case, then current projections would be overstating the deficit, perhaps by as much as one percentage point of GDP.

¹ The U.S. fiscal year begins Oct. 1, ends Sept. 30 of the subsequent year and is designated by the year in which it ends.

² Debt held by the public excludes holdings by federal agencies (mainly, the Social Security trust funds), but includes holdings by the Federal Reserve System.

³ Payroll taxes are those withheld by employers and paid on behalf of their employees and are calculated on the basis of wages or salaries. Employers also match Social Security and Medicare contributions and are subject to additional taxes (e.g., the federal unemployment tax). In addition, self-employed individuals pay a self-employment tax, similar to the payroll tax withheld from most employees.

⁴ For example, see Martin, Fernando. “A Perspective on Nominal Interest Rates.” Economic Synopses, Federal Reserve Bank of St. Louis, Dec. 16, 2016.

• On the Economy: The Rise and Fall of Nominal Interest Rates
• On the Economy: Why Does Economic Growth Keep Slowing Down?
• On the Economy: Federal Income Taxes by Income Bracket