CBO report shows two vastly different baselines moving closer together

Yesterday, the Congressional Budget Office (CBO) released their updated budget baseline in the February 2013 Budget and Economic Outlook report.  One interesting takeaway is that projected deficits for the new ten-year budget window are $7 trillion, whereas last August the agency projected $2.3 trillion in total deficits over 2013-22.1 Why such a large change in projected deficits?

First of all, the August baseline assumed the expiration of a variety of tax provisions, including the Bush tax cuts, the Alternative Minimum Tax patch, a variety of business tax extenders, indefinite war spending, a massive cut to Medicare doctors’ payment rates, and sequestration. Though CBO always calculates these baseline projections with respect to current laws, it was clear that this was not a realistic baseline and that the current policy baseline was a more accurate depiction of likely ten-year budget projections.

Secondly, each time the CBO updates their baseline budget projections, they take into account legislative, economic, and technical changes that have occurred since the previous update—changes that impact the size of projected surpluses or deficits. In this instance, passage of the American Taxpayer Relief Act of 2012 (ATRA) caused enormous changes that pretty much explain the entire increase in projected deficits (excluding debt-service costs, ATRA boosted projected deficits by $4 trillion). ATRA impacted future revenue levels by:

  • Permanently extending the Bush income tax rates for all income under $400,000 ($450,000  for joint filers); a provision that, though helpful for lower-and middle-income earners while the economy remains depressed, is already proving to be very costly down the road. In fact, lower income tax rates—which for the past number of years have been set to expire under current law but routinely thought to be extended under current policy—have been responsible for much of the disparity between these baselines for the last few years. These tax cuts, legislated in 2001 and 2003, and extended in 2010, have also played a considerable role in contributing to the massive swing from surpluses to deficits experienced since roughly 2001.
  • Permanently extending preferential capital gains and dividends tax rates. Under pre-ATRA law, the capital gains tax rate was scheduled to rise from 15 to 20 percent, and dividends were scheduled to be taxed the same as ordinary income. Current law now has most taxpayers facing 15 percent rates and high-income taxpayers facing 20 percent rates. Locking in these lower rates adds to future deficits.
  • Permanently extending higher exemption amounts for the alternative minimum tax, and indexing those for inflation. Prior to ATRA, Congress would continually “patch” the AMT, as opposed to pursuing a permanent and costly fix to the policy. Consequently, previous CBO current law baselines counted significantly more revenue from the AMT than was realistic; this current law baseline does not do that.
  • Modifying estate and gift tax policy by keeping threshold levels at income over $5 million (though indexed to inflation) and raising the top rate to 40 percent. Previous current law baselines had the estate tax rising to 55 percent and the amount subject to taxation dropping to around $1 million. As a result, the 2013 report reduces projected revenues from estate and gift taxes by about $350 billion over the decade.

The CBO report reveals what many have suspected: higher projected deficits are due to the deterioration of the current law baseline toward the current policy baseline, and policies passed under ATRA caused this.  The current policy baseline has consistently been regarded among budget circles as a more realistic projection, and ATRA made some very costly policies permanent, bringing the two baselines closer together. Since the current policy baseline has actually been the baseline that has mattered in budget discussions, these big changes to the current law baseline (for instance, 77 percent debt-to-GDP ratio at the end of the ten-year window as opposed to 58.5 last August) should be taken with a grain of salt. They certainly should not be used as new evidence that greater deficit reduction over the next decade is needed; as we have often argued, deficit reduction that imposes a drag on growth really should not begin at all until the economy moves much closer to full employment. And as the CBO report notes, that is not happening any time soon. CBO projects the unemployment rate will remain above 7.5 percent through 2014.

1. This is not simply an issue of the window shifting, either. The February Budget and Economic Outlook report shows deficits over 2013-22 (as opposed to the 2014-23 window) totaling $6.9 trillion.