Big recession, big budget deficits
Fiscal year 2012 kicked off on Oct. 1 to an economy roughly $1 trillion (-6.2 percent) below potential economic output—the level of economic activity that would be associated with full employment and industrial capacity utilization. This economic slack has significant consequences for the budget deficit because revenues are lower and more Americans rely on the social safety net.
Recently, the Congressional Budget Office estimated that this portion of the budget deficit attributable to economic weakness is $340 billion this fiscal year (FY2012). In other words, if the unemployment rate were closer to 5 percent, the budget deficit would be around a third lower than its projected level ($973 billion, or 6.2 percent of GDP). CBO’s methodology and older estimates can be found here.
While sizable, these estimates understate the impact of the recession on the budget by only focusing on economic variables and ignoring deliberate legislative efforts to prop up the economy. Objectively stimulative provisions in last December’s tax and insurance compromise added $124 billion to this year’s deficit (in addition to the $299 billion added to the deficit by extending current tax policies), the Recovery Act added $49 billion, and supplemental stimulus extensions (UI, helping states with their Medicaid bills, and a teachers’ jobs fund) added $1 billion. Similarly, tax deal stimulus added $157 billion to last year’s deficit, the Recovery Act added $163 billion (net of the alternative minimum tax patch, which wasn’t stimulus), and supplemental stimulus extensions added roughly $47 billion to last year’s deficit.
Adjusting the budget deficit (less cyclical contributions) for these legislative decisions, the effective impact of the recession is closer to $699 billion last year and $514 billion this year, or about 54 percent of last year’s actual budget deficit and 53 percent of this year’s deficit.
Even adjusting for legislated economic support underestimates the impact of the recession, because many economically sensitive projections, such as decreased revenue from capital gains realizations, show up in CBO’s ‘technical revisions’ rather than the cyclical economic revisions. Technical revisions are residual non-legislative, non-economic changes in projected receipts and mandatory outlays, influenced by factors such as the distribution of tax filers through income brackets or effective tax rates. Kitchen (2003) finds that economic and technical revisions demonstrate a statistically significant and close relationship, particularly with personal income receipts. Since the start of the recession, technical revisions to CBO’s budget outlook have cumulatively added $139 billion to the FY2011 budget deficit and $246 billion to the FY2012 deficit.
Stripping out the combined impact of cyclical economic factors, stimulus legislation, and technical revisions, this year’s structural deficit would be $223 billion, or 1.4 percent of GDP. Last year’s structural deficit would have been $446 billion, or 3.0 percent of GDP. Put differently, a host of recession-related factors account for at minimum half and upwards of 65 percent of last year’s deficit and 77 percent of this year’s deficit.
This analysis shows just how sensitive the budget is to economic activity and employment. Unfortunately, the economy faces a big drop off in deliberate fiscal support between last year and this year. Goldman Sachs recently estimated that under current law, U.S. fiscal policy will shave 1.8 percentage points from GDP growth in calendar year 2012 (or one percentage point even if the payroll tax cut is extended). We estimate that the debt ceiling deal’s initial spending cuts, coupled with failure to extend the payroll tax cut and UI, would shave 1.5 percent off growth and lower employment by 1.8 million jobs in 2012.
Congress needs to change course and enact more economically supportive policy to put millions of Americans back to work and improve the fiscal outlook.