Order Code RS22550
December 8, 2006
The Federal Budget: Sources of the
Movement from Surplus to Deficit
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division
Summary
The federal budget moved from a surplus of $128 billion in 2001 to a deficit of
$413 billion in 2004. In 2006, the deficit equaled $248 billion. This report compares
the actual budget balance from 2001 to 2006 to the projection made by the
Congressional Budget Office (CBO) in January 2001 to determine what factors caused
the budget to move from surplus to deficit. Actual results differed from CBO’s
projection for three reasons: legislative policy changes, economic changes, and technical
changes. Over the past six years as a whole, legislative changes accounted for about six-
tenths of the cumulative shift from projected surplus to deficit. The largest legislative
changes that increased the deficit were the tax cuts enacted between 2001 and 2004 and
the increase in military spending in Iraq and Afghanistan.
The economic slowdown increased the size of the deficit from 2001 to 2003. Since
then, the economy has had almost no effect on the deficit. Actual economic growth in
recent years has been nearly identical to what CBO projected before the tax cuts were
passed. This casts doubt on the claim that the tax cuts partly paid for themselves by
boosting economic growth. Overall, economic changes accounted for about one-tenth
of the cumulative shift to deficit over the past six years.
Technical changes to the projections occur when actual results turn out to be
different from the non-economic assumptions that are the basis of the projections for
mandatory spending and revenues. Technical changes accounted for about three-tenths
of the cumulative shift to deficit over the past six years. Large technical changes point
to the significant uncertainty behind budget projections, even over short periods of time.
Legislative reductions in revenue and increases in spending since 2001 have been
large enough that even if economic and technical changes had been zero (that is, even
if CBO’s projection had been perfectly accurate), the budget would still have been in
deficit from 2003 to 2006. Nor has the decline in the deficit since 2004 been attributable
to legislative changes, which have continued to rise in cost over this period. This report
will be updated annually.
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In FY2001, the federal budget recorded a surplus of $128 billion. The next year, the
budget moved into deficit and has remained there since. The deficit peaked at $413
billion in 2004, and has since fallen to $248 billion in 2006. Why did the budget move
from surplus to deficit? The simple answer is because Congress chose an overall level
of spending that exceeded their chosen revenue levels. The budget is the sum of its parts,
so no particular spending or tax decision can be taken in isolation and be said to have
“caused†the deficit in an absolute sense.
Furthermore, some determinants of spending and revenues are not directly controlled
by Congress. When economic conditions change, spending and revenues automatically
change without any change in law. For example, when economic growth slows, the
growth of taxable income slows, so that less revenue is collected at a given tax rate than
previously. Likewise, if a slowdown in economic growth causes unemployment to rise,
spending on unemployment insurance and other means-tested mandatory spending
programs will also rise without any change in law. Economists refer to these changes as
“automatic stabilizers†because they automatically cause the deficit to rise when the
economy slows, thereby helping to offset the slowdown in growth because of the deficit’s
expansionary effects on aggregate spending.1
For a more detailed answer to the question of why the budget moved from surplus
to deficit, it is necessary to have some benchmark to which the actual deficit can be
compared. One benchmark would be to compare the 2006 deficit to the 2001 surplus, but
this approach would be fraught with several difficulties. For one thing, spending and
revenues are expected to rise over time because of inflation, economic growth, and so on,
so that $1 spent in 2006 is not comparable to $1 spent in 2001. For another, the economy
in 2006 is not at the same level of production or in the same position in the business cycle
as the economy in 2001, so the economy’s effect on the budget is not the same either.
Finally, the same law yields different levels of spending or revenue over time. Therefore,
comparing spending or revenue levels from one year to the next could give the false
impression that policy had changed when it had not.
This report uses a different benchmark: it compares the actual budget balance in the
past six years to the January 2001 Congressional Budget Office’s (CBO) baseline
projection of the surplus for each of those years. CBO produces an updated 10-year
budget baseline projection twice every year.2 The baseline is a projection of the future
path of government spending and revenues under current policy assuming no changes in
the law. As can be seen in Table 1, CBO projected at that time that if policy had not
changed, the surplus would have grown each year.3 Any year could have been chosen as
the benchmark; this report uses their 2001 baseline as the benchmark because their 10-
year surpluses peaked in this projection. In subsequent reports, the surplus projections
would be continually adjusted downward, as CBO became progressively more pessimistic
1 See CRS Report RL31235, The Economics of the Federal Budget Deficit, by Brian Cashell.
2 For the most recent CBO baseline, see Congressional Budget Office, The Budget and Economic
Outlook: An Update, Aug. 2006.
3 See CRS Report RL31414, Baseline Budget Projections: A Discussion of Issues, by Marc
Labonte. For an alternative evaluation, see Alan Auerbach et al., “New Estimates of the Budget
Outlook,†Brookings Institution, Issues in Economic Policy #3, Feb. 2006.
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about the future path of revenues, until the Fall 2004 report. Since then, CBO has become
more optimistic about future revenues, although revenues are still far lower today than
they were projected to be in 2001. Thus, the results that follow are partly a function of
the benchmark chosen.
As seen in Table 1, CBO projected a 2006 budget surplus of $505 billion under the
policies in place in January 2001. The actual budget deficit in 2006 turned out to be $248
billion. In other words, the difference between CBO’s 2001 projection and the actual
outcome was $753 billion. The difference between projections and actual results peaked
in 2004, when the deficit equaled $413 billion, compared with a surplus of $397 billion
that had been projected in 2001, a shift of $810 billion. As these results suggest, budget
projections — even over relatively short periods of time — are prone to large errors far
beyond effects that can be explained by policy changes.
Table 1. Differences Between 2001 Baseline Projections and the
Actual Budget Balance, 2001-2006
($ in billions)
2001
2002
2003
2004
2005
2006
Baseline Surplus Projection in
281
313
359
397
433
505
Jan. 2001
Legislative Changes
-81
-150
-363
-519
-543
-632
Revenue (Tax Cuts)
-74
-81
-186
-272
-218
-199
Non-Defense
0
-12
-35
-49
-65
-93
Discretionary Spending
Defense Spending
0
-38
-84
-122
-155
-177
Mandatory Spending
-7
-14
-43
-41
-41
-72
Debt Service
0
-5
-15
-37
-60
-93
Economic Changes
-37
-121
-113
-59
2
15
Technical Changes
-35
-201
-259
-231
-206
-137
Total Changes
-153
-471
-737
-810
-751
-753
Actual Budget
128
-158
-378
-413
-319
-248
Surplus(+)/Deficit( — )
Source: CBO, Budget and Economic Outlook, January 2002 to January 2006, An Analysis of the
President’s Budgetary Proposals, March 2002 to March 2006.
Notes: Debt service refers to additional interest payments made on the national debt resulting from all
legislative changes to revenues or outlays. Columns may not be additive due to rounding. In the January
baseline, CBO does not report changes to the previous year budget deficit that occurred since the August
baseline. Therefore, any changes between the actual deficit and the baseline deficit reported in August have
been apportioned evenly between economic and technical changes.
Differences between the projections made in 2001 for the budget balance and the
actual budget balance in each of the past six years can be attributed to three broad causes:
legislative, economic, and technical changes.
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First, revenues have fallen and spending has risen due to legislative changes,
because, as expected, policy has changed since CBO made its projection in 2001.
Overall, legislative changes account for about three-fifths of the cumulative shift from
surplus to deficit over the past six years. The legislative changes that increased the deficit
the most were the tax cuts enacted between 2001 and 2004 and the increase in military
spending in Iraq and Afghanistan.4 For the cumulative total increase in the deficit
between 2001 and 2006, tax cuts accounted for about half of all legislative changes and
military spending accounted for about one quarter, with the other quarter being caused by
higher mandatory and non-military discretionary spending.5 Comparing legislative
changes to the baseline surplus projection made in 2001 demonstrates that, even if there
had been no economic downturn or any other projection error, legislative changes alone
would still have caused a budget deficit in each year from 2003 to 2006. The comparison
also demonstrates that the decline in the deficit since 2004 is unrelated to policy changes.
Legislative causes of the deficit have grown each year since 2001; it is only because
economic changes and technical changes have declined that the deficit has declined since
2004. In 2006, legislative changes were responsible for over four-fifths of the shift to
deficit.
These legislative changes helped move federal revenues as a share of gross domestic
product (GDP) from a 50-year high in 2000 to a 45-year low in 2004. The subsequent rise
in revenues brought revenues slightly above the 50-year average share of GDP in 2006.
Meanwhile, federal spending as a share of GDP rose from its lowest level in 35 years in
2000 to a level about equal to the 50-year average in 2004, then rising slightly in 2006.
Of course, an estimate of how much higher spending contributed to the shift to
deficit depends on one’s baseline definition of spending under current policy. Because
discretionary spending is largely determined on an annual basis and not bound by previous
year law, there is no obvious definition of current policy for discretionary spending.
CBO’s mandated definition of current policy is that discretionary spending grows at the
same rate as inflation. Many analysts have criticized this definition as being too low
because it would have consistently under-predicted spending historically. If a higher rate
of spending growth (i.e., a rate equal to GDP growth) was assumed to represent current
policy, then CBO’s original estimates of future surpluses in 2001 would have been
smaller, and higher spending would have subsequently accounted for a smaller proportion
of the shift to deficit.
Second, actual economic conditions have differed from CBO’s 2001 projection. As
a result, revenues and spending are different than projected because of “automatic
stabilizers,†higher than expected inflation, and lower than expected interest rates. These
are shown as economic changes in the table. The economic recession of 2001 was an
important cause of the deficit in 2002 and 2003, but after 2003, economic conditions
made barely any contribution to the shift to deficit. For the six years as a whole,
4 The cost of revenue changes has declined since 2004 because of the expiration of certain tax
provisions, most notably accelerated depreciation for corporate investment.
5 Debt service is excluded from this calculation since the debt service shown in the table is the
direct result of other legislative changes that increased government borrowing. (Debt service also
increased because of economic and technical changes, but that is not broken out separately in the
table.)
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economic changes accounted for about one-tenth of the shift to deficit. The effect of the
economy on the budget balance actually turned out to be slightly better in 2005 and 2006
than was projected in 2001.
Third, after legislative changes and the estimated effect of the economy are
accounted for, the remaining difference between the original projection and actual results
is classified as technical changes. These changes occur because CBO’s projections of
revenues and mandatory spending are also based on other technical assumptions unrelated
to the state of the economy, and actual results will differ from these assumptions as well.
For example, mandatory spending levels will depend on program participation rates that
will differ from projected participation rates. Similarly, tax revenues will depend not only
on the growth in income, but how quickly tax liability rises as income rises and how
income growth is distributed across taxpayers. Most technical changes tend to be on the
revenue side rather than the spending side of the budget. Technical changes peaked as a
cause of the shift to deficit at $259 billion in 2003, and have declined somewhat since
then. For the last six years overall, technical changes accounted for about three-tenths of
the shift from surplus to deficit.
Large technical changes point to the significant uncertainty behind budget
projections, even over short periods of time. For example, holding policy constant, the
2001 surplus was $72 billion smaller ($37 billion due to economic changes, $35 billion
due to technical changes) than CBO’s projection made only nine months earlier.
Some technical changes are the result of legislative changes. The cost of the
legislative changes listed in Table 1 are ex ante projections of their cost (as scored by
CBO and the Joint Committee on Taxation) made at the time the policy was enacted. If
policies turned out to be more (less) expensive than the official score, this would appear
in the table as a negative (positive) technical change. There has been recent discussion
that the 2006 deficit was smaller than anticipated because the tax cuts partly “paid for
themselves†through higher economic growth, an effect that was not included in their
original score. Table 1 suggests otherwise — although the 2006 deficit was smaller than
anticipated in projections made in 2004 and 2005, when CBO was extremely pessimistic
about future revenues, the deficit was much larger than anticipated in projections made
before 2004. The 2001 projection of the state of the economy in 2006 — made before the
tax cuts were enacted — turned out to be extremely close to the actual state of the
economy in 2006. In other words, the actual performance of the economy after the tax
cuts was almost identical to how CBO expected the economy to perform had there been
no tax cuts. For example, CBO projected in 2001 that economic growth (without tax
cuts) would average 3.1% between 2003 and 2005 (on a calendar year basis); actual
growth in those years equaled 3.2%. Furthermore, there were extremely large technical
revisions in the last five years, mostly because tax revenue turned out to be lower than
expected (after taking the tax cuts into account) each year from 2002 to 2006. If anything,
this would suggest that tax cuts cost more in reality than the original score had
anticipated, rather than less.6
6 See also CRS Report RL32502, What Effects Have the Recent Tax Cuts Had on the Economy?
by Marc Labonte; and CRS Report RL33672, Revenue Feedback from the 2001-2004 Tax Cuts,
by Jane G. Gravelle.