The Federal Budget: Sources of the Movement from Surplus to Deficit

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

The federal budget moved from a surplus of $128 billion in 2001 to a deficit of $413 billion in
2004. In 2007, the deficit equaled $163 billion. This report compares the actual budget balance
from 2001 to 2007 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 seven years as a whole, legislative changes accounted for
about two-thirds of the cumulative shift from projected surplus to deficit. The largest legislative
changes that increased the deficit were tax cuts 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 7% of the cumulative shift to deficit over the past seven 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 one-fourth of the cumulative shift to deficit over
the past seven years. Large technical changes point to the great 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 2007. Nor has
the decline in the deficit since 2004 been attributable to legislative changes, which have
continued to rise in cost over this period. Cumulatively, legislative changes accounted for 98% of
the shift to deficit in 2007. This report will be updated annually.

n 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 $163 billion in 2007. Why did the budget move from surplus to I

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 ¹
growth because of the deficit’s expansionary effects on aggregate spending.
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. For example, entitlement spending can increase automatically if the number of
beneficiaries increases. 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 ²
year. 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 ³
time that if policy had not changed, the surplus would have grown each year. 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 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.

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^Ec^onom^ic^Polic^y^#3^{, Fe}^br^ua^r^y^2006.

As seen in Table 1, CBO projected a 2007 budget surplus of $573 billion under the policies in
place in January 2001. The actual budget deficit in 2007 turned out to be $163 billion. In other
words, the difference between CBO’s 2001 projection and the actual outcome was $736 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
$810 billion.
Table 1. Differences Between 2001 Baseline Projections and the Actual Budget
Balance, 2001-2006
^{($ in billions)}
²⁰⁰¹²⁰⁰^{2 200}^{3 200}^{4 200}^{5 200}^{6 200}⁷
^Baseline^Surplus^Projectionⁱⁿ^Jan^.²⁰⁰¹^{281 313 359 397 433 505 573}
^Legislative^Changes^-81^{-150 -363 -519 -543 -632 -721}
^Revenue^(Tax^C^uts)^-74^-81^{-186 -272 -218 -199 -233}
^Non-Defense^{Discretionary}^Spen^ding⁰^{-12 -35 -49 -65 -93 -83}
^Defense^Spe^nding⁰^-38^-84^{-122 -155 -177 -205}
^Mandatory^Spe^nding^-7^{-14 -43 -41 -41 -72 -72}
^Debt^Service⁰^-5^{-15 -37 -60 -93}^-131
^Economic^Changes^{-37 -121}^{-113 -59}²¹⁵²⁰
^{Technical Changes}^-35^-201^-259^-231^-206^-137^-34
^Total^Changes^{-153 -471 -737 -810 -751 -753 -736}
^Actual^Budget^Sur^{plus(+)/Deficit(—)}¹²⁸^{-158 -378 -413 -319 -248 -163}
^Source:^CBO,^{Budget and Economic Outlook,}^Ja^nuar^{y 2}⁰⁰²^{to Jan}^u^{ary 2}⁰⁰^7,^{An Analysis of the Preside}^{nt’s Budgetary}
^Proposals^,^Ma^rch²⁰^{02 to}^Marc^{h 2}^007.
^Notes:^{Debt service refers}^{to additional}^{interest payme}^{nts made}^{on the}^{national debt resulting f}^{rom all}
^legislat^{ive changes to re}^ven^{ues or}^{outlays. Columns may not}^{be ad}^{ditive due to rounding. In th}^{e Jan}^uary^baseline,
^{CBO does not report c}^hanges^{to the p}^{revious year}^b^{udget deficit that occur}^{red since t}^{he Aug}^ust^b^aseline.
^{Therefore, any}^cha^{nges bet}^ween^{the actual deficit and t}^{he bas}^{eline deficit reported in Aug}^{ust ha}^{ve b}^een
^{apportioned evenly}^betwee^{n eco}^{nomic and tech}^{nical change}^s.
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.
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 two-thirds of the cumulative shift from surplus to deficit over the past seven
years. The legislative changes that increased the deficit the most were the tax cuts (the largest of
which were P.L. 107-16 and P.L. 108-27) and the increase in military spending in Iraq and ⁴
Afghanistan. For the cumulative total increase in the deficit between 2001 and 2007, 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

⁴^T^h^{e co}^st^o^f^reven^u^e^ch^an^{ges h}^a^{s d}^eclⁱⁿ^ed^siⁿ^{ce 2}⁰⁰⁴^b^ecau^{se o}^f^t^h^{e exp}ⁱ^ratⁱ^oⁿ^o^f^cert^aⁱⁿ^t^a^{x p}^r^o^vⁱ^sⁱ^oⁿ^s^,^m^o^st^no^t^a^b^l^y
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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 2007.
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 become smaller that the deficit has declined since
2004. In 2007, the cumulative effects of legislative changes were responsible for 98% 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 2007. 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, where it remained in 2007.
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 seven years as a whole, economic changes accounted for about 7% of the shift to deficit. The
effect of the economy on the budget balance actually turned out to be slightly better in 2005,

2006, and 2007 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

⁵^D^e^{bt s}^e^r^v^ic^e^is^e^x^c^l^ude^{d f}^r^om^this^c^a^l^c^u^la^{tion s}ⁱ^nc^e^the^de^{bt s}^e^r^v^ic^e^s^how^{n in t}^h^e^ta^ble^is^the^dir^e^c^t^r^e^s^u^{lt of}^ot^he^r
^l^e^gi^sl^atⁱ^v^{e ch}^an^ge^{s t}^h^atⁱⁿ^creased^go^vern^m^eⁿ^t^b^o^r^r^o^wⁱⁿ^g^.^(Deb^t^servi^{ce al}^soⁱⁿ^creased^b^ecau^{se o}^f^ec^onom^ic^a^nd
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the last six years overall, technical changes accounted for about one-quarter of the shift from
surplus to deficit.
Large economic and 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 2007 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 2007 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 2007—made before the tax
cuts were enacted—turned out to be extremely close to the actual state of the economy in 2007. 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 2007 (on
a fiscal year basis); actual growth in those years equaled 3.0%. Furthermore, there were
extremely large technical revisions from 2002 to 2006, mostly because tax revenue turned out to
be lower than expected (after taking the tax cuts into account) each year. If anything, this would ⁶
suggest that tax cuts cost more in reality than the original score had anticipated, rather than less.
^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^m^l^abon^t^e^@^c^rs^.l^oc.g^o^v^{, 7-}⁰⁶⁴⁰

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