Long-Term Economic Growth and Budget Projections

Publication Date: March 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

The federal budget affects, and is affected by, the performance of the economy. Because of the effects of the economy on the budget, policy decisions regarding the overall levels of spending and taxes require some idea of how the economy is likely to perform. For this reason, both the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) prepare, twice a year, a set of economic projections on which to base consideration of budget policy.

Economic growth affects both spending and taxes. Faster economic growth means higher tax receipts, because of the interaction of higher incomes with progressive personal income tax rates. Faster economic growth reduces outlays because the debt, and interest payments on that debt, are smaller than otherwise would be the case. In the short run, faster economic growth also means lower rates of unemployment, and thus reduced income support payments.

The long-run growth rate of the economy is primarily determined by the growth rate of the labor force, and the rate of growth of productivity. Labor force growth can be estimated from data regarding the age distribution of the population and is fairly straightforward. Projecting productivity growth is more difficult.

Economists have an incomplete understanding of the factors that contribute to productivity growth. Past variations in productivity growth have yet to be fully explained. Many economic models take productivity growth as a given, something that is determined outside of the models themselves. Often, projections of productivity are simply extrapolations of recent trends, which may be adjusted to reflect the relative optimism or pessimism of the forecaster.

This paper examines the accuracy of past forecasts of economic growth by OMB, CBO, and the Blue Chip Economic Indicators, beginning with 1985. For the most part, the three forecasts did about equally well. CBO and the Blue Chip forecasts tended to be slightly pessimistic, on average, but there was no evidence of a statistically significant bias in any of the forecasts. Neither was there any tendency for errors to increase the further into the future the forecasts go.

Slower expected economic growth reduces projected revenues and increases projected outlays. The effect on revenues is substantially larger than the effect on outlays, but over five years, just 0.1% slower growth increases the cumulative projected deficits by $38 billion. This report will be updated annually.