New CBO Outlook Adds Fuel to Budget Fight – Washington Polic
On February 15, the CBO released its Budget & Economic Outlook, outlining a worsening U.S. fiscal environment and amplifying the coming fiscal fights in Washington. U.S. debt-to-GDP is projected to increase to 118% from 97% by 2033, higher interest rates are increasing debt servicing costs, and long-term demographic pressures are building into Social Security and Medicare.
The Congressional Budget Office (CBO) update added $3.4 trillion of new deficits over the next 10 years since its May 2022 forecast. More than half of this increase is the result of legislation and executive actions taken since last summer and another 40% is due to a change in the economic environment—most notably, higher inflation and its effect on interest rates. As such, the CBO projects that federal spending will remain elevated at roughly 24% of GDP, significantly above the budget’s long-run average of 20% of GDP and more consistent with an economic emergency level of spending. These elevated spending levels are not being matched with higher tax revenues, leading to higher deficits and faster debt accumulation.
Interest costs are in a regime change. For the past 35 years, the U.S. government has been able to cut taxes and increase spending without a meaningful change in the budget’s debt-servicing cost. As long as inflation was low, interest rates stayed low and debt-servicing costs were manageable. Those days are over due to higher inflation. As interest rates rise to squeeze out inflation, the net interest cost on the debt increases. The CBO underestimated interest costs by $76 billion in FY22 and $198 billion in FY23. Importantly, increased spending on interest crowds out other spending items. Historically, when U.S. debt servicing costs hit 14% of tax revenues, financial markets begin to impose fiscal austerity on policymakers. Interest costs hit 11% of tax revenues in January, but will get close to 14% later this year.
Trust fund insolvency is a catalyst for austerity. Short-term budget pressures are now bleeding into longer-term structural issues caused by demographics. The CBO projects that three major trust funds will become insolvent over the next 10 years: 1) Highway in 2028; 2) Social Security Old-Age in 2033; and 3) Medicare Hospital Insurance in 2033. Without Congressional action, Social Security benefits will be cut by 25% in 2033. This will likely become an action-forcing event for Congress to deal with the budget’s longer-term structural issues on the tax and spending side. Interestingly, the last time Social Security was facing a funding crisis like this 40 years ago, net interest costs were more than 17% of tax revenues and Congress stepped in with a major tax and spending reform package to replenish Social Security.
The debt ceiling fight is the starting point for these new fiscal fights. The CBO’s bleak outlook on the U.S. fiscal environment will encourage fiscal hawks in Congress to push for spending cuts and other fiscal reforms throughout 2023. This will show up as part of the debate over how to raise the U.S. debt ceiling later this year, as well as in the debate over government spending and reauthorizing other government programs. The CBO believes the U.S. government can continue to operate without raising the debt ceiling until at least July. As such, the CBO report sets the stage for a summer debate over whether spending cuts should be included in a package to raise the debt ceiling.
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