Wednesday, August 10, 2011

The CBO’s Long Term Budget Outlook

In June, the CBO released their Long Term Budget Outlook (LTBO) for the United States. It does some guesstimating on our fiscal future through the year 2085. It made the papers because it had some scary numbers, but some that weren’t so scary. People talked about it for a few days, and then forgot about it.

After a few minutes of looking at it, I determined that it might be the scariest financial document ever released by our government. Three days of in depth study on the details have not changed my mind.

After my review, I can say one thing for certain. No one in Washington examined this report in detail. No one. Had anyone done so, S&P would not have downgraded our credit rating as there would have been no need. Congress and the President would have come up with a better plan.

You think that statement is naïve? Wait until I get finished.

This will be fairly long, so for those without the patience to read the whole thing, here’s the spoiler ending. The CBO projects two scenarios, one of which is like being doused with gasoline and lit on fire, and the other is more like being covered in barbecue sauce and slow roasted.

The other point I have to make before I get started is this. CBO Director Doug Elmendorf should be embarrassed that his office put this thing out. Part of the reason it’s taken me a while to get around to writing this blog post is because there’s so much in the spreadsheet that is either nonsensical or impossible. I’ve spent the last three days trying to reconstruct where all their numbers came from, what they mean, and determine where exactly the problems exist. It has not been fun.

The LTBO examines our fiscal situation and projects it out 75 years. Of course, this should be examined with a high degree of skepticism. Economists aren’t generally very good at projecting things out even 1 year, much less 75 (and Reuters’ economists can’t even project out next week—but I digress).

The CBO makes no attempt to guess at future law changes or new programs or the possibility of some unforeseen economic boom or bust. It merely attempts to project the effect of current law and current policy.

The LTBO examines two fiscal scenarios, one they call the extended baseline which is based on current law, and one they call alternative which is based more or less on current policy.  In short, the alternative is the doomsday scenario and the extended one is the “good” version, if you can call it that.

The differences between the two scenarios amount to two significant things: continuation of the Bush tax cuts, and continuation of changes to the AMT. The AMT is is the liberals way of making sure our tax code is more “fair”. Basically the AMT says that if you make enough money, you aren’t allowed to take any deductions. It’s a fairly flat tax set around 25%, and you’re required to pay the greater of it or whatever you calculate as your regular income tax using all the deductions available to you. Your income has to reach a certain threshold for the AMT to apply to you. The problem is that the threshold is not indexed, so every couple of years, Congress has to change the AMT law so that it still only affects the high income people and not the middle class.

Neither scenario envisions any sort of entitlement reform. Both scenarios assume an average of somewhat anemic 2.28% GDP annual growth over the next 75 years. That’s disturbing enough itself. That’s the best case scenario. There are some additional tables that assume even lower economic growth down to an average of 1.33%.

The alternative scenario projects that the Bush tax cuts will remain in place for the foreseeable future and that Congress will keep adjusting the AMT. The extended scenario assumes the opposite.

In both scenarios the CBO projects GDP growth, growth of U.S. debt held by the public, and makes projections of government receipts and outlays.

Ok, enough preamble. You with me so far?

Ready for the bad news now?

We’ll start with the alternative scenario. It assumes revenue vs. GDP at roughly 18.4% throughout.

I said the report goes out to 2085, remember? Well, that’s not completely true. Under the alternative scenario the CBO stops projecting the U.S. debt after 2037, 26 years from now. There’s no point in continuing past that point. We’re at 200%. Those are end-of-the-country type numbers. The weight on the economy from that would be so high that it’s hard to see how the country would ever recover. We’d have to just default and start over. It’s likely this would happen long before 2037, and that’s a mere 26 years away. This is the douse yourself with gasoline and light a match scenario. We’ll almost certainly experience riots like what we’ve seen in Greece, Italy, and now the UK this year, only possibly worse.

Remember the alternative is the scenario that I consider far more likely. Cheery news, huh?

Then there’s the extended baseline. This is the Keynesian good news scenario and it assumes that none of the bad things that you’ve ever heard about Keynesian economics are true. It assumes that there’s a 1:1 relationship between taxation and revenue. The CBO has never heard of the Laffer curve, apparently. It’s also never heard of Hauser’s Law, either.

The extended baseline looks much more encouraging, at first glance. Publicly held debt never exceeds 87% of GDP. That’s great news. But outlays reach a mind boggling 34.1% of GDP. Huh? How is it possible to keep the debt down, then? Well, revenues under the extended baseline scenario reach 30.6% of GDP. This is where the CBO begins to engage in outright fantasy. I’m sure that most people who glanced at the CBO report saw that if we don’t make any changes to existing law that things stabilize, and it’s not that awful a situation, and didn’t look at the details.

The details show that it IS an awful situation. Possibly worse than the alternative baseline.

But there’s missing data in the spreadsheet for this one as well. And there’s no mathematical reason for this data to have been scrubbed. The tab containing the data on the AMT stops in 2035. There’s no good reason for this. The other tables show the tax revenue projections out to 2085, which means that AMT had to have been calculated out that far. Yet, for some reason the CBO elected not to show it. The only reason I can see that it was left out was to keep from terrifying people. So, I’m going to let the cat out of the bag and terrify you.

The last year for which AMT calculations are shown, 2035, estimates that 49.5 of all American households will be affected by the AMT. This would hit household income levels at about $50,000 in 2008 dollars. When I attempted to extend this table out to 2085, it becomes quickly apparent why they stopped. Based on my calculations, sometime after 2050, depending on inflation, the AMT reaches all the way down to the poverty level. And that’s how they blast through Hauser’s Law and get to 30.6% revenue.

Let me show you what this means with a simple chart showing about what you’d pay in Federal income tax. This is just the income tax, not social security, Medicare, state & local taxes. And I’m going to base it on the quintiles used by the Census Bureau and the CBO. The data is from a June 2010 CBO report that includes tax data through the year 2007.

Quintile Effective Tax Rate Now Avg. Income Tax $ Paid Effective Tax Rate ~2050 Tax $ Paid (2007 dollars) Growth
1st -6.4% $18,400 $(1,178) -6.8% $(1,178) 0%
2nd 0.1% $42,500 $425 20% $8,500 1900%
3rd 4.1% $64,500 $2,645 25% $16,125 505%
4th 7.0% $94,100 $5,834 25% $23,525 303%
5th 19.0% $264,700 $50,293 25% $66,450 32%


Gulp.

There are some assumptions in this table. I assumed that no matter what the AMT would never dip into the 1st quintile. That’s probably optimistic. It looks like to me that it would hit the very top end. Also, the AMT isn’t completely flat. There is an exempt level. That’s the reason for the 2nd quintile’s effective rate only going up to 20%. Yes, that’s mostly a guess, but if anything I feel I’m on the low side here. Also, I would’ve preferred to use median income over average income, but I was unable to obtain that data.

Here’s the same chart including social security and federal excise taxes, assuming those rates stay at constant 2007 levels.

Quintile Effective Tax Rate Now Avg. Income Tax $ Paid Effective Tax Rate ~2050 Tax $ Paid (2007 dollars) Growth
1st 4% $18,400 $736 4% $736 0%
2nd 10.6% $42,500 $4,505 30.5% $12,750 183%
3rd 14.3% $64,500 $9,224 35.2% $22,704 146%
4th 17.4% $94,100 $16,373 35.4% $33,311 103%
5th 25.1% $264,700 $66,440 31.1% $82,322 24%

 

Ok, imagine you’re a politician running for office. Go tell the guy making $42,500 that his total federal taxes are going to nearly triple. Tell the guy making $64,500 that his will more than double. Same for the guy making $94,100. Let me know how those conversations work out for you. I’m guessing you’re not going to get elected. This scenario isn’t happening. Thank God.

These are economy killing numbers. Very very few of the people would have any disposable income under this scenario. That means people who earn their livings based upon products and services paid for with disposable income would have no jobs. These are easily Great Depression type scenarios. At the very least. It’s easy to envision a Great Depression here as a best-case outcome.

And yet the CBO envisions near 4% annual growth in wages, 2.25% GDP growth, and 5% unemployment. These things are quite literally impossible.

So, which scenario is worse? Hard to say. I’d probably prefer the alternative baseline, because at least we get through the pain quicker and can move on. The truth is that both of these scenarios are beyond awful. Anyone, whether you’re a member of the Democrat, Republican, or even The Rent is Too Damn High Party should look at this and realize we need to make significant changes. Now.

I may have issues with President Barack Obama (D-USA), House Speaker John Boehner (R-OH-08), Senate Majority Leader Harry Reid (D-NV), and the rest of the gang up on Capitol Hill, but I do think they’re as good at panicking as the next guy. Anyone studying this report should be panicking. They aren’t. Therefore I stand by my earlier statement that they didn’t read it.

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