How to Deal With Budget Projection Uncertainty

Jul 23, 2014 | Budgets & Projections

In our series on the long-term budget outlook, we covered how debt projections would change if some of CBO's economic and technical assumptions turned out differently. Uncertainty is clearly a factor in any budget projection and especially so for 75-year estimates. But CBO also points out that there are ways for policymakers to remove or lessen this uncertainty by changing federal policies, including by reducing federal debt to lessen the risk of negative revisions to projections.

Recall that the four parameters for which CBO evaluated alternate assumptions were mortality, productivity, interest rates, and health care cost growth. While it is difficult to insulate the budget from productivity shocks, government policy can mitigate the effect of shocks for the three other variables on the budget.

Mortality

While lower mortality is clearly a good thing for the country, it is not the case for the budget, since it raises spending on retirement and health care programs (although it also can raise the number of years a person remains in the labor force). One way to make a positive development less negative for the budget is to index retirement ages, particularly for Social Security, to longevity. This would mean that the ratio of years worked versus years receiving federal retirement benefits for the average person would remain constant over time, rather than increasingly continuously as it does now. Alternatively, current Council of Economic Advisers chair Jason Furman wrote in a 2007 Brookings Institution paper that policymakers should focus on the concept of "robust solvency" for Social Security, by making it solvent enough to be robust to changes in demographics or other projections. As an example, he showed the effect of "dependency indexing" the payroll tax rate or the benefit formula, or changing those factors based on the projected ratio of workers to beneficiaries.

Health Care Cost Growth

For health care, making federal deficits less subject to health care cost growth could involve putting health care spending on a budget, linked to a specific growth rate. Medicare already has this limit imposed by the Independent Payment Advisory Board (IPAB), which is instructed to cap annual per-beneficiary spending growth to GDP growth plus 1 percentage point. However, IPAB's purview is somewhat limited, so it is questionable whether it actually has the tools to limit Medicare spending over the long term (CBO basically ignores it in the long-term projections). Having a broader limit for health care with sufficient tools to meet that limit would reduce the uncertainty over health care spending in long-term projections.

Interest Rates

The federal government could smooth interest rate fluctuations by issuing longer-term debt, something that it is already in the process of doing in this low interest rate environment. Taking this step would make borrowing costs more predictable, but it would not necessarily make them lower, since longer-term securities have higher interest rates than shorter-term ones, and interest rates could go down, leaving the government less able to take advantage of them.

A General Solution

Outside of these specific steps, policymakers could minimize the effect of uncertainty on the budget by keeping a low level of debt. If debt were on a clear downward path, the budget would be better able to withstand negative revisions to technical assumptions and economic downturns. CBO states:

Policymakers could improve the federal government’s ability to withstand the effects of events that would significantly worsen the budgetary outlook. In particular, reducing the amount of federal debt held by the public would give future policymakers more flexibility in responding to extraordinary events.

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In addition, a high ratio of debt to GDP increases the risk of a fiscal crisis in which investors lose confidence in the government’s ability to manage its budget and the government thus loses its ability to borrow at affordable rates. There is no way to predict the amount of debt that might precipitate such a crisis, but starting from a position of relatively low debt would reduce the risk.

In addition, as we noted in a previous blog about different economic and technical assumptions, having lower debt can help ensure stronger productivity growth, lower health care cost growth, and lower interest rates.

Of course, downside risks to budget projections would still exist if debt was on a downward path, but they would be less costly for policymakers to correct. With debt on its current course, the budget can ill afford any further significant negative turns.