The Nation's Long-Term Fiscal Outlook, August 2007 Update:	 
Despite Recent Improvement in the Annual Deficit, Federal Fiscal 
Policy Remains Unsustainable (28-SEP-07, GAO-07-1261R). 	 
                                                                 
Since 1992, GAO has published long-term fiscal simulations of	 
what might happen to federal deficits and debt levels under	 
varying policy assumptions. GAO developed its long-term model in 
response to a bipartisan request from Members of Congress who	 
were concerned about the longterm effects of fiscal policy. GAO's
simulations were updated with the CBO's August budget projections
and economic assumptions and continue to indicate that the	 
long-term federal fiscal outlook remains unsustainable. This	 
update combined with our analysis of the fiscal outlook of state 
and local governments demonstrates that the fiscal challenges	 
facing all levels of government are linked and should be	 
considered in a strategic and integrated manner. GAO updates its 
simulations three times a year as new estimates become available 
from: CBO's Budget and Economic Outlook (January), Social	 
Security and Medicare Trustees Reports (spring), and CBO's Budget
and Economic Outlook: An Update (late summer). This product	 
responds to congressional interest in receiving updated 	 
simulation results.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-1261R					        
    ACCNO:   A76817						        
  TITLE:     The Nation's Long-Term Fiscal Outlook, August 2007       
Update: Despite Recent Improvement in the Annual Deficit, Federal
Fiscal Policy Remains Unsustainable				 
     DATE:   09/28/2007 
  SUBJECT:   Balanced budgets					 
	     Budget cuts					 
	     Budget deficit					 
	     Deficit reduction					 
	     Econometric modeling				 
	     Economic analysis					 
	     Economic growth					 
	     Federal social security programs			 
	     Fiscal policies					 
	     Gross national product				 
	     Medicaid						 
	     Medicare						 
	     Fiscal imbalance					 

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GAO-07-1261R

   

     * [1]What Drives Our Nation's Bleak Long-Term Fiscal Outlook?
     * [2]The Fiscal Gap--Another Way to Measure the Challenge
     * [3]State and Local Governments Face Similar Long-Term Fiscal Ch
     * [4]Key Assumptions in GAO's Federal Simulations
     * [5]Key Assumptions of GAO's State and Local Simulations
     * [6]What Changed in This Update?
     * [7]PDF6-Ordering Information.pdf

          * [8]Order by Mail or Phone

                 United States Government Accountability Office

[GAO] The Nation's Long-Term Fiscal Outlook August 2007 Update

GAO's Long-Term Fiscal Simulations

Since 1992, GAO has published long-term fiscal simulations of what might
happen to federal deficits and debt levels under varying policy
assumptions. GAO developed its long-term model in response to a bipartisan
request from Members of Congress who were concerned about the longterm
effects of fiscal policy.

GAO's simulations were updated with the CBO's August budget projections
and economic assumptions and continue to indicate that the long-term
federal fiscal outlook remains unsustainable. This update combined with
our analysis of the fiscal outlook of state and local governments
demonstrates that the fiscal challenges facing all levels of government
are linked and should be considered in a strategic and integrated manner.

GAO updates its simulations three times a year as new estimates become
available from:

     o CBO's Budget and Economic Outlook (January),
     o Social Security and Medicare Trustees Reports (spring), and
     o CBO's Budget and Economic Outlook: An Update (late summer).

This product responds to congressional interest in receiving updated
simulation results. Additional information about the GAO model, its
assumptions, data, and charts can be found at

[9]http://www.gao.gov/special.pubs/l ongterm/. For more information,
contact Susan J. Irving at (202) 512-9142 or [email protected].

Despite Recent Improvement in the Annual Deficit, Federal Fiscal Policy Remains
Unsustainable

Figure 1:  Unified  Surpluses  and  Deficits  as  a  Share  of  GDP  under
Alternative Fiscal Policy Simulations

GAO's updated long-term simulations illustrate that despite some
improvement in the annual deficit estimate for this fiscal year, the
longterm fiscal outlook remains essentially the same and is clearly
unsustainable--ever-larger deficits lead to a federal debt burden that
ultimately spirals out of control. Figure 1 shows two alternative fiscal
paths. The first is "Baseline Extended," which extends the Congressional
Budget Office's (CBO) August baseline estimates beyond the 10-year
projection period, and the second is an Alternative based on recent trends
and policy preferences. Under these alternative assumptions, discretionary
spending grows with the economy during the first 10 years, Medicare
physician payments are not reduced as in current law, ^[10]1 and revenues
are brought to their historical level. Although the timing of deficits and
the resulting debt buildup varies depending on the assumptions used, both
simulations show that we are on an unsustainable fiscal path.

^1Under the sustainable growth rate system in current law, physician
payments are scheduled to be reduced by 10 percent in 2008 and 5 percent
in each subsequent year through 2016.

What Drives Our Nation's Bleak Long-Term Fiscal Outlook?

By definition, what is unsustainable will not be sustained. The question
is how and when our current imprudent and unsustainable path will end. At
some point, action will be taken to change the Nation's fiscal course. The
longer action to deal with the Nation's long-term fiscal outlook is
delayed, the greater the risk that the eventual changes will be disruptive
and destabilizing. Acting sooner rather than later will give us more time
to phase in gradual changes, while providing more time for those likely to
be most affected to make compensatory changes.

Simulations are not forecasts or predictions. They are designed to ask the
question "what if?" GAO's "what ifs" include that discretionary spending
may grow slower than the 20-year historical average (as in Baseline
Extended) or nearly at it (as in the Alternative), and revenues may be
higher than the historical average (as in Baseline Extended) or be at the
historical average (as in the Alternative), but in both cases, the
Nation's long-term fiscal future is at risk. Under this range of
assumptions, the risks posed to the Nation's future financial condition
are too high to be acceptable.

What Drives Our Nationï¿½s Bleak Long-Term Fiscal Outlook?

The long-term fiscal outlook results from a large and persistent gap
between expected revenues and expected spending. The spending that drives
the outlook is primarily spending on the large federal entitlement
programs (i.e., Medicare, Medicaid, Social Security) especially health
care programs. The retirement of the baby boom generation is one key
element of this. In 2008 the first boomers will be eligible to draw Social
Security early retirement benefits, and in 2011 the first boomers will
become eligible for Medicare. In the succeeding two decades America's
population will age dramatically, and relatively fewer workers will be
asked to support ever larger costs for retirees.

Although Social Security is a major part of the fiscal challenge, it is
far from our biggest challenge. Spending on the major federal health
programs (i.e., Medicare and Medicaid) represents a much larger, faster
growing, and more immediate problem. In fact, the federal government's
obligations for Medicare Part D alone exceed the unfunded obligations for
Social Security. Over the past several decades, health care spending per
capita has grown on average 2.5 percentage points faster than average
annual GDP per capita, absorbing increasing shares of the Nation's
resources, and this rapid growth is projected to continue. For this reason
and others, rising health care costs pose a fiscal challenge not just to
the federal budget but to American business and our economy and society as
a whole.

Figures 2 and 3 look behind the deficit path to the composition of federal
spending under the two scenarios. Both figures show that the estimated
growth in the major entitlement programs leads to an unsustainable fiscal
future--whether revenues as a share of gross domestic product (GDP) are
above historical levels, as in Baseline Extended, or at about historical
levels as in the Alternative simulation.

Figure 2: Potential Fiscal Outcomes under Baseline Extended: Revenues  and
Composition of Spending as Shares of GDP

Note: In addition to the expiration of tax cuts, revenue as a share of GDP
increases through 2017 due to (1) real bracket creep, (2) more taxpayers
becoming subject to the alternative minimum tax (AMT), and (3) increased
revenue from tax-deferred retirement accounts. After 2017, revenue as a
share of GDP is held constant--implicitly assuming that action is taken to
offset increased revenue from real bracket creep, the AMT, and
tax-deferred retirement accounts.

Figure 3: Potential Fiscal Outcomes under Alternative Simulation: Revenues
and Composition of Spending as Shares of GDP

Note: Discretionary spending grows with GDP after 2007. AMT exemption
amount is retained at the 2006 level through 2017 and expiring tax
provisions are extended. After 2017, revenue as a share of GDP is brought
to its historical level of 18.3 percent of GDP plus expected revenues from
deferred taxes (i.e., taxes on withdrawals from retirement accounts).
Medicare spending is based on the Trustees April 2007 projections adjusted
for the Centers for Medicare and Medicaid Services alternative assumption
that physician payments are not reduced as specified under current law.

In these figures the category "all other spending" includes much of what
many think of as "government"--discretionary spending on such activities
as national defense, homeland security, veterans health benefits, our
national parks, highways and mass transit, foreign aid, plus mandatory
spending on the smaller entitlement programs such as Supplemental Security
Income, Temporary Assistance for Needy Families (TANF), and farm price
supports. ^[11]2 The growth in Social Security, Medicare, Medicaid, and
interest on debt held by the public dwarfs the growth in all other types
of spending.

Under Baseline Extended we follow CBO's August baseline for the first 10
years: tax provisions that are scheduled to expire are assumed to do so
(including the temporary increase in the alternative minimum tax [AMT]
exemption amount) and discretionary spending is assumed to grow with
inflation. At the end of the 10-year period, revenues in Baseline Extended
are at 20.3 percent of GDP--a couple of points above the 20-year
historical average. Discretionary spending is 6.4 percent of GDP--somewhat
below the 20-year historical average of 7.7 percent of GDP. For the
remainder of the simulation period, levels of revenues and discretionary
spending as shares of GDP are held constant, and for Social Security and
Medicare, we use the Trustees' April 2007 intermediate estimates. The
Medicare estimates assume the continuation of current law, under which
fees for physicians treating Medicare patients would be cut in future
years. ^[12]3

Under the Alternative scenario in the first 10 years we assume that all
expiring tax provisions are extended, and the 2006 exemption amount for
the alternative minimum tax is continued but not indexed for inflation.
After the first 10 years we bring revenues to their historical share of
the economy--18.3 percent--plus expected revenues from deferred taxes
(i.e., taxes on withdrawals from retirement accounts). Discretionary
spending grows with the economy throughout the simulation period--it
remains at
7.6 percent of GDP throughout the simulation. This means that over the
long term, discretionary spending is slightly under its 20-year historical
average. In addition, the Alternative scenario uses Medicare estimates
developed by the Centers for Medicare and Medicaid Services (CMS) that
assume payment rates to physicians will not be reduced as specified under
current law and assumed by the Trustees in their intermediate
projections. ^[13]4 As in Baseline Extended, after the first 10 years the
Alternative scenario uses the Trustees' intermediate estimates for Social
Security.

^2Discretionary spending refers to spending based on authority provided in
annual appropriations acts. Mandatory spending refers to spending that
Congress has authorized in legislation other than appropriations acts that
entitles beneficiaries to receive payment or that otherwise obligates the
government to make payment.

^3The Trustees noted in their April 2007 report that Medicare expenditures
"are substantially understated because projected current-law physician
payment updates are unrealistically reduced under the sustainable growth
rate system (the statutory formula that governs fee updates) by about 10
percent in 2008 and 5 percent in each subsequent year through 2016. In
practice, Congress is virtually certain to prevent some or all of the
scheduled reductions through new legislation, as it has for 2003 through
2007."

Both these figures show that waiting makes the size of the problem worse.
For example, even under GAO's Baseline Extended scenario--under which
revenues rise to about 20 percent of GDP and discretionary spending falls
to 6.4 percent of GDP--waiting until 2040 to balance the budget would
require drastic change. To close that gap in that year, federal revenue as
a share of GDP would have to increase by almost 50 percent or noninterest
federal spending cut by about 40 percent in order to balance the budget in
that year. If changes in federal individual income taxes were the sole
means used to balance the budget, these would have to increase by about 90
percent. Sudden, drastic changes of either kind--and revenues at such a
level--are outside post-World War II historical experience in this
country.

  The Fiscal Gap-- Another Way to Measure the Challenge

Many ways exist to measure the long-term fiscal challenge. One
quantitative measure is called "the fiscal gap." The fiscal gap is the
amount of spending reduction or tax increases that would be needed today
to keep debt as a share of GDP at or below today's ratio. In contrast to
waiting until 2040 to balance the budget as described above, the fiscal
gap is an estimate of the action needed today and maintained for each and
every year to achieve fiscal balance over a certain time period. Another
way to say this is that the fiscal gap is the amount of change needed to
prevent the kind of debt explosion implicit in figure 3. The fiscal gap
can be expressed as a share of the economy or in present value dollars.
(See table 1.)

^4 This reflects the fact that Congress has generally acted to prevent
payment rates from being reduced. CMS developed two illustrative Medicare
estimates that vary from the intermediate estimates. One set of estimates
assumes a 0-percent update to physician fees; the other assumes updates
for medical inflation. GAO's Alternative simulation uses the 0-percent
update estimates. For more information on these estimates, see CMS's April
2007 memorandum "Projected Medicare Part B Expenditures under Two
Illustrative Scenarios with Alternative Physician Payment Updates,"
available at
http://www.cms.hhs.gov/ReportsTrustFunds/05_alternativePartB.asp

Table 1: Federal Fiscal Gap 2007-2081 Fiscal gap Change required to close
gap

                                              Percentage  Percentage decrease 
               Trillions        Percentage   increase in  in noninterest      
               of 2007   Share  increase in   individual                      
               dollars   of GDP revenue      income taxes spending 23.6%      
Baseline    $31.1     4.3%   22.9%        50.6%                            
Alternative     $54.3   7.5%        39.9%        88.2%               41.0% 

Source: GAO analysis.

To close the fiscal gap under Baseline Extended would require action today
equal to about a 23 percent increase in revenue or reduction in
programmatic spending that would need to be maintained over the entire
period. Under GAO's Alternative simulation, the required action would be
even more dramatic--about 40 percent. These annual tax increases and
spending cuts would exceed the fiscal year 2006 deficit of 1.9 percent of
GDP. Delaying action would make things worse. Under our Alternative
simulation, waiting even 10 years would require a revenue increase of
about 50 percent or noninterest spending cuts of about 46 percent.

This gap is too large for us to grow our way out of the problem. It would
require decades of double-digit real economic growth, but the United
States has not had a single year of double-digit real economic growth
since World War II. To be sure, additional economic growth would certainly
help the nation's financial condition and our ability to address our
fiscal gap, but it will not eliminate the need for action.

  State and Local Governments Face Similar Long-Term Fiscal Challenges

In 2007 GAO expanded its work on the long-term fiscal outlook to develop a
model of the state and local government sector. ^[14]5 Figure 4 presents
the results of GAO simulations that combine the federal government fiscal
outlook with that of the state and local government sector. ^[15]6 The
simulations imply that state and local fiscal challenges will add to the
nation's fiscal difficulties and suggest that the nation's fiscal
challenges cannot be remedied simply by shifting the burden from one
sector to another.

^5GAO, State and Local Governments: Persistent Fiscal Challenges Will
Likely Emerge within the Next Decade, GAO-07-1080SP (Washington, D.C.:
July 18, 2007).

^6In order to combine the federal and state and local budget simulations
using a consistent set of economic assumptions, we modified our
methodology underlying our federal simulations to remove the negative
feedback from deficits on economic growth. This change does not alter the
conclusion that fiscal policy is unsustainable over the long term.

Figure 4: Federal and Combined Federal, State, and Local Surpluses and
Deficits as a Share of GDP

    Percent of GDP

5

0

-5

-10

-15

-20

             2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

    Fiscal year

Federal surplus deficit Combined surplus deficit

Source: Historical data from National Income and Product Accounts, GAO
analysis.

Note: Historical data from 2000 to 2006, projections from 2007 to 2050;
federal simulation is the "Alternative" scenario; state and local balance
measure is similar to the federal unified budget measure.

Rapidly rising health care costs are not simply a federal budget problem;
they are our nation's number one fiscal challenge. Growth in healthrelated
spending--Medicaid and health insurance for state and local employees and
retirees--is the primary driver of the fiscal challenges facing the state
and local governments. As we have noted elsewhere, the expected continued
rise in health-care costs poses a fiscal challenge not just to government
budgets, but to American business and society as a whole. ^[16]7 In short,
the fundamental fiscal problems facing all levels of government are
similar and are linked. As such, solutions to address these challenges
should be considered in tandem.

^7For example, see GAO, Highlights of a Forum: Health Care 20 Years From
Now--Taking Steps Today to Meet Tomorrow's Challenges, GAO-07-1155SP
(Washington, D.C.: September 2007).

  Key Assumptions in GAO's Federal Simulations

GAO's two simulations project current revenue and spending policies
forward. The first, Baseline Extended, takes CBO's August 10-year baseline
estimates ^[17]8 and extends them over a 75-year period and the second,
Alternative simulation, is based on recent trends and policy preferences.
As CBO recognized in both its January 2007 Budget and Economic Outlook and
its August 2007 Budget and Economic Outlook: An Update, its baseline
estimates incorporate some very problematic assumptions that we adjust for
in our Alternative simulation as summarized below.

     Table 2: Assumptions for Baseline Extended and Alternative Simulations

             Model inputs Baseline Extended Alternative Simulation

Revenue CBO's August 2007 baseline through 2017; All expiring tax
provisions are extended through 2017; thereafter remains constant at 20.3
percent of GDP thereafter equal to 40-year historical average of 18.3
(CBO's projection in 2017) percent of GDP plus CBO's estimate of revenue
from tax-deferred retirement plans

Social Security CBO's August 2007 baseline through 2017; Same as  Baseline
Extended  spending  (OASDI)  thereafter  based  on  2007  Social  Security
Trustees'

intermediate projections

Medicare CBO's August 2007 baseline through 2017; CMS's intermediate
projections adjusted for alternative

spending thereafter 2007 Medicare Trustees' intermediate assumption of 0
percent physician payment updates in projections preparedby CMS that
assume per the first 10 years. enrollee Medicare spending grows on average
1 percent faster than GDP per capita over the long term.

Medicaid CBO's August 2007 baseline through 2017; Same as Baseline
Extended

spending thereafter CBO's December 2005 long-term projections under
Scenario 2 that assume per enrollee Medicaid spending grows with GDP per
capita plus 1 percent over the long term

Other mandatory CBO's August 2007 baseline through 2017; Baseline Extended
through 2011, then adjusted for spending thereafter increases at the rate
of economic growth extension of certain tax credits through 2017;
thereafter (i.e., remains constant as a share of GDP) increases at the
rate of economic growth

Discretionary CBO's August  2007 baseline through  2017; Increases at  the
rate of economic  growth starting after  spending thereafter increases  at
the rate of economic growth 2007

Source: GAO.

^8 The Balanced Budget and Emergency Deficit Control Act of 1985, which
established rules that govern the calculation of CBO's baseline, expired
on September 30, 2006. Nevertheless, CBO continues to prepare baselines
according to the methodology prescribed in that law.

  Key Assumptions of GAO's State and Local Simulations

The GAO state and local model projects the level of receipts and
expenditures of the state and local sector in future years based on
current and historical spending and revenue patterns. To develop these
long-run simulations, we make projections for each receipt and expenditure
category of the state and local government sector in future years. On the
receipt side, key categories of receipts for state and local governments
include several types of taxes (personal income, sales, property, and
corporate), income on assets owned by the sector, and grants from the
federal government. Categories of expenditures include wages and salaries
of state and local employees, health insurance costs, pension costs,
social benefit payments (e.g. Medicaid and unemployment), depreciation
expense on state and local capital stock, interest payments on state and
local financial debt, and other expenditures of the sector. In the "base
case" model we assume that the tax structure is not changed in the future
and that the provision of real government services per capita remains
roughly constant. That is, a basic assumption of the primary model is that
the current set of policies in place across state and local governments
remains constant.

In GAO simulations that combine the fiscal outcomes for all levels of
government, the methodology underlying the federal simulations differs
slightly from GAO's usual approach. Usually, GAO's federal budget
simulations incorporate the negative effect on economic growth of large
deficits that divert funds from private investment. In order to combine
the federal and state and local budget simulations using a consistent set
of economic assumptions, this feedback from deficits to economic growth is
removed. With or without feedback, the simulations imply that fiscal
policy is clearly unsustainable over the long term. The January 2008
update of GAO's federal budget simulations will exclude feedback except
for an appendix comparing results with and without feedback.

  What Changed in This Update?

GAO simulations have been updated with CBO's most recent budget and
economic outlook. ^[18]9 Despite some near-term improvement in the
projected deficit for fiscal year 2007, the long-term outlook remains
largely unchanged and clearly unsustainable.

Since our last update in April, the Congress passed the emergency
supplemental appropriation for the Global War on Terrorism (GWOT) and
other activities. ^[19]10 Because of rules governing the baseline, CBO
must
assume that discretionary budget authority for fiscal years 2008-2017 are
based on fiscal year 2007 funding, which includes both regular and
supplemental appropriations. The use of supplementals and their timing can
cause sharp swings in discretionary outlay projections. In this case,
CBO's January baseline showed only $70 billion for GWOT in fiscal year
2007. With the passage of the supplemental, fiscal year 2007 budget
authority increased by $100 billion leading to a move in the 10-year
baseline projection of $1 trillion between the January baseline and August
update. This led to changes in GAO's long-term assumptions for
discretionary spending of about 0.7 percent of GDP in our Baseline
Extended simulation and 0.1 percent of GDP in our Alternative simulation.
However, as we noted above, while the timing of deficits and the resulting
debt buildup varies depending on the assumptions used, both simulations
continue to show that we are on an unsustainable fiscal path.

^9The CBO report can be accessed at www.cbo.gov.

^10Pub. L. 110-28.

This product is based on GAO's work on the long-term fiscal challenge,
including reports and testimonies. These efforts were conducted in
accordance with generally accepted government auditing standards.

Additional information and related products can be found at
[20]http://www.gao.gov/special.pubs/longterm/longtermproducts.html.

(450626)

References

Visible links
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  20. http://www.gao.gov/special.pubs/longterm/longtermproducts.html
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