Wednesday, August 24, 2011

The CBO Estimates Are So Wrong They're Dangerous

Ken Arrow, the Nobel Prize winning economist, likes to tell a funny anecdote about his time as a statistician in World War II. He and his team were assigned to come up with long term weather forecasts, which they figured out would be impossible for them to do. So they wrote this to their superiors and asked to be relieved of this duty. The response they received was "The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes."

Times haven't changed much in government and it seems that this is the exact thinking behind the economic and budgetary estimates the CBO puts out (as they did today). As the chart below shows, their track record in predicting the economy, and hence, revenues, is about as good as a rhesus monkey's:

As you can see, the CBO has an unrealistic view that this economy never goes into a recession and therefore doesn't plan on any. Between 2002 and 2010 all of their real GDP projections were between 2.6% and 2.9%. By overestimating growth, you overestimate revenues, which underestimates the deficit and gives politicians the impression they have more of our money to spend before they get into trouble.

The CBO's current estimates are so bad that they even include a section on page 34-35 where they comment on the recent negative economic data that they DIDN'T TAKE INTO ACCOUNT in their projections, and mention that there is downside risk to their estimates. My question is, if they were aware of the recent data, I'm not quite clear exactly why they wouldn't take them into account? Would it have required too many changes to the tables in the report and that was too much damn work?

Their real GDP growth projection is 2.4% for 2011, which, barring a miracle, is almost certainly not going to happen. With annualized GDP growing by 0.4% in Q1 and 1.3% in Q2, GDP growth would have to be close to 4% in Q3 and Q4 to hit the CBO's bogey. And with negative data coming out of the regional fed surveys for August, if anything growth is falling, not increasing. Their 2012 estimate of 2.6% growth is also very clearly at risk as any recession that starts around now will probably still be going on next year.

2013 is where the real fun begins. In their current baseline estimate, they assume the Bush tax cuts expire, providing a whopping $234 billion in additional revenues. There are a few problems with this, first, if we are in recession next year, that won't happen. Obama will probably use an extension as an October surprise to help himself get re-elected. Second, the CBO is not even close to accounting for what kind of impact such a huge tax raise will have on the economy. In 2013, that amount would be equal to 1.4% of GDP, an extremely large amount of money to be sucked out of people's wallets and then vanish in deficit reduction land, with no offsetting increase in spending. The negative impact of this would likely be around 4% of GDP (assuming a multiplier of around 3). Yet the CBO GDP estimates only fall 0.7% on a nominal basis and 0.9% on a real basis. Somehow, billions of dollars in revenues will magically appear in government coffers without actually being taken from anywhere else in the economy (a neat trick). As 2013 is a critical year for CBO estimates as they see income tax revenue going up by 25% in that year alone, what actually happens then is critical for their long term deficit projections, as that tax base is added to in future years.

So, I decided to play a little bit with the CBO's revenue estimates, to see how sensitive they are to their rosy estimates, that assume no major negative impact from a massive increase in taxes and, once again, assume we have no recessions over 10 years. The changes I made to the estimates were slight and only impacted the individual income tax line, the most impacted by the economy. I still assumed they would eliminate the Bush tax cuts and that the Super Committee would do what it promises to do (yeah, like that is going to happen, but one thing at a time). For 2011, I shaved a little bit off of individual income tax growth, dropping it from 21% to 15%. Then in 2012, I assumed no growth, which could potentially be overshooting still as in the last recession we saw individual income tax revenues drop 20% in 2009 alone. For 2013, I assume 10% growth, offsetting the elimination of the Bush tax cuts with a slower economy. After that, I assume 6% individual income tax growth, the average from 1970-2010 (the average increase from 2000-2009 was only 0.4%).

I don't think any of these assumptions are particularly unreasonable or bearish. I still don't assume a fall in revenues in any year, I just make the growth look more realistic. So what do these relatively minor changes do to the deficit projections? Blow them sky high. Currently, the CBO is assuming a deficit of $3.5 trillion from 2012-2021. Using my projections, the deficit from 2012-2021 is $9.6 trillion! You can see the difference in the chart below:

Now you see why I think the CBO's estimates are dangerous. The current baseline is saying that we don't need any fundamental entitlement reform. That as long as the Bush tax cuts expire and we follow through on with the debt ceiling agreement, the deficit will be manageable and everything will be okay. However, if you just change their assumptions slightly to account for a more realistic revenue scenario, you see we are on a path where deficits blow up massively and we end up in very serious trouble as a nation.

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