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March 15, 1988

The GRH legislation excludes certain
one-time savings from the calculation

the current deficit problem is not cyclical and that further deficit reduction

of deficit reduction, eliminating continued reliance on one-time saving
methods. Congress and the administration will be forced to focus on
spending and revenue policies.

is unlikely without additional
action.

The amended GRH Act does allow for
several escape clauses, however. The
budget summit agreement oflast fall included some limits on the size of automatic cuts for FY 1988 and FY 1989.
Furthermore, provisions retained from
the original GRH Act allow for suspension of the automatic spending reductions if the economy either declines
or is expected

to perform poorly.'

The GRH Act is a step in the right direction by forcing attention on the structural component of the deficit. The
Act also permits flexibility for changing economic conditions and allows
the executive branch-the
OMB in
particular-discretion
for determining
the need for spending adjustments.
•

Conclusion

The economy has been operating at
high employment for the past several
quarters, but is still generating large
deficits. This suggests that the core of

fiscal

Rapid economic growth from 1983 to
1985 was associated with rising,
instead of declining, deficits. Onetime, special factors accounted for
some of the deficit improvement in
FY 1987. Policy decisions to slow the
growth of outlays and speed the
growth of revenues, however, also
provided improvement.
The experience of FY 1987 illustrates
the need for further policy action if
structural deficits are to be reduced.
Despite the two-year deficit reduction
plan, projections for the five-year outlook still show high deficits.
Policy decisions that would reduce
federal deficits have been difficult in
recent years because of conflicting
national priorities. Consequently,
some budget analysts have suggested
that a freeze on spending accompanied
by continued growth in revenues
would minimize these differences
and would still allow the budget to
move toward a surplus by 1991.

-

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

john]
Erceg is an assistant vice president
and economist at the Federal Reserve
Bank oj Clereland, Theodore G. Bernard
is a research assistant at the Bank.
The uieus stated herein are those oj the
authors and not necessarily those oj the
Federal Reserve Bank oj Cleveland or oj
the Board oj Governors oj the Federal
Reserue System.

•

Federal Budget Deficits:
Sources and Forecasts

Footnotes

1. For a further discussion of the cyclically

adjusted federal budget concept, see Frank
de Leeuw and Thomas M. Holloway, "Cyclical Adjustment of the Federal Budget and
Federal Debt," Survey oj Current Business,
vol. 63, no. 12 (December 1983), pp. 25-40.

by John J. Erceg and Theodore G_ Bernard

2. During an economic cycle, as defined
by the National Bureau of Economic
Research, each quarter is classified into
one of four phases. Constant-growth-rate
lines are used to connect the averages of
real GNP during the middle-expansion
phase and thus give the path of middleexpansion trend GNP. See de Leeuw and
Holloway, ibid., pp. 28-29.

Federal
budget deficits have been
large and persistent over the past several years, rising to a postwar high of
$221 billion in fiscal year (FY) 1986
before declining a record $7] billion
in FY 1987. The Congressional Budget
Office (CBO) and the administration's
Office of Management and Budget
(OMB) project a declining trend of deficits over the next five years (table L),

3. "The Economic and Budget Outlook:
Fiscal Years 1989-1993," Congressional
Budget Office, February 1988, pp. xiii-xvii.
4. Congress can suspend the automatic
spending cut mechanism if real GNP is
negative for two consecutive quarters or if
the OMB and the CBO project real growth
of less than one percent for two consecutive quarters.

The OMB's more optimistic economic
assumptions and policy proposals
foresee a steadily declining federal
deficit trend between fiscal years ] 988
and 1993. Nevertheless, in two of the
next three years, projected deficits
slightly exceed the recently upwardrevised deficit targets initially established under the Gramm-RudmanHollings Act (GRH). Between 1991

Additional deficit-reduction legislation will be necessary if deficits are to
be gradually reduced to meet annual
deficit targets.

Federal Reserve Bank of Cleveland
Research Department
P_o. Box 6387
Cleveland, OH 44101

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

and 1993, they exceed the initial GRH
targets by about $20 billion annually.
By ]993-the
year now targeted for a
balanced budget-the
federal budget
would still be in a slight deficit,
according to OMB projections.
The CBO's less optimistic scenario
projects a jagged downward path of
deficits between 1988 and 1993. The
projected deficit path is much higher
than that projected by OMB, and
increasingly exceeds the GRH deficit
targets, reaching $]34 billion in 1993.
This Economic Commentary
discusses the sources of federal budget
deficits, examines the OMB and CBO
forecasts, and suggests the need for
additional policy actions to achieve a

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101
ISSN 0428·1276

declining trend of deficits into the
1990s. Under either scenario, it is
likely that at some point during the
next five years, automatic spending
cuts will be required under the current GRH Act.
• The Cyclically Adjusted
Federal Budget
U.S. Department of Commerce estimates suggest that much of the deficits
are associated with policy decisions,
although the federal budget is highly
sensitive to changes in economic
activity. To distinguish between these
deficit sources, analysts divide the
budget into cyclical and structural
components.'
The cyclical component of the budget measures the
response of outlays and revenues to
changes in economic conditions,
while the structural component measures discretionary fiscal policy and
other noncyclical components.
We can estimate what federal receipts
and outlays would be if the economy
were growing at a trend rate of gross
national product (GNP), free from
cyclical fluctuations; this calculation
yields the structural component of the
budget. The difference between the
actual and structural measures of receipts and outlays is the cyclical component. This disaggregation helps to
separate the interaction between the
federal budget and economic activity.
Currently, the U.S. Department of Commerce, Bureau of Economic Analysis
(BEA) publishes two alternative esti-

-

Despite a two-year deficit reduction

plan, government

projections

for the

five-year federal budget outlook still
show large deficits. Additional

legis-

lative actions will be necessary

if

federal budget deficits are to be
reduced

sufficiently to meet annual

deficit targets.

mates of the structural budget, also
called the cyclically adjusted budget.
The high-employment budget measures what the federal budget, on a
National Income and Product Account
(NIPA) basis, would be if the unemployment rate were 6 percent. The
second measure is an estimate of what
the NIPA-basis federal budget would
be if the economy were expanding
along a particular trend path-middleexpansion trend GNP in this case.s
Cyclically adjusted federal budget deficits, measured either way, increased
substantially during the 1980s and
account for the bulk of actual deficits
in recent years. The federal deficit was
reduced in 1987 on both an actual
and a cyclically adjusted basis; the
actual deficit is now between the two
BEA measures of the structural deficit.

Thus, under either adjusted measure,
structural deficits account for all, or
almost all, of the current federal
deficit. Moreover, BEA estimates of the
cyclically adjusted budget suggest that
both OMB and CBO projected deficits
are mostly structural and that a highgrowth economy alone would not
eliminate the deficit.
•

Composition

of Federal Spending

Because the cyclical component of the
federal deficit is now estimated to be
near zero, further reductions in the
actual deficit must come from the
structural component. The sources of
structural deficits have varied over the
years as budget priorities and policies
have changed. Throughout the 1960s
and early 1970s, revenues and outlays
tended to grow at a similar pace. Outlays (on a unified budget basis) began
to soar during the late 1970s and rose
to about 24 percent of GNP by the
mid-1980s, while revenue growth
slowed (figure 1).
Moreover, the composition of spending has changed dramatically in recent
years. Spending for national defense
more than doubled between 1980 and
1987 while spending for nondefense
items increased by 58 percent. Consequently, defense spending rose from
5-0 percent of GNP in 1980 to 6.4 percent in 1987 (figure 2).
As a share of GNP, defense

outlays

have leveled off and are well below
the 9.4 percent share of the early
1960s. Apparemly, the defense buildup has run its course. Growth in
defense spending is projected to slow
sharply through the early 1990s,
according to both the CBO and OMB.
The CBO projects that growth in nondefense spending will also slow in the
early 1990s and, relative to GNP, will
decline from a high of 16.7 percent in
1983 to 14.1 percent in 1993. Most of
the slowdown in total spending
growth in the past several years has
occurred in discretionary spending
programs, such as training programs,
social services, energy, and natural
resources and the environment. Continued slow growth in discretionary
spending will reduce its share of GNP

from a recent high of 5.9 percent in
1980 to a projected 3.4 percent by
1993, according to the CBO.
Entitlements and so-called mandatory
spending have been the major growth
category since the late 1960s and have
accounted for the steady upward trend
in total federal spending. Entitlements, which encompass virtually all
of the major federal benefit programs,
provide benefits to those who meet
eligibiliry requirements set by Congress. Outlays for the greater portion
of entitlement programs, dominated
by Social Securiry and Medicare, are
not subject to an income standard for
eligibiliry. Social Security, in fact,
accounts for nearly one-fourth of the
entire federal budget.
In general, entitlement spending is projected to continue to grow into the
early 1990s, according to the CBO, despite little or no growth for some programs, such as family support, veterans'
pensions, guaranteed student loans,
and unemployment compensation.
Interest expense has also accounted
for trend growth in total spending. Net
interest costs are the costs of borrowing to finance the federal debt, offset by the receipt of interest payments
from government trust funds and
loans. A combination of recent asset
sales, prepayments, and sluggish new
lending portends virtually flat interest
income over the next several years.
As the total federal debt rises, the

government needs to borrow money
in order to finance current operations,
while also seeking new funds to refinance maturing debt. Although refinancing often occurs at higher interest
rates, lower rates during FY 1987
offset much of the cost associated
with the growing federal debt and
allowed for large one-time savings.
Net interest costs, of course, are
highly sensitive to interest rates. Thus,
projections of future net interest
expenses depend on assumptions
about interest rates and the size of
deficits. Although economic variables
are closely related and seldom, if

ever, move in isolation, some
thumb from the CBO offer an
into how higher interest rates
affect the budget. These rules

rules of
insight
would
indicate

TABLE 1

1988

Neither the CBO nor the OMB expects
relief over the next several years.
Thus, even if the current status of the
cyclically adjusted budget allowed for
further deficit reduction from eco-

1991

1992

1993

$-147
(3.1%)

$-130
(2.6%)

$-104
(1.9%)

$-79
(1.4%)

$-51
(0.8%)

$-23
(0.4%)

$-157
(3.4%)

$-176
0.5%)

$-167
(3.1%)

$-158
(2.8%)

$-151
(2.5%)

$-134
(2.1%)

Gramm- Rudman- Hollings
(GRH) target

$-144

$-136

$-100

$-64

$-28

-0-

Shortfall from GRH target
OMB estimate

$-3

$6

$-4

$-15

$-23

$-23

CBO baseline estimate

FIGURE 1

1990

CBO baseline estimate
(% of GNP)

-

1989

OMB estimate
(% of GNP)

that a one-percentage-point
increase
in interest rates from the beginning of
FY 1988 to the end of FY 1993- for
all maturities of debt issued-would
cause outlays in 1988 to increase by
$3 billion and by 1993 to increase by
$30 billion.
High federal deficits and the federal
debt explosion in recent years have
boosted net interest costs to nearly 14
percent of total outlays and slightly
more than 3 percent of GNP, well
above recent historical experience.

FEDERAL BUDGET DEFICIT PROJECTIONS
(fiscal year, billions of dollars)

$-13

$-40

$-67

$-94

$-123

$-134

SOURCES: Office of Management and Budget, Budget oj the United States Government,
sional Budget Office, The Economic and Budget Outlook: Fiscal Yea" ]989-]993.

Fiscal Year ]989; and Congres-

Moreover, about $54 billion has
already been cut from previously projected defense spending between FY
1988 and FY 1990. Future deficit
reductions will therefore require hard
choices among nondefense, noninterest spending components of the
budget, unless taxes are increased.
• Recent Policy Actions
Revenues as a share of GNP averaged
nearly 19 percent annually between
FY 1980 and FY 1987, but this average
masks an important development.
From FY 1980 through FY 1982,
revenues averaged 19.7 percent of
GNP. Extensive tax changes since
1981, especially the Economic Recovery Act of 1981, substantially reduced
revenue growth. Revenues have averaged only 18.3 percent of GNP
between FY 1983 and FY 1986.
A Significant change in the budget
outlook occurred in FY 1987, when
the deficit fell to $150 billion, a
reduction of $71 billion from FY
1986. The FY 1987 deficit reduction
resulted from three major factors: 1)
special one-time gains, 2) favorable
economic conditions, and 3) discretionary policy changes.
Approximately half of the $71 billion
reduction was the result of one-time

Other one-time gains arose from federal asset sales (including loan prepayments, direct loan sales, and the
Conrail sale), which added about $8
billion, and the shifting of certain outlays into FY 1988, which saved about
$5 billion. This unprecedented
deficit
reduction is not likely to be sustained
without further policy actions.

FEDERAL GOVERNMENT OUTLAYS AND REVENUES RELATIVE TO GNP
Percent of GNP

nomic expansion, the growing burden
of net interest costs would continue.

-,

A second source of improvement was
cyclical in nature. Generally lower
interest rates and an improvement in
the agricultural economy led to lower
outlays. In addition, stronger
employment and income growth in

c.>»> --

FIGURE 2

1960

1995

FEDERAL GOVERNMENT OUTLAYS RELATIVE TO GNP
Percent of GNP

r--------------------------------------------------,

30

----

-----

-----

Defense

-----

1960
NOTE: Actual data through 1987 and projected data from 1988-1993 are measured in the fiscal year for both figure 1
and figure 2. Solid lines represent actual data: dashed lines represent projections by the Congressional Budget Office:
and dotted lines represent projections by the Office of Management and Budget. Revenues and outlays are on a unified
budget basis.
SOURCES: U.S. Department
gressional Budget Office.

of Commerce,

Bureau of Economic

Analysis: Office of Management

factors. The initial effects of the Tax
Reform Act of 1986 boosted receipts
by an estimated $22 billion more than
would have been expected without tax
law changes. Capital gains payments
surged in late 1986 as investors apparently took advantage of the special
long-term capital gains treatment
under the old tax law. On the other
hand, CBO estimates project that tax
law changes, due to the implementation of the remaining individual tax
rate reductions, will reduce receipts by
approximately $10 billion in FY 1988.3

and Budget: and Con-

1987 helped to boost receipts. These
gains from economic factors helped
to reduce the cyclical component of
the budget deficit, which was small
relative to the structural component.
Discretionary policy changes, which
affect the structural component of the
deficit, also accounted for some of the
deficit reduction. Spending cuts in
defense programs and in several nondefense discretionary programs, such
as education, transportation, housing,
and fiscal assistance to state and local
governments, represented policy
actions to cut the federal deficit.
Against a prospect for large deficits
that exceed the GRH annual targets,
Congress and the administration have
agreed to legislation to cut the FY
1988 deficit by $30 billion and to
reduce the projected FY 1989 deficit
by $46 billion. Economic and technical assumptions for FY 1989, to be
presented in the administration's midsession budget report in August, will
indicate if further legislative action is
necessary.

Thus, under either adjusted measure,
structural deficits account for all, or
almost all, of the current federal
deficit. Moreover, BEA estimates of the
cyclically adjusted budget suggest that
both OMB and CBO projected deficits
are mostly structural and that a highgrowth economy alone would not
eliminate the deficit.
•

Composition

of Federal Spending

Because the cyclical component of the
federal deficit is now estimated to be
near zero, further reductions in the
actual deficit must come from the
structural component. The sources of
structural deficits have varied over the
years as budget priorities and policies
have changed. Throughout the 1960s
and early 1970s, revenues and outlays
tended to grow at a similar pace. Outlays (on a unified budget basis) began
to soar during the late 1970s and rose
to about 24 percent of GNP by the
mid-1980s, while revenue growth
slowed (figure 1).
Moreover, the composition of spending has changed dramatically in recent
years. Spending for national defense
more than doubled between 1980 and
1987 while spending for nondefense
items increased by 58 percent. Consequently, defense spending rose from
5-0 percent of GNP in 1980 to 6.4 percent in 1987 (figure 2).
As a share of GNP, defense

outlays

have leveled off and are well below
the 9.4 percent share of the early
1960s. Apparemly, the defense buildup has run its course. Growth in
defense spending is projected to slow
sharply through the early 1990s,
according to both the CBO and OMB.
The CBO projects that growth in nondefense spending will also slow in the
early 1990s and, relative to GNP, will
decline from a high of 16.7 percent in
1983 to 14.1 percent in 1993. Most of
the slowdown in total spending
growth in the past several years has
occurred in discretionary spending
programs, such as training programs,
social services, energy, and natural
resources and the environment. Continued slow growth in discretionary
spending will reduce its share of GNP

from a recent high of 5.9 percent in
1980 to a projected 3.4 percent by
1993, according to the CBO.
Entitlements and so-called mandatory
spending have been the major growth
category since the late 1960s and have
accounted for the steady upward trend
in total federal spending. Entitlements, which encompass virtually all
of the major federal benefit programs,
provide benefits to those who meet
eligibiliry requirements set by Congress. Outlays for the greater portion
of entitlement programs, dominated
by Social Securiry and Medicare, are
not subject to an income standard for
eligibiliry. Social Security, in fact,
accounts for nearly one-fourth of the
entire federal budget.
In general, entitlement spending is projected to continue to grow into the
early 1990s, according to the CBO, despite little or no growth for some programs, such as family support, veterans'
pensions, guaranteed student loans,
and unemployment compensation.
Interest expense has also accounted
for trend growth in total spending. Net
interest costs are the costs of borrowing to finance the federal debt, offset by the receipt of interest payments
from government trust funds and
loans. A combination of recent asset
sales, prepayments, and sluggish new
lending portends virtually flat interest
income over the next several years.
As the total federal debt rises, the

government needs to borrow money
in order to finance current operations,
while also seeking new funds to refinance maturing debt. Although refinancing often occurs at higher interest
rates, lower rates during FY 1987
offset much of the cost associated
with the growing federal debt and
allowed for large one-time savings.
Net interest costs, of course, are
highly sensitive to interest rates. Thus,
projections of future net interest
expenses depend on assumptions
about interest rates and the size of
deficits. Although economic variables
are closely related and seldom, if

ever, move in isolation, some
thumb from the CBO offer an
into how higher interest rates
affect the budget. These rules

rules of
insight
would
indicate

TABLE 1

1988

Neither the CBO nor the OMB expects
relief over the next several years.
Thus, even if the current status of the
cyclically adjusted budget allowed for
further deficit reduction from eco-

1991

1992

1993

$-147
(3.1%)

$-130
(2.6%)

$-104
(1.9%)

$-79
(1.4%)

$-51
(0.8%)

$-23
(0.4%)

$-157
(3.4%)

$-176
0.5%)

$-167
(3.1%)

$-158
(2.8%)

$-151
(2.5%)

$-134
(2.1%)

Gramm- Rudman- Hollings
(GRH) target

$-144

$-136

$-100

$-64

$-28

-0-

Shortfall from GRH target
OMB estimate

$-3

$6

$-4

$-15

$-23

$-23

CBO baseline estimate

FIGURE 1

1990

CBO baseline estimate
(% of GNP)

-

1989

OMB estimate
(% of GNP)

that a one-percentage-point
increase
in interest rates from the beginning of
FY 1988 to the end of FY 1993- for
all maturities of debt issued-would
cause outlays in 1988 to increase by
$3 billion and by 1993 to increase by
$30 billion.
High federal deficits and the federal
debt explosion in recent years have
boosted net interest costs to nearly 14
percent of total outlays and slightly
more than 3 percent of GNP, well
above recent historical experience.

FEDERAL BUDGET DEFICIT PROJECTIONS
(fiscal year, billions of dollars)

$-13

$-40

$-67

$-94

$-123

$-134

SOURCES: Office of Management and Budget, Budget oj the United States Government,
sional Budget Office, The Economic and Budget Outlook: Fiscal Yea" ]989-]993.

Fiscal Year ]989; and Congres-

Moreover, about $54 billion has
already been cut from previously projected defense spending between FY
1988 and FY 1990. Future deficit
reductions will therefore require hard
choices among nondefense, noninterest spending components of the
budget, unless taxes are increased.
• Recent Policy Actions
Revenues as a share of GNP averaged
nearly 19 percent annually between
FY 1980 and FY 1987, but this average
masks an important development.
From FY 1980 through FY 1982,
revenues averaged 19.7 percent of
GNP. Extensive tax changes since
1981, especially the Economic Recovery Act of 1981, substantially reduced
revenue growth. Revenues have averaged only 18.3 percent of GNP
between FY 1983 and FY 1986.
A Significant change in the budget
outlook occurred in FY 1987, when
the deficit fell to $150 billion, a
reduction of $71 billion from FY
1986. The FY 1987 deficit reduction
resulted from three major factors: 1)
special one-time gains, 2) favorable
economic conditions, and 3) discretionary policy changes.
Approximately half of the $71 billion
reduction was the result of one-time

Other one-time gains arose from federal asset sales (including loan prepayments, direct loan sales, and the
Conrail sale), which added about $8
billion, and the shifting of certain outlays into FY 1988, which saved about
$5 billion. This unprecedented
deficit
reduction is not likely to be sustained
without further policy actions.

FEDERAL GOVERNMENT OUTLAYS AND REVENUES RELATIVE TO GNP
Percent of GNP

nomic expansion, the growing burden
of net interest costs would continue.

-,

A second source of improvement was
cyclical in nature. Generally lower
interest rates and an improvement in
the agricultural economy led to lower
outlays. In addition, stronger
employment and income growth in

c.>»> --

FIGURE 2

1960

1995

FEDERAL GOVERNMENT OUTLAYS RELATIVE TO GNP
Percent of GNP

r--------------------------------------------------,

30

----

-----

-----

Defense

-----

1960
NOTE: Actual data through 1987 and projected data from 1988-1993 are measured in the fiscal year for both figure 1
and figure 2. Solid lines represent actual data: dashed lines represent projections by the Congressional Budget Office:
and dotted lines represent projections by the Office of Management and Budget. Revenues and outlays are on a unified
budget basis.
SOURCES: U.S. Department
gressional Budget Office.

of Commerce,

Bureau of Economic

Analysis: Office of Management

factors. The initial effects of the Tax
Reform Act of 1986 boosted receipts
by an estimated $22 billion more than
would have been expected without tax
law changes. Capital gains payments
surged in late 1986 as investors apparently took advantage of the special
long-term capital gains treatment
under the old tax law. On the other
hand, CBO estimates project that tax
law changes, due to the implementation of the remaining individual tax
rate reductions, will reduce receipts by
approximately $10 billion in FY 1988.3

and Budget: and Con-

1987 helped to boost receipts. These
gains from economic factors helped
to reduce the cyclical component of
the budget deficit, which was small
relative to the structural component.
Discretionary policy changes, which
affect the structural component of the
deficit, also accounted for some of the
deficit reduction. Spending cuts in
defense programs and in several nondefense discretionary programs, such
as education, transportation, housing,
and fiscal assistance to state and local
governments, represented policy
actions to cut the federal deficit.
Against a prospect for large deficits
that exceed the GRH annual targets,
Congress and the administration have
agreed to legislation to cut the FY
1988 deficit by $30 billion and to
reduce the projected FY 1989 deficit
by $46 billion. Economic and technical assumptions for FY 1989, to be
presented in the administration's midsession budget report in August, will
indicate if further legislative action is
necessary.

March 15, 1988

The GRH legislation excludes certain
one-time savings from the calculation

the current deficit problem is not cyclical and that further deficit reduction

of deficit reduction, eliminating continued reliance on one-time saving
methods. Congress and the administration will be forced to focus on
spending and revenue policies.

is unlikely without additional
action.

The amended GRH Act does allow for
several escape clauses, however. The
budget summit agreement oflast fall included some limits on the size of automatic cuts for FY 1988 and FY 1989.
Furthermore, provisions retained from
the original GRH Act allow for suspension of the automatic spending reductions if the economy either declines
or is expected

to perform poorly.'

The GRH Act is a step in the right direction by forcing attention on the structural component of the deficit. The
Act also permits flexibility for changing economic conditions and allows
the executive branch-the
OMB in
particular-discretion
for determining
the need for spending adjustments.
•

Conclusion

The economy has been operating at
high employment for the past several
quarters, but is still generating large
deficits. This suggests that the core of

fiscal

Rapid economic growth from 1983 to
1985 was associated with rising,
instead of declining, deficits. Onetime, special factors accounted for
some of the deficit improvement in
FY 1987. Policy decisions to slow the
growth of outlays and speed the
growth of revenues, however, also
provided improvement.
The experience of FY 1987 illustrates
the need for further policy action if
structural deficits are to be reduced.
Despite the two-year deficit reduction
plan, projections for the five-year outlook still show high deficits.
Policy decisions that would reduce
federal deficits have been difficult in
recent years because of conflicting
national priorities. Consequently,
some budget analysts have suggested
that a freeze on spending accompanied
by continued growth in revenues
would minimize these differences
and would still allow the budget to
move toward a surplus by 1991.

-

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

john]
Erceg is an assistant vice president
and economist at the Federal Reserve
Bank oj Clereland, Theodore G. Bernard
is a research assistant at the Bank.
The uieus stated herein are those oj the
authors and not necessarily those oj the
Federal Reserve Bank oj Cleveland or oj
the Board oj Governors oj the Federal
Reserue System.

•

Federal Budget Deficits:
Sources and Forecasts

Footnotes

1. For a further discussion of the cyclically

adjusted federal budget concept, see Frank
de Leeuw and Thomas M. Holloway, "Cyclical Adjustment of the Federal Budget and
Federal Debt," Survey oj Current Business,
vol. 63, no. 12 (December 1983), pp. 25-40.

by John J. Erceg and Theodore G_ Bernard

2. During an economic cycle, as defined
by the National Bureau of Economic
Research, each quarter is classified into
one of four phases. Constant-growth-rate
lines are used to connect the averages of
real GNP during the middle-expansion
phase and thus give the path of middleexpansion trend GNP. See de Leeuw and
Holloway, ibid., pp. 28-29.

Federal
budget deficits have been
large and persistent over the past several years, rising to a postwar high of
$221 billion in fiscal year (FY) 1986
before declining a record $7] billion
in FY 1987. The Congressional Budget
Office (CBO) and the administration's
Office of Management and Budget
(OMB) project a declining trend of deficits over the next five years (table L),

3. "The Economic and Budget Outlook:
Fiscal Years 1989-1993," Congressional
Budget Office, February 1988, pp. xiii-xvii.
4. Congress can suspend the automatic
spending cut mechanism if real GNP is
negative for two consecutive quarters or if
the OMB and the CBO project real growth
of less than one percent for two consecutive quarters.

The OMB's more optimistic economic
assumptions and policy proposals
foresee a steadily declining federal
deficit trend between fiscal years ] 988
and 1993. Nevertheless, in two of the
next three years, projected deficits
slightly exceed the recently upwardrevised deficit targets initially established under the Gramm-RudmanHollings Act (GRH). Between 1991

Additional deficit-reduction legislation will be necessary if deficits are to
be gradually reduced to meet annual
deficit targets.

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and 1993, they exceed the initial GRH
targets by about $20 billion annually.
By ]993-the
year now targeted for a
balanced budget-the
federal budget
would still be in a slight deficit,
according to OMB projections.
The CBO's less optimistic scenario
projects a jagged downward path of
deficits between 1988 and 1993. The
projected deficit path is much higher
than that projected by OMB, and
increasingly exceeds the GRH deficit
targets, reaching $]34 billion in 1993.
This Economic Commentary
discusses the sources of federal budget
deficits, examines the OMB and CBO
forecasts, and suggests the need for
additional policy actions to achieve a

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declining trend of deficits into the
1990s. Under either scenario, it is
likely that at some point during the
next five years, automatic spending
cuts will be required under the current GRH Act.
• The Cyclically Adjusted
Federal Budget
U.S. Department of Commerce estimates suggest that much of the deficits
are associated with policy decisions,
although the federal budget is highly
sensitive to changes in economic
activity. To distinguish between these
deficit sources, analysts divide the
budget into cyclical and structural
components.'
The cyclical component of the budget measures the
response of outlays and revenues to
changes in economic conditions,
while the structural component measures discretionary fiscal policy and
other noncyclical components.
We can estimate what federal receipts
and outlays would be if the economy
were growing at a trend rate of gross
national product (GNP), free from
cyclical fluctuations; this calculation
yields the structural component of the
budget. The difference between the
actual and structural measures of receipts and outlays is the cyclical component. This disaggregation helps to
separate the interaction between the
federal budget and economic activity.
Currently, the U.S. Department of Commerce, Bureau of Economic Analysis
(BEA) publishes two alternative esti-

-

Despite a two-year deficit reduction

plan, government

projections

for the

five-year federal budget outlook still
show large deficits. Additional

legis-

lative actions will be necessary

if

federal budget deficits are to be
reduced

sufficiently to meet annual

deficit targets.

mates of the structural budget, also
called the cyclically adjusted budget.
The high-employment budget measures what the federal budget, on a
National Income and Product Account
(NIPA) basis, would be if the unemployment rate were 6 percent. The
second measure is an estimate of what
the NIPA-basis federal budget would
be if the economy were expanding
along a particular trend path-middleexpansion trend GNP in this case.s
Cyclically adjusted federal budget deficits, measured either way, increased
substantially during the 1980s and
account for the bulk of actual deficits
in recent years. The federal deficit was
reduced in 1987 on both an actual
and a cyclically adjusted basis; the
actual deficit is now between the two
BEA measures of the structural deficit.