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entitled 'The Nations Long-Term Fiscal Outlook: August 2007 Update' 
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The Nation's Long-Term Fiscal Outlook: 

August 2007 Update: 

GAO: 

GAO-07-1261R: 

GAOs 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 long-term effects of fiscal policy. GAOs simulations were updated 
with the CBOs 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: 

* CBOs Budget and Economic Outlook (January), 
* Social Security and Medicare Trustees Reports (spring), and 
* CBOs 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 [hyperlink, 
http://www.gao.gov/special.pubs/longterm/]. For more information, 
contact Susan J. Irving at (202) 512-9142 or irvings@gao.gov. 

United States Government Accountability Office: 

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: 

[See PDF for image] 

Source: GAO's August 2007 analysis. 

[End of figure] 

GAO's updated long-term simulations illustrate that despite some 
improvement in the annual deficit estimate for this fiscal year, the 
long-term 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,[Footnote 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. 

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 Nation's 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: 

[See PDF for image] 

Source: GAO's August 2007 analysis. 

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. 

[End of figure] 

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

[See PDF for image] 

Source: GAO's August 2007 analysis. 

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. 

[End of figure] 

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.[Footnote 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.[Footnote 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.[Footnote 4] As in Baseline Extended, 
after the first 10 years the Alternative scenario uses the Trustees' 
intermediate estimates for Social Security. 

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.) 

Table 1: Federal Fiscal Gap 2007-2081: 

Baseline; 
Fiscal gap: Trillions of 2007 dollars: $31.1; 
Fiscal gap: Share of GDP: 4.3%; 
Change required to close gap: Percentage increase in revenue: 22.9%; 
Change required to close gap: Percentage increase in individual income 
taxes: 50.6%; 
Change required to close gap: Percentage decrease in noninterest 
spending: 23.6%. 

Alternative; 
Fiscal gap: Trillions of 2007 dollars: $54.3; 
Fiscal gap: Share of GDP: 7.5%; 
Change required to close gap: Percentage increase in revenue: 39.9%; 
Change required to close gap: Percentage increase in individual income 
taxes: 88.2%; 
Change required to close gap: Percentage decrease in noninterest 
spending: 41.0%. 

Source: GAO analysis. 

[End of table] 

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.[Footnote 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.[Footnote 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. 

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

[See PDF for image] 

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. 

[End of figure] 

Rapidly rising health care costs are not simply a federal budget 
problem; they are our nation's number one fiscal challenge. Growth in 
health-related 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.[Footnote 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. 

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

Model inputs: Social Security spending (OASDI); 
Baseline Extended: CBO's August 2007 baseline through 2017; 
thereafter based on 2007 Social Security Trustees' intermediate 
projections; 
Alternative Simulation: Same as Baseline Extended. 

Model inputs: Medicare spending; 
Baseline Extended: CBO's August 2007 baseline through 2017; thereafter 
2007 Medicare Trustees' intermediate projections prepared by CMS that 
assume per enrollee Medicare spending grows on average 1 percent faster 
than GDP per capita over the long term; 
Alternative Simulation: CMS's intermediate projections adjusted for 
alternative assumption of 0 percent physician payment updates in the 
first 10 years. 

Model inputs: Medicaid spending; 
Baseline Extended: CBO's August 2007 baseline through 2017; 
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; 
Alternative Simulation: Same as Baseline Extended. 

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

Model inputs: Discretionary spending; 
Baseline Extended: CBO's August 2007 baseline through 2017; 
thereafter increases at the rate of economic growth; 
Alternative Simulation: Increases at the rate of economic growth 
starting after 2007. 

Source: GAO. 

[End of table] 

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.[Footnote 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.[Footnote 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. 

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: 

[hyperlink, 
http://www.gao.gov/special.pubs/longterm/longtermproducts.html]. 

Footnotes: 

[1] Under 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. 

[2] Discretionary 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. 

[3] The 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." 

[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 [hyperlink, 
http://www.cms.hhs.gov/ReportsTrustFunds/05_alternativePartB.asp]. 

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

[6] In 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. 

[7] For 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). 

[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. 

[9] The CBO report can be accessed at [hyperlink, http://www.cbo.gov]. 

[10] Pub. L. 110-28. 

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