Tricky Business

Where have you gone, Rosy Scenario? That disparaging nickname for an excessively optimistic budget forecast was as much a fixture of the 1980s as Ronald Reagan. For anybody following today's budget politics, however, it's hard not to conclude that, like the former President, Rosy has long since left town.

When Congressional Budget Office (CBO) director June E. O'Neill makes her yearly pilgrimage to Capitol Hill on Jan. 28 to discuss the CBO's annual economic and budget forecast, she'll probably face concerns about whether her agency is too gloomy these days, not too optimistic.

With a budget surplus just around the corner, lawmakers are tickled at the prospect of spending more money, cutting taxes, reducing the national debt--or some combination of the three. But legislators will have a hard time making plans for money that the CBO says the government doesn't have.

They have one big reason to be skeptical of what the CBO tells them about how much there is to spend: the unprecedented budget windfall of 1997. Last January, the CBO predicted a budget deficit for fiscal 1997 of $124 billion. But billions of dollars in revenues that no one had predicted began gushing into the Treasury Department's coffers. The CBO adjusted its deficit figures downward in the spring. Then--at a crucial moment in negotiations over last summer's balanced budget deal--it revised its numbers again, announcing that the deficit would fall by another $45 billion and predicting some $225 billion in extra tax revenues over five years. When the final numbers were tallied up in October, the year-end deficit turned out to be just $22 billion, $102 billion less than initially forecast.

Of course, the CBO was hardly alone in failing to foresee the rapid decline of the deficit. The White House Office of Management and Budget (OMB) was just as far off. And many private forecasters, who typically make general economic predictions but don't try to pinpoint the federal deficit, also missed the remarkable and continuing strength of the nation's economic boom.

The CBO took some heat for its rapidly changing estimates, but last year was by no means the first time the budget office figures had been off target. Eleven years ago this month, when then-CBO director Rudolph G. Penner testified before the Senate Budget Committee, Republican Pete V. Domenici of New Mexico made no bones about his unhappiness with the accuracy of the CBO's deficit forecasts. "Clearly, we need to do better," Domenici chided. The previous fall, the CBO had predicted a deficit of $151 billion, only to estimate several months later that the correct figure would be closer to $174 billion.

In those days, it was common for the CBO--along with OMB, its more politicized executive branch equivalent--to issue economic forecasts that proved to be too optimistic. In four of the five fiscal years preceding its 1987 prediction, the CBO's deficit outlook had also been too sunny. "We at CBO tend to err on the side of optimism," an agency staff member was quoted as saying at the time, in a National Journal article titled "CBO's Wishful Thinking."

Now, says CBO deputy director James L. Blum, "If anything, we're too cautious, we're too conservative." Blum, who has been with the office since it opened its doors in 1975, notes that the CBO has overestimated the deficit to some degree in 10 of the last 11 years.

The Grim Reaper

Like economic prognosticators everywhere, CBO economists are quick to point out that forecasting is the art of the possible. Forecasters must work with a huge number of variables to come up with estimates of everything from unemployment and interest rates to the nation's gross domestic product (GDP). They acknowledge that the $102 billion error in last year's deficit estimate was unusually large but say there's no sure way to prevent such errors in the future. "The unpredictable is the unpredictable," said O'Neill in a recent interview in her Ford House Office Building office. "A surplus in one year could very easily be followed by something else in the next year."

She points to numerous uncertainties: the impact of Asia's financial crisis on the U.S. economy; the potential for inflation to reemerge; the possibility that the United States has entered an unprecedented "golden age" of sustained economic growth; or the contrasting prospect that this will be a "turning-point year" in which growth declines sharply. "All of these things are possible--it would be hard to blame anyone for not knowing," O'Neill said. "This year is truly a very difficult year to be making either an economic forecast or certainly a budget forecast."

Although CBO directors often find themselves assailed by lawmakers who don't like the office's cost estimates for their pet proposals, O'Neill said she isn't feeling any particular pressure from Capitol Hill to make cheerier forecasting assumptions. "I think most Members realize that 1997 was an aberration. We couldn't be expected to know what nobody else foresaw," she said. Indeed, O'Neill believes the CBO's credibility is "quite high" these days--certainly in comparison to the early years of the office, which was created by the 1974 Congressional Budget Act. She headed the CBO's human resources cost estimates unit from 1976-79, after spending five years as a senior staff economist at the Council of Economic Advisers. "We were sort of the new guys on the block at the time," she said. "The budget committees were used to dealing with OMB."

Still, while CBO officials emphasize the inherent difficulties of forecasting, they're certainly aware that it doesn't look good to be as far off as they were last year--particularly when undue pessimism may force lawmakers to absorb fiscal pain they'd rather not endure. "We don't want to look like the Grim Reaper," said Rosemary D. Marcuss, the CBO's assistant director for tax analysis. She says it's "very painful" to miss the mark on projected tax receipts. "We'd rather be right sooner than later."

About 70 per cent of the CBO's overestimate of the deficit last year was due to its underestimate of tax revenues. By the end of last April, it became apparent not only that withheld taxes for the 1997 calendar year were coming in at higher-than-expected levels, but also that final income tax payments for the previous year were heftier than either Treasury or CBO models had predicted. "April is a tricky month," O'Neill said. "We had anticipated a good April, but as it turned out, April came in $25 billion higher than we had estimated." By the end of the fiscal year, revenues were more than $70 billion ahead of the CBO's--and OMB's--initial forecasts.

Revenue estimators have been scrambling for months to figure out where that extra money came from--and whether a repeat performance is likely this year. Marcuss said about $20 billion of the unexpected revenues came from a surge in capital gains realizations. Another $25 billion "is consistent with" wage and other personal income being above the levels that were predicted, leading to higher tax receipts from withholding, she said.

The origins of the rest of the money will remain somewhat mysterious until after June, when the CBO, Treasury and the Joint Committee on Taxation receive and begin analyzing detailed data files on 1996 tax returns. One possible explanation, Marcuss said, is that a disproportionate share of the extra personal income came from wage earners in high tax brackets. Another is that independent contractors and members of professional partnerships may have taken increasing advantage of Internal Revenue Service rules that allow them to delay tax payments--meaning that the revenue effects of a boom year in 1995 wouldn't be felt until April 1997.

However much progress they make toward figuring out what happened last year, the central question for Marcuss and other revenue estimators is whether the extraordinary revenue growth of recent years can continue. In normal years, growth in tax revenues tends to track growth in GDP fairly closely. "Yet for the last four years, tax growth has exceeded GDP growth," Marcuss said. "That can't happen forever."

If the good times do not keep on rolling, the chatter about the surplus that's dominating Washington budget circles may soon evaporate.

Getting Second-Guessed

On the spending side of the ledger, a portion of next year's federal outlays is reasonably predictable because the 1997 budget deal locked in maximum levels of annual discretionary spending. In addition, the agency's January forecast will spell out a set of key assumptions about the economy's future performance, from real growth and the level of inflation to unemployment and interest rates. The CBO's inflation estimates will in turn affect its spending estimates for veterans' benefits, Social Security and other programs that include cost-of-living increases indexed to inflation. Similarly, the CBO's assessment of which way interest rates are heading will determine how much it expects the government to spend on servicing the $5.4 trillion federal debt.

The CBO doesn't draw up its forecasts in a vacuum. To come up with a picture of future economic activity, staff economists rely in part on the Blue Chip Economic Indicators, a monthly survey of what 50 private forecasters are saying about economic trends. Then the agency runs its preliminary forecast past its panel of economic advisers. The 20-member advisory board includes two former CBO directors--Penner and Robert D. Reischauer--as well as a host of well-known economists, including Rudiger Dornbusch, Martin Feldstein, Lyle E. Gramley, N. Gregory Mankiw, Allan Meltzer, John Taylor, and James Tobin. After the panel's November meeting, which was also attended by a couple of private-sector forecasters and several House and Senate Budget Committee aides, the CBO made what Blum called "very minor changes" to its forecast.

In its midyear budget and economic forecast last September, the CBO estimated the fiscal 1998 deficit at $57 billion and the fiscal 1999 deficit at $52 billion. Given the continuing strong economy, Blum said, "there is an expectation that we'll be lowering those numbers when we come out in January" with the new projections--probably below the level of the $22 billion fiscal 1997 deficit. At the same time, that doesn't mean the budget office will be predicting a surplus as soon as some lawmakers might like to see one. The CBO's September report doesn't forecast a surplus until 2002, but Treasury receipts for the early months of fiscal 1998 have led some economists to predict a surplus this year. While he wouldn't go into any details of the CBO's forecast, which is completed in December for publication in January, Blum suggested the optimists shouldn't get too starry-eyed. "We will be projecting a significant slowdown in the rate of growth in revenues," he said, "and people are going to say, 'But why?' "

One good reason for the CBO to err on the side of caution, some suggest, is to keep its congressional clients happy. For all Members' eagerness to get their hands on a budget surplus, an overly rosy scenario from the CBO would bring the agency a lot more flak than it caught over last year's unduly gloomy prediction. CBO analysts "become more of a scapegoat if they overestimate the positive and underestimate the negative," said Mark A. Weinberger, an attorney with the law and lobbying firm Washington Counsel and the former chief of staff to the President's 1994 Bipartisan Commission on Entitlement and Tax Reform. "Congress never has a problem spending additional `found money.' They're always going to have a problem when they have to start making cuts from money they thought they had, that they end up not having."

The real problem with deficit forecasts made by both the CBO and OMB is that they tend to smooth out the economic cycle and fail to predict either recessions or years of high growth, says budget and tax expert C. Eugene Steuerle, a senior fellow at the Urban Institute. "Past economic cycles have not yielded obvious statistical patterns by which to portend the future," he wrote recently in his regular column for the trade weekly Tax Notes. Since forecasting turning points is so difficult as to be seldom accurate, "those in charge of projections would feel mighty silly every time a predicted year of recession went by without a downturn."

Indirect political pressures also contribute to the problem, in Steuerle's view. "To make matters worse, predicting the precise point of a downturn would also imply the failure of the executive branch or the Congress or the Federal Reserve Board at that point in time, but not others," he wrote. "Predicting a recession in the next year could be interpreted as implying a lack of faith by budget analysts in their own bosses."

No matter where the CBO pegs the economic and budget figures that kick off this year's taxing-and-spending debate, it's probably inevitable that the budget office will be second-guessed. The CBO hopes to forestall some of that by devoting a lot more ink than usual in its January report to explaining the nuts and bolts of its forecasting assumptions. "We pride ourselves on really exposing all of our work, not having any secrets, so Members and the general public can understand what our thinking is, what we did to arrive at the forecast," O'Neill said. If, say, the revenue forecast proves too low once April tax returns are in, anybody suspicious of a CBO-engineered "windfall" can look up exactly what the budget office was counting on for that period.

Whatever slings and arrows come the CBO's way this year, the analysts at the budget office seem prepared to face them with the equanimity for which economists are known. Said O'Neill: "The CBO motto is, On the one hand . . . on the other hand."